Funding acquisitions with private debt funding will often reduce cost of capital and equity dilution. There is a plethora of options to choose from, but gaining the most optimal structure and terms for your business can be challenging. It certainly helps if you know where to start your search search, and if you don’t, talk to someone who does.
So, what are the financing options for M&A?
Private debt
This loan type evaluates whether your future cash flows can cover the debt load. The main benefit of a private business acquisition loan is that it is much more flexible and can be executed faster compared to other sources of financing. Though interest rates may be higher, it is still low in the absolute sense.
Bank loan
This is typically the first port of call for most businesses, but also the most difficult, especially for fast growing small-mid size technology companies. As mentioned earlier, the modern technology business model (i.e. negative cashflows and few tangible assets) does not go well with traditional bank underwriting models and banking ratios.
Further, stricter lending requirements post the Global Financial Crisis in 2008 has meant that bank lending is a lot more conservative today. Business acquisition loans are made to larger and not smaller firms, and dealing with banks can be a long, drawn-out process with very strict terms and structure.
Company equity
Equity can either be given to the seller or to a third-party financier (e.g. private equity, family office etc.) in exchange for financing.
It is a very expensive option in the long-term but can be worthwhile if you wish to retain the seller’s expertise, or if a third-party financier can provide certain expertise which you do not have.
This is also an attractive option for publicly listed technology companies which enjoy high valuations and has been commonly used in 2020. However, it may not be as easily used for private companies.
Company funds
A company’s cash is typically used to finance part of a transaction, but it is very rare to finance an entire deal with it. Firstly, the buying price is typically a multiple of a company’s cashflow, and few companies will have years of profits kept as cash, unless the target company is a much smaller one.
Secondly, using too much cash will pose a liquidity risk, especially as capital is needed for post-merger integration.
Asset backed loan
These loans are made on the basis that in the worst-case scenario, the company pay off the loan even if its assets are liquidated. However, as mentioned, asset backed loans are typically not viable for fast growing, small & mid-sized technology companies.
Seller financing
This type of loan involves a smaller upfront payment and a promissory note for the remaining to be repaid over the next 3-5 years. As this is advantageous to the buyer, not many sellers may accept it.
Earnout
An earnout structure involves paying the seller a smaller upfront payment and a % of reviews in the following years post acquisition. This can be used in situations when the seller wants to retire or exit and wants to pull forward the medium-term revenue to the present, but still retain some longer-term upside.
Joint venture (JV)
You can also enter an acquisition with a JV partner who has the financial muscle power, but this introduces a lot more complexities in terms of operations.
Evaluation of the various financing tools for business acquisitions
In conclusion, we can see that private debt makes the most sense for fast growing, small-mid sized technology companies today as it is much more flexible, takes less time to secure and is cost effective.
