Acquiring other companies is commonplace for businesses looking to boost operation capacity and profit margins. In order to do so, the acquiring company needs to secure the necessary capital — i.e., engage in acquisition financing. There are many different ways to accomplish this, and many of the tactics used depend on the size and value of the institutions involved in addition to other factors.
Companies investigating how to finance an acquisition can go the conventional route and apply for a loan through a bank, but there are instances when a company won’t meet a bank’s requirements. A bank, for instance, might only approve a loan if the company that is poised to be acquired is profitable, asset-rich, and offers a steady revenue stream. Alternative lenders like business development companies (BDCs) are a viable option for companies facing such circumstances.
Take tech companies, for example. They might not have as many tangible assets as other enterprises but nevertheless boast the sort of recurring revenue that makes them appealing to a BDC. Another example would be healthcare companies. While their complex reimbursement models might give traditional lenders pause, alternative lenders are flexible enough to meet their needs.
Companies in various sectors, from energy to real estate, choose to go the alternative lending route for this very reason. For those wondering how to finance an acquisition — particularly those whose needs cannot be met by banks — alternative lenders may be the best option.
What Is Acquisition Financing?
Acquisition finance refers to the different sources of capital used to fund a merger or acquisition. Unlike some other transactions, this often involves using different types of financing. Where alternative lenders are concerned, this most often involves equity financing, debt financing and/or mezzanine financing.
With various alternatives available to finance an acquisition, the challenging part is obtaining the appropriate mix of financing that offers the lowest cost of capital.
Companies looking to acquire other enterprises would do well to consider how well the financing suits the company’s goals; flexibility is also key, as companies should feel comfortable and confident that their financing plans are adaptable to different circumstances and contexts as necessary.
At its simplest definition, acquisition financing is capital obtained so that a company can buy another business. Acquisition financing provides immediate funding for application to a business transaction, whether through debt, equity, or other hybrid practices. Financing options tend to vary depending on a number of factors including company value, credit history, and the state of the markets.
While pursuing financing for these initiatives, companies are focused on identifying and executing the most efficient, effective, and optimal acquisition finance structure.
Different Types
There are several different ways companies can obtain the funding to buy other businesses, including the pursuit of a traditional loan or line of credit, a Small Business Administration (SBA) loan, a stock swap or even by completing a cash transaction.
However, here are some of the most common types of acquisition financing through alternative lenders:
1. Acquisition Through Equity
In acquisition finance, equity is the most expensive form of capital. Ultimately, selling company shares entails sharing profits for an undefined period of time; this contrasts with the nature of a loan, which is finite in terms of time frames and interest rates. Additionally, debt is often considered a less expensive form of capital because interest paid on loans is tax-deductible.
However, there are circumstances in which equity financing could be suitable. When looking to acquire a business, companies may choose equity if the target company is in a volatile industry or does not have a steady cash flow. Because equity financing does not have payment deadlines or expectations, it is also more flexible than the alternatives.
When it comes to acquisition through equity financing, investors will, in turn, assume some ownership of the target company, which ultimately relinquishes some control over its operations.
2. Acquisition Through Debt
Compared to equity, debt is regarded as a cheaper way to obtain financing for acquisition. Very few companies can pay to acquire another business with cash, and even when they are able, most refrain from doing so for the sake of long-term budget concerns. That’s where debt financing comes into play.
Acquisition through debt can include senior debt, asset-backed financing, or subordinated debt, all of which are considered inexpensive and advantageous when it comes to tax purposes.
To qualify for debt financing, companies should expect a thorough analysis of their finances; acquisition financing lenders will assess the acquiring and target companies for projected cash flow, profit margins, and liabilities.
Deciding between debt or equity financing is a common conundrum for acquiring businesses. There are a few situations in which debt financing would be preferable. Acquiring companies that are seeking smaller amounts of funding and hope to obtain this funding more quickly will often pursue debt financing as opposed to equity funding. Businesses that want to retain control and remain local are also likely to seek debt-based acquisition financing.
3. Acquisition Through Mezzanine or Quasi Debt
Acquiring companies might consider mezzanine financing if the target company boasts a history of steady profitability as well as a strong balance sheet. This type of acquisition funding features aspects of both equity and debt financing; mezzanine funding can also often be converted to equity if that is desired.
