Acquisition Funding: One Size Does NOT Fit All
Historical Acquisition Funding
For decades, a common funding method for private company acquisitions has been term loans obtained from commercial banks, a form of “senior” financing. This financing is generally supported (collateralized) by a pledge of all business assets of the company. These loans carry a stipulated interest rate, and term, with the best rates at or near the prime rate of interest. While this remains a fundamental source for acquisition currency, several other currencies can be deployed under the right circumstances to enable deal-making and cash flow when senior financing alone is not sufficient to complete the deal.
Categories of Potential Acquisition Financing Sources
Let’s look at the role that senior lending plays, and expand the discussion to other financing sources. Senior lenders provide a lower cost capital than most other types of funding, in terms of pure cash outlay. Senior lenders are generally able to finance 50 – 75% of the total acquisition price. So at first glance, this would seem to be the beginning, middle, and end of the financing discussion. In practical terms, however, senior financing carries a monthly payment, cash flow out, and imparts a certain risk to the borrower as opposed to certain other types of financing. Senior financing will generally be limited by the amounts of collateral to which the borrowings can be attached, and requires significant cash/equity down payment from the borrower, generally starting at a minimum of 25% of the total purchase price. So in a case of a $10 million acquisition, assuming adequate collateral and other conditions acceptable to the senior lender, perhaps $7.5 million of the purchase can be done with a senior (term) loan. That means the $2.5 million balance must come from other sources.
In many cases the buyer does not have $2.5 million in cash to complete the deal. Alternatives to augment the cash down payment can include the following:
- Seller financing
- Mezzanine financing
- Convertible (unsecured) debt
- Lease financing
- Working capital lines of credit
- Private (angel) investors
- Private Equity investors
- Capital market groups
Sellers can agree to carry a note receivable for some of the purchase price of their company being sold. Seller notes in the range of 15 – 25% of the transaction price are not uncommon, and notes can be larger or smaller than the range cited here. Seller notes will typically have a shorter term than senior notes, and often carry an interest rate at or near prime. Due to the shorter-term duration for paydown, however, seller notes can create a cash flow squeeze to the buyer unless the owner can put up other equity to augment the purchase. Seller notes can be structured to amortize fully from day one, or can be interest only with a balloon payment at the end, or can a combination of interest-only for part of the term and principal amortization for the remainder of the term. Not all sellers will agree to accept such notes, and terms can vary significantly. Further, seller notes usually have some sort of ‘claw back’ provision whereby a default by the buyer can result in loss of partial or total ownership of the subject company. The seller notes will be subordinated to the bank’s senior notes, and an agreement must be struck between the senior note-holder.
Since senior lenders usually have a pledge of most if not all business assets of the company being acquired, any other type of financing will have less, if any, collateral to support their funding to the acquirer. In the event of company failure and resultant liquidation, senior lenders have the most security, while at the other end of the spectrum, the purchaser buying the company is considered the equity holder, having no claim to assets unless all other financing entities recoup their investments. Mezzanine financing is subordinate to the senior financing, but takes priority over common equity holders / the purchaser. In event of liquidation, senior lenders will be satisfied first, mezzanine funders will be next in line, then seller notes will be next, ahead of the equity holder / purchaser. Due to the subordination of their claim to assets in event of liquidation, mezzanine financers charge higher fees and rates than do senior funders. Mezzanine can be convertible notes, interest only and / or delayed principal repayment, and may include issuance of warrants to the mezzanine funder. The convertible note feature may include the right of the note-holder to convert the debt obligation to equity at a discount to the FMV of the equity at time of conversion. So a typical mezzanine funder may carry both debt and equity in the company. These financing arrangements may also have significantly more restrictions and covenants, whereby the owner’s ability to do certain things like capital spending, owner distributions, sale of additional equity, etc. may be restricted or prohibited. Like seller notes, mezzanine fundings will require approval by the senior lender, and an inter-creditor agreement between the two parties will be required. Due to the risk level to the provider of mezzanine financing, these funding arrangements will generally be priced at an annual rate of return to the funder of 10% – 15% in excess of commercial bank prime rate. The return to the mezzanine provider will be periodic (monthly) interest on the principal invested plus the accredited value of the equity when options when redeemed. The periodic interest rate, when annualized, will generally be in the 6 – 10% range above prime rate. While this is expensive financing, the overall debt service in the early years of the repayment schedule will generally be lower than a fully amortizing senior loan. So a mezzanine funder provides a potential cash flow benefit to the purchaser as compared to a senior loan. Often an acquirer will refinance the mezzanine principal years down the road, replacing this with senior term debt when the company has grown and improved its cash flow.
