Different options for funding acquisitions
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Acquisition finance refers to the different sources of capital that are used to fund a merger or acquisition. This is usually a complex mission requiring thorough planning, since acquisition finance structures often require a lot of variations and combinations, unlike most other purchases.
Moreover, acquisition financing is seldom procured from one source. With various alternatives available to finance an acquisition, the challenging part is getting the appropriate mix of financing that offers the lowest cost of capital.
Companies can grow in various ways, such as by increasing their workforce, launching new services or products, expanding marketing, or reaching new customers. However, the abovementioned growth methods are often less exciting to investors.
Apart from rapid growth, synergistic acquisitions can offer other significant benefits such as economies of scale and increased market share. However, the acquisition of another company is a major decision that needs sound financial resources.
Types of Acquisition Finance
Let’s look at some of the popular acquisition financing structures that are available:
1. Stock Swap Transaction
When companies own stock that is traded publicly, the acquirer can exchange its stock with the target company. Stock swaps are common for private companies, whereby the owner of the target company wants to retain a portion of the stake in the combined company since they will likely remain actively involved in the operation of the business. The acquiring company often relies on the proficiency of the owner of the target firm to operate effectively.
Careful stock valuation is important when considering a stock swap for private companies. There are various stock valuation methodologies used by proficient merchant bankers, such as Comparative Company Analysis, DCF Valuation Analysis, and Comparative Transaction Valuation Analysis.
2. Acquisition through Equity
In acquisition finance, equity is the most expensive form of capital.Equity financing is often desirable by acquiring companies that target companies that operate in unstable industries and with unsteady free cash flows. Acquisition financing is also more flexible, due to the absence of commitment for periodic payments.
3. Cash Acquisition
In an all-cash acquisition deal, shares are usually swapped for cash. The equity portion of the balance sheet of the parent company remains the same. Cash transactions during an acquisition often happen in situations where the company being acquired is smaller and with lower cash reserves than the acquirer.
4. Acquisition through Debt
Debt financing is one of the favorite ways of financing acquisitions. Most companies either lack the capacity to pay out of cash or their balance sheets won’t allow it. Debt is also considered the most inexpensive method of financing an acquisition and comes in numerous forms.
When providing funds for an acquisition, the bank usually analyzes the target company’s projected cash flow, profit margins, and liabilities. Analysis of the financial health of both the acquiring company and the target company is a prep course.
Asset-backed financing is a method of debt financing where banks can lend funds based on the collateral offered by the target company. Collateral may include fixed assets, receivables, intellectual property, and inventory. Debt financing also commonly offers tax advantages.
4. Acquisition through Mezzanine or Quasi Debt
Mezzanine or quasi-debt is an integrated form of financing that includes both equity and debt features. It usually comes with the option of being converted to equity. Mezzanine financing is suitable for target companies with a strong balance sheet and steady profitability. Flexibility makes mezzanine financing appealing.
5. Leveraged Buyout
A leveraged buyout is a unique mix of both equity and debt that is used to finance an acquisition. It is one of the most popular acquisition finance structures. In an LBO, the assets of both the acquiring company and target company are considered as secured collateral.
Companies that involve themselves in LBO transactions are usually mature, possess a strong asset base, generate consistent and strong operating cash flows, and have few capital requirements. The principal idea behind a leveraged buyout is to compel companies to yield steady free cash flows capable of financing the debt taken on to acquire them.
6. Seller’s Financing / Vendor Take-Back Loan (VTB)
Seller’s financing is where the acquiring company’s source of acquisition financing is internal, within the deal, coming from the target company. Buyers usually resort to the seller’s financing method when obtaining capital from outside is difficult. The financing may be through delayed payments, seller note, earn-outs, etc.
Modeling Acquisition Financing
When building an M&A model in Excel it’s important to have a clearly laid out set of assumptions about the transaction and the sources of cash (financing) that will be used to fund the purchase of a business or an asset. Below is a screenshot of the sources and uses of cash in an M&A model.
To learn more, check out CFI’s M&A Modeling Course.
Key Takeaways
There are many different ways to acquire financing for an acquisition. The acquiring company can pay the target company through methods such as cash, stock swaps, debt, mezzanine financing, equity, leveraged buyout, or seller’s financing. What is important is how optimal the financing is, and how well it aligns with the goals and nature of the business deal. It is vital to plan the acquisition financing structure to fit the circ*mstances.
Moreover, the acquisition finance structure must come with enough flexibility to be altered to fit different contexts. It can be realized only if the adaptability, as well as the cost of the acquisition financing structure, is grounded in the cash-flow generating capacity of the organization and the strength of its asset base.
Even though debt is quite inexpensive relative to equity, the interest it requires can inhibit the flexibility of an organization. Huge volumes of debt are more appropriate for companies that are mature, with steady cash flows, and that do not require large capital expenditures. Firms that compete in unstable markets, want to grow fast, and also need huge amounts of capital to grow are most likely to need equity financing.
However, it is important to note that for large acquisitions, acquisition finance structures may combine more than two financing methods.
Additional Resources
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:
