In a recent article, I shared the 4 “must-have” things you need to sell your business for a top dollar. If you missed this article and want some easy tips on how to optimize the saleable value of your business, they can be accessed through the Compass Wealth blog by clicking here.
Now if you’re on the other side of the business transaction, you’re likely looking for the best financing options available to you that can adequately fit within your overall business objectives. This can be both arduous and challenging and depending on which financing option you choose, this could most certainly impact the overall negotiation and asking price of a potential vendor.
Your strategic business plan had led your company to enter into the mergers and acquisition market to help you find a business to acquire that fits well with your strategic objectives. Now that you’ve found the right fit, you understand how critical it is to find the right financing arrangement with the right capital structure to ensure a smooth transition and position your business for more growth in the future. You know that there are several different options and ways to structure a financing arrangement but you’re not quite sure where to start.
DETERMINING THE VALUE OF THE ACQUISITION BUSINESS
Before considering any financing arrangements, you will first need to understand the value that you’ll be receiving from the target business you’re about to purchase. This is a crucial first step you must take in setting any acquisition up for success. Typically speaking, the value of a company is usually measured by its earnings before interest, taxes, depreciation and amortization (known as EBITDA). However, you may consider other factors outside of the numbers and these factors will likely have more to do with the strategic fit that the target business offers to your business growth objectives.
Now that you’ve assessed the value of the acquisition business, here are the top 4 options to consider when financing your acquisition.
#1 – SENIOR DEBT
A senior lender providing financing to you for your business acquisition will secure the loan with assets of the target company. In practice, this amount may not be fully secured by specific assets. However, it is considered “senior debt” because the lender positions themselves to have first claim against assets in the event of a default situation.
Commonly, a senior lender exemplifies the most restrictive repayment terms compared to other financing sources. If you require loan payment flexibility, this financing arrangement may not be the most suitable for you. Further, the senior lender usually assesses the assets and makes a decision on a multiple of EBITBA that it would be willing to lend.
#2 - EQUITY
With an equity investment, a buyer will typically contribute a fixed percentage of the purchase price and the funds can be sourced from a variety of places. Examples of this could be a third-party investor who subsequently becomes an owner of the combined company or the use of surplus cash that the acquiring company has on their balance sheet.
In an acquisition deal, utilizing equity is usually a show of commitment to the long-term success of the acquisition. By utilizing physical equity over borrowed money, it also demonstrates a sense of seriousness and confidence.
#3 - VENDOR DEBT
It’s not uncommon in many acquisitions for the seller to help finance the deal with a vendor take-back provision. This can be done with a vendor note or could come in the form of a provision within the asset purchase agreement. In this financing example, the seller agrees to the terms of how much interest they are to be paid and at what intervals interest and principal payments are to be made.
Vendor debt can be structured in many forms. A common example would be what’s called an “earn out”, which is based on the performance of the company and uses the company’s EBITDA (increasing or decreasing) as the underlying repayment variable.
What’s great about an “earn out” is it keeps the seller self-interested and motivated in the success of the company after the deal is completed. This is because their ability to get paid for the sale could hinge on the buyer’s success. This can sometimes enhance the success of an acquisition and lead to a win-win deal if both parties still have skin in the game.
#4 - MEZZANINE FINANCING
Often times, after you’ve collected financing from all other sources, there may be a gap to meet the full purchase price of the target company. Or perhaps you couldn’t qualify for financing from other traditional sources at all. Maybe the traditional financing terms didn’t fit with your needs. Regardless of the circumstances, mezzanine financing is designed to help fulfil this gap.
Due to its subordinated position in the capital structure (compared to senior debt), it represents a higher degree of risk to the lender. As a result of this, it is common that the lending terms will reflect this increased level of risk to the lender. However, what’s great about mezzanine debt is that it often times represents more flexibility than senior loans.
For example, in exchange for a lower interest rate on the debt itself, the lender may be willing to accept an equity stake in the business. This kind of flexibility might be exactly what you need or want, depending on the details of your acquisition. So don’t be afraid to think outside the box when it comes to your financing needs. There may be some creative ways to borrow money on terms that work best for you.
If you’re in the market to finance an upcoming business acquisition, you can see that there are several different options to help you meet your growth objectives. Don’t be afraid to think outside the box. Depending on your objectives and the level of risk that you are willing to take on, your financing arrangements can take on many different forms.
Make sure to speak to a financial professional who can help you make sense of all the various options available to you and which option is best suited to your circumstances. Choosing the right financing arrangements can be the difference between a successful and unsuccessful acquisition.
The following was authored by Isaac Musial, Partner & Wealth Advisor at Compass Wealth Partners in Oshawa (Durham Region). The foregoing is for general information purposes only and is not intended to provide specific personalized advice including without limitation, financial, legal, accounting or tax advice.