A Concise Introduction to Funding Merger and Acquisition (M&A) Deals for Entrepreneurs
M&A is not the only business growth option. Companies can grow organically in various ways, including by investing in launching new products or services, increasing the workforce, expanding markets, and reaching new customers. However, M&A provides a means to rapid growth, a prospect that is not just exciting, but also inspiring for investors. Besides rapid growth, M&A can bring many synergistic benefits, such as reduced competition, increased market share, and economies of scale. However, the acquisition of another business, a major business decision, needs sound financial resources.
Though sometimes you could be preoccupied with identifying the right target and valuation, finding the most appropriate financing structure is perhaps the most crucial aspect of an acquisition process. Often, the acquisition's success, which is accretive, depends upon the future growth of the acquired company.
Acquisition finance usually comprises various sources of funding that are utilized to achieve a merger or acquisition. Unlike most other purchases, acquisition finance structures often require various combinations, making it a complex process that demands thorough planning and a comprehensive understanding of the various funding sources and their implications. This complexity underscores the need for a comprehensive understanding of the various funding sources and their implications, which is crucial for a successful acquisition.
Acquisition financing, with its various financing alternatives, is typically arranged from multiple sources. The challenge lies in getting the appropriate mix of financing that offers the lowest cost of capital and aids the future growth of the combined business. This strategic decision-making, where you are in control, is a key aspect of successful acquisition financing.
Striking an optimum balance between the acquiring company's liquidity needs and the funding needed for the acquired business's potential growth is a crucial consideration. This balance, which ensures that both the acquiring and the acquired businesses receive the necessary liquidity to fund the future development of the combined business, is a weighty decision that can significantly impact the acquisition's success.
In practice, a combination of financing methods would typically be used. To understand the available options, let's examine the types of M&A finance frequently utilized.
CASH
All cash acquisition deals are structured, so shares are swapped for cash consideration. Provided the acquiring company has the required cash resources, cash as a payment method is the most uncomplicated and straightforward consideration settlement for business acquisitions.
With an all-cash acquisition deal, the acquirer’s equity on the balance sheet remains the same. The acquiring company often reserves a portion of the cash payment, sometimes called a holdback. The release of the holdback is usually attached to the satisfaction of terms of representations and warranties, i.e., when the target company's assurances, promises, and commitments are satisfactorily met.
Acquisition deals are structured as all-cash, typically when the company being acquired is smaller and has lower cash reserves than the acquirer.
DEBT
Debt financing is among the most inexpensive and favored methods of financing M&A deals. Most acquiring businesses either cannot pay out cash or have limitations on their balance sheets that won't allow it. A typical provider of debt finance for larger and stable businesses is banks. When providing acquisition finance, banks analyze the target company’s cash flow, profit margin, and liabilities and assess the acquiring company's and the target's financial health.
Bank financing typically comes in the form of asset-backed financing, where banks lend funds based on collateralized assets of the target company. These collaterals could include liens on fixed assets, receivables, intellectual property, and inventory. Debt financing also commonly offers tax advantages.
SENIOR DEBT
Senior Debt is a debt obligation with a superior or first claim on a business’s cashflows. Strong collaterals typically back senior debt; therefore, by definition, it is more secure than any other form of debt, e.g., subordinated debt. If the company fails to fulfill the repayment obligations, the lender has a first lien or claim on the collateralized assets, including the company's property, plant, or equipment.
Utilizing debt financing, the acquirer can acquire a target company without necessarily diluting their equity. If the acquirer or the target has positive cash flow or is likely to have positive cash flow in the short run, debt can be a significant element of the financing structure. Debt financing for acquisitions is typically structured as a term loan, i.e., the borrower is required to start repayment to the lender after a set period of time. For smaller businesses, approaching alternative commercial lenders is usually a more viable option than traditional banks. Alternatively, lenders tend to be more flexible in the transaction structure and require fewer covenants.
Mezzanine or Quasi Debt
Mezzanine finance is a form of subordinated debt that fills the gap between senior debt and equity. Though similar to other forms of debt financing, since Mezzanine finance is a subordinated form of debt, it comes with much higher interest rates than senior debt. Many Mezzanine lenders would also require an equity component to increase their returns, whereas, other than as an unsecured loan, Mezzanine finance is structured as preferred stock. When structured as preferred stock, lenders have an option to convert to equity.
Mezzanine financing suits target companies with a strong balance sheet and steady profitability. It could be a vital component of the deal structure to acquire target companies with high cash flows, avoiding giving the lender a senior position.
