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Acquisition Financing - What Are The Options?
Posted by Ed Fixen on Friday, September 9, 2011 8:15 AM
Understanding acquisition financing options is important whether you are a buyer seeking to acquire a company or an owner considering selling your business. For a buyer, available financing options will play an important role in determining minimum equity investment, debt service, post-acquisition cash flow and return on investment. From a buyer’s perspective, it is most cost effective to create a capital structure that secures the most funding, offers the lowest cost of capital, and maximizes return on equity. For sellers, the availability of acquisition financing will directly affect the sale price that can be obtained since both price and terms are fundamental to the marketability of a business for sale.
For example, a business with strong asset value and cash flow would likely qualify for attractive acquisition financing using a number of alternatives and the business should be able to demand a fair market value and perhaps even a slight premium depending on the strength of the deal. A business that does not qualify for attractive acquisition financing will have difficulty obtaining fair market value and is likely to be discounted to some degree by qualified buyers since the terms of an acquisition would not be normal market terms. Ultimately, the type of financing best suited to the situation will depend on many factors but largely depend on the type of business (e.g., service vs manufacturing), value of assets, strength of cash flow, profitability, industry risk and company specific growth potential.
SBA Bank Financing
The most common form of financing for small and medium sized business acquisitions includes SBA acquisition loans. SBA and conventional bank lenders rely heavily on the collateral of a business as a key underwriting factor. If the target company has strong asset value, positive cash flow and strong profit margins, the buyer should be able to find financing through an SBA lender. On the other hand, service companies with very little asset collateral and predominantly goodwill value may have difficulty securing attractive bank financing.
SBA loans are typically financed at prime plus 2 to 2.75 percent depending on the business. The Small Business Jobs Act of 2010 increased the lending limits for the SBA 7(a) loan program from $2 million to $5 million which substantially increases the number of businesses that could qualify for SBA acquisition financing with 20 to 30 percent down payment.
Seller Financing
For small and medium sized businesses, it is very common for the seller to be asked to finance part of the transaction even if it qualifies for SBA financing. In many small business acquisitions, a business is purchased with a combination of down payment and seller financing in the form of a promissory note for the balance of the purchase price, where the business itself and its assets provide the primary collateral for the note.
Seller financing is typically provided at rates comparable to SBA loans in the range of prime plus 2 to 3 percent. Refer to my previous Business Press articles, “Advantages of Seller Financing When Selling Your Business” and “Properly Constructed Earn-Out Can Increase Proceeds in Sale” for more information on the topic of seller financing.
Mezzanine Financing
Mezzanine financing is a more expensive form of financing compared to bank financing, often on the order of 12 to 25 percent, used to fill the gap between available bank/seller financing and buyer’s equity. Mezzanine financing can be in the form of either unsecured/subordinated debt or preferred stock. Mezzanine lenders claim to the assets of the company are usually after senior, secured lenders such as a bank but before the buyer and common stock shareholders. Unlike most equity investors, mezzanine lenders will likely only require a minority ownership interest when using preferred stock.
Equity Financing
Equity financing involves the use of either individual private equity investors or private equity groups who acquire some percentage of interest in the target company. Private equity investors and groups will typically demand a significant amount of control of the company, often as much as a 51 percent plus majority stake.
Private equity groups typically have required rates of return of 25 percent or higher depending on the business. Private equity groups also have exit time frames on the order of five to seven years. Business brokers and investment bankers work with private equity groups regularly and can be a good source of contacts.
Asset-Based Financing
Asset-based financing consists of revolving loans secured by available collateral, such as inventory, accounts receivable, equipment and other fixed assets. The amount that can be borrowed is typically between 60 percent and 80 percent of the asset value depending on the liquidity of the asset class. Asset-based lending has become an increasingly popular source of financing but has some limitations for acquisitions since it is limited to a percentage of asset value which rarely approaches the value of a successful, profitable business. However, asset-based lending can be a good strategy to supplement the buyer’s equity or finance working capital.
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