How to finance a business acquisition
A critical part of making a successful acquisition is negotiating an optimal financing structure. You want a financing mix that will allow for a smooth ownership transition and position your company to flourish in the years to come.
It can be challenging to understand how each type of financing works and finding the right mix can be difficult.
“When properly structured, the financing package will provide you with the flexibility to successfully integrate your acquisition and support your future growth,” says Robert Duffy, a Vice President in BDC’s Growth & Transition Capital team.
Duffy, who has financed dozens of business acquisitions, explains the typical financing package for an acquisition in the example below.
Establish the value of the acquisition target
The first task when arranging financing is to establish how much the company you want to buy is worth. The value of a company is usually based on its profitability as measured by earnings before interest, taxes, depreciation and amortization (EBITDA). Additionally, EBITDA should be normalized by removing non-recurring expenses or revenue to accurately represent the future earnings capacity of the company.
An acquisition price is negotiated by agreeing to a multiple of the company’s normalized EBITDA that reflects the dependability of its profits and growth prospects. In our example, the company generates $3 million of EBITDA a year and the vendors have agreed to sell for five times EBITDA or $15 million.
Example: Acquisition financing
| Acquisition of 100% of the shares | |
|---|---|
| Senior debt | $9,000,000 |
| Vendor debt | $3,000,000 |
| Mezzanine financing | $2,000,000 |
| Equity investment | $1,000,000 |
| Total | $15,000,000 |
Equity investment: A proof of commitment
The buyer often contributes a percentage of the buying price and these funds can come from a variety of sources, such as surplus cash that the acquiring company has saved for this purpose. Another source of equity might be a third-party investor who then becomes an owner of the combined company. BDC is one option for this type of equity financing.
The equity participation lowers the amount that needs to be borrowed and demonstrates to the lenders that the shareholders are committed, by their financial contribution, to making a success of the acquisition.
Senior debt: The bulk of the financing package
The senior lender in an acquisition deal provides a loan that is secured on the assets of the company. While this amount may not be fully secured by specific assets, it is called senior debt because the lender will have a first charge against assets such as accounts receivable, inventory, real estate and equipment in a recovery situation.
Duffy says the senior lender typically decides how many multiples of EBITDA it’s willing to lend to finance an acquisition. In our example, the senior lender is willing to lend three times EBITDA or $9 million.
A senior lender will usually have the most restrictive repayment terms among the financing participants, including requiring the loan be paid off in a relatively short period. You most likely will have to make monthly payments and fulfill other loan conditions that include maintaining certain debt ratios, known as financial covenants. BDC provides this type of financing, referred to as a cash flow term loan.
Vendor debt: A useful aid to the transition
In many acquisitions, the seller will help finance the deal with what’s known as a vendor takeback or a vendor note. Here, the seller agrees to be paid a portion of the purchase price over a certain period of time with interest. In our example, the vendor has agreed to be paid $3 million or 20% of the acquisition price over time.
Duffy says a vendor note can come in many different sizes and forms. It can sometimes be based on the performance of the company—increasing or decreasing with the amount of EBITDA the company produces during the repayment period. This portion is referred to as an earn-out.
If the vendor is owed $3 million after closing, they are going to be motivated to make sure the business survives the transition and continues to thrive.
Robert Duffy
Vice President, Transition Capital
Vendor notes are generally a very useful for the buyer because they usually come with few conditions and favourable interest cost. As well, the vendor will likely be a patient in demanding repayment if they company runs into difficulty.
“The other compelling reason is that often times one or both parties want the vendor to stay involved in the business in some capacity,” Duffy says. “If the vendor is owed $3 million after closing, they are going to be motivated to make sure the business survives the transition and continues to thrive.”
Mezzanine financing: A flexible option
Mezzanine financing is often used to cover any gap left between the purchase price and financing from the various other sources.
Mezzanine financing entails higher risk for the lender than senior debt and therefore carries a higher interest rate. However, its repayment terms are highly flexible and can be tailored to a company’s needs.
For example, Duffy notes that repayment of mezzanine financing from BDC Growth & Transition Capital can be patient following an acquisition. This can be critical if the company’s needs its cash flow to repay the senior lender and the vendor note, and execute on a growth strategy.
“We have full flexibility and that’s make us the perfect gap filler because we can accommodate everything else happening in the transaction.”
Duffy says BDC’s ability to provide the senior debt, mezzanine financing and minority equity portions of a financing package for an acquisition, make it a good acquisition financing option, especially for companies who are interested in a financing solution that is tailored for their specific situation or are keen to diversify financial providers.