Stock Swap
If the acquirer has publicly traded stocks, the target company’s shares can be swapped against the acquirer’s stock. This exchange of shares is relatively straightforward, i.e., the acquirer gives the target a certain number of shares in the acquirer’s company as payment for the acquisition.
If the acquirer company is not publicly traded, by default, it becomes difficult for the sellers to liquidate the shares they received in consideration. They may also get exposed to a sizeable tax liability, with little scope to liquidate their shares. This is known as Phantom tax, which is tax liability without the receipt of any cash consideration.
Stock swaps also occur in private companies when the target company's owners want to retain a portion of the combined company’s stake. This happens more often when the sellers must remain actively involved in managing the business operation. Companies acquired by financial rather than strategic buyers typically continue to rely on the expertise of the selling owners of the acquired business to manage the business. Stock payment is also instrumental in incentivizing the retained employees of the acquired company. Typically, an employee will receive stock options at certain milestones after the acquisition.
For sellers of a company with a share swap consideration, careful valuation of the acquirer is fundamental. There are various stock valuation methods for private businesses, such as Comparative Company Analysis, DCF Valuation Analysis, and Comparative Transaction Valuation Analysis.
Leveraged Buyout
A leveraged buyout or LBO is one of the most popular M&A finance structure. It is essentially a mix of both equity and debt financing, where the assets of the acquirer and the acquired company are used as secured collateral to raise debt finance for the transaction.
Since LBO could be a complex structure, taking a somewhat deeper dive makes sense to understand it better. A leveraged buyout (LBO) is a transaction where an acquirer acquires a company using debt as the primary source of consideration. Private equity (PE) firms typically borrow as much as they can from various lenders, usually up to 70% or 80% of the purchase price, and fund the balance with their own equity.
A PE firm uses leverage (debt) to maximize its expected returns. Since only a little of their money is used for the transaction, the PE firm aims to achieve a significant ROE and IRR. While leverage increases equity returns, the drawback is that it also increases risk. By strapping multiple tranches of debt onto an operating company, the PE firm significantly increases the transaction risk, which is why LBOs typically pick stable companies.
Generally speaking, LBO transactions are more suitable for acquiring mature companies with a solid asset base and generating consistent and robust operating cashflows with little reinvestment or capital needs. This steady cash flow enables the company to service its debt efficiently.
Public Offering
A public offering is not much different from a share swap arrangement in the sense that for the acquired company, the consideration is in the form of stock. The main difference is that the public offering provides liquidity to both companies. i.e., once the transaction is through and trading resumes, the stockholders of both companies can liquidate their stocks by selling in the public market.
Usually, the agreement has a limiting clause where the acquired company’s sellers must hold their shares. This holding period could typically range from six months to two years. This period, however, could vary based on numerous factors, including the number of shares, the amount of cash paid upfront, and any other types of payment involved. Broadly speaking, the more significant the portion of consideration paid in stock, the shorter the time for the sellers to hold the shares.
Earnout/Revenue Share/Royalty
Sometimes, as a risk allocation mechanism, the purchase price of the target is made contingent on its future performance. The acquirer pays most of the purchase price upfront when closing the deal, and the remainder is contingent on the performance of the target. This is called an Earnout.
This is typically deployed when there is a disagreement on the target’s valuation. Similar to any sales and purchase transaction for which a publicly observable price is unavailable, disagreements about a company’s valuation in any M&A deal are widespread. The seller always wants the highest possible price and may believe the business is worth more than the acquirer thinks. Conversely, the acquirer could have concerns about the target company’s growth prospects or retention of key employees or major customers. A possible solution is incorporating earnout in the deal structure, which helps bridge the gap between an optimistic seller and a skeptical buyer.
For example, if the seller thinks the business is worth $10 million and the acquirer believes it is worth $7 million, they can agree on an initial price of $7 million. The remaining $3 million can form part of the earnout. The $3 million may be contingent on factors such as revenue, EBITDA margins, earnings per share, or retention of key employees.
In practice, earn-out and revenue share structures are usually a part of a larger consideration package rather than the sole compensation means for an acquisition transaction.
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✅ Strategic Finance Consultant ✅ ACS SYNERGY ✅ At ACS, we help growth seeking businesses with Finance Transformation, Accounting & Finance Operations, FP&A, Strategy, Valuation, & M&A 🌐 acssynergy.com
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