Acquisition Financing: What It Is and How It Works
May 25, 2022 •Oak Street Funding
Acquisition financing is a wraparound term for the many ways companies obtain the capital they need to purchase other businesses. Companies may choose to buy other businesses for a variety of reasons, including expanding the size and scope of their operations, growing into new geographic areas or business sectors, adding new capabilities, and one of today’s most common reasons, increasing headcount.
While acquisitions offer the opportunity to substantially increase the size of a company, many sellers are commanding higher and higher down payments at closings and buyers don’t have sufficient capital on hand to make the purchase or are unwilling to tie up large portions of their working capital. Acquisition financing strategies allow buyers to gain access to enough capital to complete the transaction, and then gradually pay the lender from the increased revenues resulting from the purchase.
What is acquisition financing?
Funding from a lender to use in the purchase or acquisition of another company.
Many types of acquisition financing
Just as no two transactions are identical, the financing options available to companies interested in an acquisition vary widely. Some buyers opt for relatively straightforward business loans. Others may leverage equity in the newly combined company to allow sellers to share the future benefits of the combination. Still others may decide to use a combination of these options.
The best choice depends on the nature of the transaction, the value of both companies, and the current state of financial markets, but no matter which approach is used, the primary objective is to optimize the investment and a key piece to that is to source the lowest cost of capital. We’ll explore each of the primary types of acquisition financing separately:
- Leveraged Buyout
How do you finance an acquisition?
Commercial loans are the most familiar option for acquisition financing. Other options include SBA loans, issuing debt or equity, leveraged buyout, installment loan, or an owner earnout.
Acquisition financing through loans
Perhaps the most familiar acquisition financing approach (especially for smaller businesses) involves obtaining a commercial loan. As is the case with most types of loans, a lender agrees to advance a set amount of money in return for payments with interest over a time period. While the concept of a business loan is straightforward, the specifics can be anything but simple. Beyond the interest rate, the terms required by the lender can affect the overall cost and impact of the loan. In addition, depending upon the situation, some lenders will also require business owners to put up a personal guarantee, placing their family’s finances at risk.
Many businesses assume the best sources for acquisition financing are traditional loans from commercial banks, including options guaranteed by the Small Business Administration (SBA). However, those sources come may not be a great fit for certain types of businesses and business conditions. For example, commercial banks are more inclined to loan money to customers who have physical assets such as facilities and inventory. They aren’t always comfortable with businesses whose primary revenue comes from fees or commissions.
SBA loans include lending restrictions that don’t necessarily align with the best way to execute on an acquisition, including a limitation on the amount of time post funding the seller can be involved with the business. SBA loans may sometimes include personal guarantees secured by one’s primary residence and may involve extensive paperwork and lengthy delays.
That’s why a growing number of companies are turning to specialty lenders who focus on specific types of financing in a limited number of sectors. For example, Oak Street Funding regularly makes acquisition loans to companies in several industries based upon anticipated increases in cash flow resulting from a purchase.
What percentage of purchase price do lenders cover?
Just as there is a wide variety of lenders, the share of the acquisition price lenders are willing to assume also varies. Lenders are primarily interested in ensuring they’ll be paid back and are unlikely to lend so much that they take on uncomfortable levels of risk. Most often, lenders will be willing to contribute between 50 and 80 percent of the acquisition price, although there may be situations when a lender is willing to take on a larger share. The creditworthiness of the borrower and their history in running the business are key factors in determining how much lenders may be willing to contribute.
Acquisition financing by issuing debt
Another form of debt-based financing for acquisition is issuing securities such as bonds and selling them on the open market. While this approach involves some complexity, it may be ideal for companies that are unable or unwilling to meet the expectations of and covenants required by lenders. Some bonds may be convertible into equity shares after some time.
Although this method tends to carry a higher cost than other approaches, it may be the best alternative for companies unable to obtain loans. Investors inject capital into the acquiring business in return for a share of ownership in the combined company.
Leveraged buyouts are usually associated with larger companies (and were once linked to “junk” bonds), but they may offer another acquisition approach. Generally, they involve the issuance of both equity and debt based on the combined value of both businesses. One concern is that leveraged buyouts are generally seen as riskier transactions because of the high debt-to-equity ratio.
Acquisition financing through owners
In some cases, the owners of the business being acquired may be willing to provide part or all of the capital needed for the transaction. One approach is like an installment loan, in which the acquirer agrees to make a down payment and then a series of regular payments over a certain amount of time. Another is the earnout, in which the seller agrees to accept a percentage of the combined company’s future earnings for a period of time. This approach is especially advantageous when the buyer wants the seller to remain active with the business.
Obtaining acquisition financing
Companies seeking financing for an acquisition will quickly discover the process is far more complex than obtaining a home mortgage or a vehicle loan. That’s why it’s always a good idea to explore acquisition financing options before identifying potential acquisition targets. Lenders are generally happy to take the time to discuss a company’s objectives and explain their expectations of potential borrowers. Much as home buyers will often speak with mortgage loan officers to learn how much home they can comfortably afford; potential acquirers may be able to get a sense of how much financing lenders are willing to offer.
While requirements vary from lender to lender, nearly all can be expected to take a close look at the borrower’s assets and business practices. Indicators such as steady or increasing revenues, efficient utilization of working capital, available collateral, management expertise, and a clearly defined acquisition plan make borrowers more attractive to lenders.
Borrowers should seek out lenders with solid experience and strong reputations in their industry. It’s also important to work with lender representatives who are willing to take the time to listen and develop an understanding of the company's acquisition goals. A unique situation may call for tailored acquisition financing for your ongoing acquisition strategy such as an acquisition facility that allows access to capital for future acquisitions. Therefore, a lender with a one-program-fits-all approach may not be the best choice. Lenders should also be easy to work with, such as offering a simple, well-organized application process.
Oak Street Funding has earned a strong record of successful acquisition funding for companies in industries in which cash flow matters more than a piece of real estate. Oak Street Funding’s team recognizes the right acquisition will drive significant increases in revenue to your business, so they structure acquisition financing around your company’s expected cash flows. In essence, they help you grow your business by sharing in your success.
Disclaimer: Please note, Oak Street Funding does not provide legal or tax advice. This blog is for informational purposes only. It is not a statement of fact or recommendation, does not constitute an offer for a loan, professional or legal or tax advice or legal opinion and should not be used as a substitute for obtaining valuation services or professional, legal or tax advice.