Business acquisitions are a chance to grow your business and tighten your grip on your market. Whilst most speak of choosing targets, negotiation and conducting due diligence, one subject you can’t ignore is money.
This guide discusses how to finance your business acquisition and how it works.
What is the most common way to finance an acquisition?
Funding an acquisition is easier said than done, but UK SMEs find themselves in better positions than before the pandemic. According to Shawbrook Bank, the total value of UK SME cash reserves rose from £66 billion to £329 billion over the last five years as firms looked to consolidate.
Even with these dormant cash reserves, most SMEs and even larger companies cannot finance an acquisition by tapping this resource exclusively.
Instead, the two most common ways firms finance business acquisitions are:
Debt Finance – This is a term for borrowing money via business loans and other sources to fund an acquisition.
Equity Finance – In contrast, public limited companies often give up equity to get the required funds, but private companies can do the same with their own shares. This involves issuing new shares, but it also comes with the consequence of diluting the power of existing shareholders.
In short, these are the two categories you can use to finance your acquisition. Speak to a corporate financial advisor to support you in making the right decision for your organisation.
How does acquisition financing work?
Acquisition financing works similarly to other types of financing. All you have to do is find a willing lender, present a proposal, negotiate the terms of your loan and get approved; but, there’s more to it than that.
Believe it or not, acquisition financing rarely involves seven and eight-figure sums.
For example, Pfizer’s proposed $43 billion acquisition of Seagen is perhaps the largest of 2023 thus far, but most deals never reach this amount. Most big-money deals are driven by mega-corporations.
Even a company like Pfizer will use the exact mechanisms as an SME looking to complete an acquisition but on a larger scale. For example, the pharmaceutical giant has used a $31 billion debt offering to fund the deal, which is essentially a corporate bond promising to repay investors at regular intervals.
In other words, business owners can leverage the same mechanisms as they would for financing any other type of investment, including purchasing new business units, expanding their workforce, or funding research and development.
The most crucial decision is to choose the correct financing method and get approved. Some of the factors that go into making this decision include:
- Size of the acquisition
- The financial health of your company
- Interest rates
- Stakeholder risk appetite
- Financial implications
What is a business acquisition loan?
A business acquisition loan is an umbrella term for different types of loans to fund a business acquisition. In other words, with UK businesses expected to borrow £513 billion in 2023, a considerable part of this figure will consist of acquisition financing.
Some of the features of these loans include:
- Loans are usually capped at 90% of the acquired business’s value.
- Most loans are time-limited, meaning you must use the loan within a specific time frame.
- These are loans secured against assets.
- Some providers may allow you to roll up the interest and pay it after your loan period.
What are the types of business acquisition loans?
As mentioned, business acquisition loans point toward several types of loans. No loan is better than the other. Your decision must be tailored to your specific circumstances.
So, what are the main types of loans?
Secured Term Loans – Known as senior debt, lenders provide an interest-only payment term with rates that may be fixed or variable. Your business will need suitable assets to secure this type of loan.
Working Capital Loan – Also called a cash flow loan, lenders provide you with a cash advance based on your future cash flow.
Mezzanine Debt – This type of loan is standard, but if the borrower cannot repay, it’s converted into equity in your business. Due to the high-risk nature of mezzanine debt, interest rates tend to be higher.
Asset–Based Lending – Under an asset-based lending scheme, you can use the assets of the business you’re about to acquire to act as security for the loan. Lending amounts range from 70-90% of the new business’s total asset value.
Private Debt – Taking on private debt means approaching a company or investor instead of a bank. Typically, this is the method of last resort for businesses that cannot get approved elsewhere, making it the most expensive option.
What can I use a business acquisition loan for?
Business acquisition loans are designed for a specific purpose, so there are limits on what you can do with the money.
Some of the expenses you can cover with your acquisition loan include:
- Purchase price
- Professional advisor fees
- Legal costs
- Restructuring expenses
- Property costs
What are the different types of acquisition financing?
Acquisition financing can take many forms. If you’re wondering the best way to purchase a business, here are some options available to you.
The first and simplest option is to use cash. Although many companies avoid draining their internal cash reserves, it can be an option if you’re determined to remain debt-free.
For example, Brazilian cosmetics company Natura & Co. purchased The Body Shop in 2017 for one billion Euros. Despite the high figure, Natura & Co. funded the entire deal through its cash reserves and existing operations’ resources.
Also known as an earnout arrangement, deferred consideration is a pricing structure written into M&A deals.
In this scenario, the buyer spreads risk by introducing performance-based considerations of the business after the acquisition. In other words, the seller must earn part of the deal value over the months and years after the acquisition.
Non-cash deals may involve the transfer of shares. Giving up equity in exchange for a lower price is a popular way of funding mergers between similar-sized businesses. It’s also an excellent idea if you have a less-than-stellar credit history and find it tough to secure traditional financing.
Some sellers will agree not to receive all their cash upfront in exchange for maintaining a stake in the business. This can be advantageous because the seller can support you in the long-term growth of your newly-acquired business.
Alternatively, you can opt for a vendor loan. Instead of providing the seller with equity, they become debt holders. This allows the seller to become a lender, allowing the buyer to stretch out their payments over time.
External debt financing
This is a fancy word for external financing through your local high street bank or other traditional lender.
Examples of debt financing include mezzanine financing, senior debt and asset-based lending.
External equity financing
Opting for external equity financing incentivises investors to become shareholders in your business by providing capital to fund the deal. Even though this can be an alternative to traditional financing, this is usually the most expensive option as you must give away a slab of your acquisition’s upside.
How to finance a business acquisition
Thinking about your business acquisition financing should begin about the same time that you are identifying target companies. Before proceeding, ensure that you have a professional team of solicitors and financial experts to provide tailored advice on how to proceed.
Here’s a brief breakdown of the process of financing your acquisition:
Step One – Begin by identifying target companies. It should also include acquiring valuations and conducting your due diligence. This should show you how much money you’ll need to cover the acquisition.
Step Two – Decide on the acquisition structure. Whether you are acquiring assets or shares in the target company, your decision here will impact the financial and tax aspects of the final deal.
Step Three – The next step is to decide how much money you’ll actually need. Don’t forget your cash flow needs and post-acquisition integration costs. Approximately 78% of successful acquiring companies spend 6% of their total deal value on integration.
Step Four – Select the financing option for you, whether it’s debt or giving up equity. No right or wrong answer exists because every company will have its own needs. Focus on factors like loan terms, interest rates, repayment schedules and the financial impact on your business.
Step Five – Follow the lender’s loan application process. Be prepared to create a financing proposal to present as part of your application.
Proper planning is essential, and you should maintain regular contact with all stakeholders throughout the process. Remember, obtaining all the necessary approvals can take considerable time.
FAQs about business acquisition finance
What is the cheapest way to finance an acquisition?
It depends, but using your cash reserves is usually the cheapest way to finance an acquisition.
On the other hand, if you need to take on debt, it’s usually cheaper to opt for a standard “no strings attached” business acquisition loan, but this will depend on your deal, current financial position and credit history.
Who is eligible for a business acquisition loan?
Any business is technically eligible for an acquisition loan, but getting approved is another issue entirely. Some of the factors lenders will account for include:
- Financial stability
- Previous acquisition track record
- Credit history
- Business plan
- Acquisition structure
- Size of the acquisition
How much can you borrow with a business acquisition loan?
No limits exist on how much you can borrow with a business acquisition loan, but lenders usually cap the maximum loan amount at 90% of the total acquisition value.
Is a business acquisition loan tax deductible?
Business loans themselves are not considered tax-deductible expenses. However, businesses can claim the interest as a tax deduction on corporate tax filings.
Tax deductions can get complicated and cost your company a lot of money if you make a mistake. During the process of acquiring a new business, you need professional support. Speak to Hilton Smythe for more information from our independent finance consultancy.