Working Capital Line of Credit
In the months immediately following an acquisition, operating costs such as rents, payroll, inventory, may impose cash demands on the purchaser over and above the cost of acquisition. Often the acquirer has the option of securing a working capital line of credit. A line of credit is often preferable to having the purchaser fund this out of the acquirer’s cash (equity) reserves. This line of credit will be limited to 70 – 85% of inventory and accounts receivable balances, and is typically opened commensurate with the consummation of the purchase transaction and the related execution of the acquisition term loan. Unlike the term loan, the line of credit generally has a 12 month term and requires interest-only on a monthly basis until the loan matures. At maturity, assuming the company is in good financial condition, the line is renewed for another 12 months without requiring repayment of the initial principal. Such loans generally carry interest rates at or near prime. Many companies routinely carry an open working capital line for several years as a means of keeping their cost-of-capital low.
In certain cases, an acquired company may possess hard assets that can be sold to a leasing company and leased back by the company. Often the lessor will provide 100% financing of such assets, thereby affording the buyer the ability to preserve cash or put a larger down payment in the deal to reduce the amount of the senior note. Generally this is most appropriate when the company has newer, well maintained equipment. Often the lessor in such cases will provide a competitive interest rate on the lease, at or even below the rate that a bank might charge on the senior loan, to secure the company as a customer for future business.
Private / Angel Investors
A private investor (usually an affluent person or entity) can often be a viable provider of additional capital to complete an acquisition. Their investment can be the form of convertible debt or equity. As is true of the Mezzanine funders, these investors will often impose restrictions on certain activities such as executive comp, capital spending, transfers of equity, or dilution. Also like mezzanine funding, this capital will carry an annual return on investment expectation at a premium of 10% – 15% over prime rate of interest. An Angel investor is a private investor who supports a start-up entity.
Private Equity Sponsors
Private Equity (PE) investors provide substantial funding across a spectrum of industries and entities. Private equity can take the form of mezzanine / convertible or non-convertible subordinated debt, common equity, preferred equity, as well as certain other derivatives such as warrants. Private equity providers can be either control or non-control minded. In the scale of priority of claims to assets in event of liquidation, private equity can be at the mezzanine level, or further down the list of priority, depending on their risk profile. In cases where the PE investor is pure equity, their risk matches the risk of the owner. In exchange for taking the highest risk, PE investors will seek the highest return as opposed to all other categories of funding. This is the highest cost capital due to that risk profile. PE investors are typically seeking annual returns north of 20%. Their investment usually also carries a management fee paid monthly. Depending on the size and type of investment, PE investors will seek a seat or seats on the board, and may require board control to manage their investment. Their investment criteria generally preclude investments in entities whose operating cash flow or EBITDA is below $3 million. PE firms will also often provide access to other capital partners, and often will provide certain industry knowledge /expertise and a focused portfolio of entities in the same industry as the acquired entity, whereby the PE firm can also contribute certain industry expertise and guidance.
Capital Markets Groups within Financial Institutions
For larger transactions, funding may be available through entities typically referred to as “Capital Markets Groups”. These entities usually operate in tandem with banks, insurance companies, and wealth management entities. Since these companies hold and invest substantial sums of cash, part of their diversification strategy is to invest into operating companies. They will generally operate in a manner akin to a PE investor, although their investment is generally much larger, in the $20 million and up range, and often their restrictions are such that often they effectively control the acquired company. This is an excellent source of capital in larger deals, and their rates can be competitive with senior and sub rates depending on their investment profile and where their investment fits in the priority scale of claims to assets upon liquidation.
A Matter of Choice
Clearly, acquisition financing is not a one-size-fits-all exercise. The good news is that multiple avenues and strategies can be deployed to get to “yes” in the acquisition transaction. Finding the right mix and getting all the sources to operate seamlessly is a delicate balance of collaboration, open mindedness, and balanced expectations by both the acquirer and their financing partners. While not simple, this is happening all around the business spectrum every day.
When assessing your options, it’s essential to partner with an advisor who can help you navigate the process. If you have questions about the funding sources, what it means for your business, or need assistance with mergers, acquisitions, audit or accounting issues, Barnes Dennig can help! For additional information call us at 513-241-8313 or click here to contact us. We look forward to speaking with you soon.