Acquiring companies might seek mezzanine financing over debt financing for a few different reasons, as there are several advantages to this kind of financing. Interest on mezzanine debt is tax-deductible, which is a compelling feature. Additionally, interest can be incorporated into the loan, and interest payments can be deferred if necessary.
4. Leveraged Buyout
As one of the more popular types of acquisition funding, a leveraged buyout (LBO), like mezzanine financing, combines debt and equity. In these situations, collateral is secured with assets from both the target company and the acquiring company. LBO financing is often used with mature companies that have strong and steady cash flows.
One recent example of the melded assets as collateral can be seen in the 2016 acquisition of Krispy Kreme Doughnuts by JAB Beech. This acquisition was supported by the British investment bank Barclays, which tacked a 0.5 percent interest rate on top of the $350 million loan and $150 million revolving credit to sell the target company’s debt.
Acquiring companies should keep in mind that LBO financing is high-risk and high-reward. By using leverage (debt) on the target company’s assets, an acquiring company can generate enough cash flow to account for the debt generated by the acquisition process. Taking proper precautions and ensuring that this is the optimal financing option can help companies from acquiring more debt than they can afford.
The 1980s witnessed plenty of LBOs as a result of junk-bond mania, and during the mid-2000s, the influence of private equity firms also contributed to more LBOs. Like cash transactions, LBOs are certainly less common than they previously were, but they are not obsolete. Look to Dell’s $60 billion acquisition of EMC, a cloud computing products and services provider, as an example.
5. Earnout
Considered to be one of the more creative ways to finance an acquisition, an earnout is suited for target companies that are flexible and looking for an exit. This might occur when a business owner is looking to retire, for example, and wants an opportunity to generate some short-term returns in the process.
In short, an earnout can occur when the target company is willing to participate in a deferred purchase price, often higher than a cash deal, which takes into account the company’s future success. Much of the time, this arrangement entails a percentage of the company’s future earnings to be paid to the seller.
Advantages of Acquisition Financing
As far as growth strategies go, acquisition financing is one of the most popular and effective tactics to implement. It is remarkably time-efficient, providing companies the opportunity to acquire resources or competencies they might otherwise go without. Through acquisition financing, companies can also increase market presence and gain a competitive advantage.
By acquiring another business, companies can more easily navigate new and different markets through the acquisition of new resources and capabilities. Acquisition financing can help companies meet shareholder expectations for growth and returns, and in a similar fashion, acquisition financing tends to lead to financial gain, as well. Companies looking to expand, grow, or boost returns may benefit from considering this course of action.
What To Look for in a Lender
Regardless of the method chosen to pursue acquisition funding, it is important to know what to look for in an acquisition finance lender. Reputation should be a key factor. Seek out a lender with an established track record of success and satisfaction. One who is accessible and communicative will be beneficial throughout the acquisition financing process. It is also helpful to select a lender who makes the application process simple.
Other key features include efficiency and flexibility — i.e., those lenders who can provide variable acquisition finance structures. Companies should also seek acquisition financing lenders who can meet their expectations, cooperate with any limitations, and provide the right information in a clear, effective manner.
It is important to do sufficient research when searching for a lender; companies must do their due diligence if they want to secure one that will suit their needs, as winding up with the wrong lender — particularly one that doesn’t offer sufficient flexibility — can be a recipe for failure.
Conclusion
When looking for company growth strategies, consider acquisition financing as a solid tactic to implement. There are numerous benefits to this strategy, including access to new resources and different markets as well as financial growth opportunities, and depending on company sizes and goals, there are various ways to secure acquisition financing. Be sure to consider what lenders have to offer, and how resourceful they can be in meeting your needs.
With acquisition financing as well as other financial services, Saratoga Investment Corp. brings numerous benefits to the table: non-dilutive capital, with low costs and no desire to take a controlling interest in a target company. We also offer flexible financing options and a speedy application process.
Reviewing Saratoga’s investment profile is a good place to start, for those seeking a flexible, comprehensive approach to acquisition financing. That will best determine if you are a strong fit.