Types of financing available for business acquisitions
1. Equity investment
The buyer usually provides their own funds to cover part of the purchase price.
2. Senior debt
If the company has valuable tangible assets and recurring historical cash flows, term financing secured with the company’s assets usually makes up the bulk of the financial package.
3. Mezzanine financing
This is a specialized type of unsecured financing that is given based on historic and expected future cash flows of the company. It can be useful in rounding out a transition financing package as it requires no specific collateral and little or no personal guarantees and offers highly flexible terms (which is why it’s known as patient capital).
4. Vendor note
Vendor financing is sometimes called a vendor note or vendor takeback. It’s effectively a loan that the vendor gives the buyer to cover part of the sale price. The vendor typically agrees to be repaid over time with interest.
An earn-out is a type of vendor financing in which the amount due is not earned at closing and payable later, but earned only if and when certain conditions are met. Earn-outs are tied to either:
- financial conditions—overall profitability, sales of a specific product or to a specific client
- operational conditions—maintaining employment of the vendor, staff turnover, etc.
Earn-outs are used to mitigate the effect of a gap in value perception between the seller and buyer when there is uncertainty in the business or to allow the vendor to profit from the upside of some new initiative (new product, new client, etc.) that the purchasers did not give any value to when establishing the purchase price.
6. Outside equity
A buyer may get equity capital by selling an ownership stake in the company to outside investors, such as a private equity fund, individual investors or a financial institution’s venture capital or private equity arm.
If there is too much short-term debt and the financing isn’t flexible enough, the company’s new owner may have difficulty maintaining profitability or fund their growth plans.
Ask to review the deal structure
If you provide vendor financing as part of the transaction, you should ask for and review details about the buyer’s entire financing package to ensure the financing isn’t overly aggressive.
Ill-suited leverage may leave the new owner struggling, especially if the transition causes disruption to the business, as is often the case. This could jeopardize vendor note repayments.
Typical financing structure example
The table below shows a financing structure for the sale of Company A, which generates $3 million in annual earnings before interest, taxes, depreciation and amortization (EBITDA).
|Financing: Company A
The vendor has agreed to provide a $3-million vendor note and is selling for five times EBITDA, or $15 million.
If the transition goes smoothly, the mix of financing illustrated will probably allow the new owner to both have enough cash to reinvest in the business and repay the vendor note in a timely way.
Does the structure leave enough flexibility for disruption?
But much depends on the terms of the $9 million in senior debt and the company’s financial performance after the transition.
If the amortization period is short (e.g. four years) and the loan is subject to tight covenants, the business could face difficulties in the event of a disruptive ownership transition. Such problems could in turn imperil repayment of the vendor note.
“Many businesses face disruption after a transition,” Drouin says. “Competitors could target the company, the new owners may have a knowledge gap; it’s often challenging. If the financing structure isn’t flexible enough, a whole lot of things could go wrong.”
Tailored structure with more flexibility
The table below gives an example of a more flexible financing structure for Company B. It has the same EBITDA and sale price as Company A, but is being bought by an outside purchaser, has more variable revenues and must navigate fluctuating commodity prices.
|Financing: Company A
What types of businesses should increase their flexibility?
“It’s important to ask yourself which type of business you are,” Drouin says. “You want a financing structure that creates the right amount of flexibility for the company.”
A more flexible structure is especially appropriate for some kinds of businesses and transitions, including cases where:
- The new owner is an outside buyer. Outsiders won’t know the company as well as an inside or family buyer, possibly leading to more disruption risk.
- The business has variable revenues.
- The company is subject to strongly fluctuating conditions, such as variable commodity prices.
How can you increase flexibility in a financing package?
Even with the same profitability, such a business likely can’t afford as much leverage as Company A. More flexibility in the financing structure would be appropriate, consisting of:
- Less senior debt and/or a longer amortization period (e.g. eight years).
- More patient capital (i.e. higher portions of buyer equity, vendor take-back and mezzanine financing).
Make sure package is sound
A sound financing package is important for the post-transaction success of the business and ensuring that you collect any vendor financing. “As more businesses are transferred in Canada, there are best practices emerging and successful transitions happen on a regular basis,” Drouin says. “However, don’t forget that transition transactions are an operational disturbance for the company, usually add financial stress and increase the minimum level of profitability required to pay the bills. Also, the outside business environment will not pause because your company is undergoing a transition.”
“If you want to see your business and former employees thrive, ensure your legacy remains secure and collect your vendor note after you’ve sold, it’s a good idea to make sure the financing package for your purchasers is sound.”