How to Finance an Acquisition
The credit crunch has led to an increase in seller financing, asset-based lending and alternative sources of capital for buyers.
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In pursuing an acquisition there are always key items to consider such as the continued growth opportunity provided by the target company, purchase price, and financing terms. Many acquisitions fail due to these priorities not being in line, say M&A experts. For instance, a common mistake buyers make is to focus on an attractive purchase price, rather than the strategic importance of the company's present and future growth plans.
Securing capital and the best financing terms for an acquisition can be daunting and challenging. The sub-prime lending crisis and sluggish economy over the past 24 months has created huge changes in our financial system. Many traditional lenders have modified their lending criteria, thus restricting available credit and the flow of capital to many entrepreneurs, says Michael Fekkes, a Certified Business Intermediary and senior broker at Enlign Business Brokers in Nashville.
In a million dollar transaction, the buyer would be expected to have a 10 percent down payment, or possibly more depending on the industry. The seller would hold an additional 10 percent in seller financing, and the lending institution would offer a combination of conventional or SBA financing to cover the 80 percent balance of the purchase price, depending on the eligible collateral.
Now buyers are seeing the total transaction value self financed by 20 percent, seller financed by around 30 percent and bank financing is at or even less than 50 percent for the rest of the purchase price, says Anthony S. Hussain, managing partner and founder of Miami-based Capvesco, a capital advisory firm. "Lenders have really asked for more equity in terms of the transaction by the buyer and more notes being held by the seller." Also, because of the credit crunch there are a lot of alternative financing sources that have surfaced. Private lenders are coming to the forefront with the cost of capital higher than the traditional bank loan, adds Hussain.
Despite current economic conditions, there still remain numerous funding sources to raise capital for the acquisition of an established company, says Fekkes. "Each lender or source of capital will have its own unique and frequently modified criteria for financing, so it will be necessary for the buyer to spend adequate time to properly research and explore all options to determine which source is appropriate and available for their specific business opportunity."
A key to the type and availability of funding is the structure of the company that is being acquired. "A company with little debt, significant assets, and strong cash flow is a good candidate for an acquisition with a significant portion of long-term debt financing," notes Andrew J. Sherman, author of Mergers and Acquisitions from A to Z, and a partner at the law firm Jones Day in Washington, DC.
Acquisitions often involve different layers of capital which could include bank financing, mezzanine financing and private equity. The type of business being acquired, the valuation of assets and cash flow, perceived market risk as well as growth plans, are the characteristics that determine which capital sources and financing structure is the most appropriate, says Hussain. Each type of transaction will have its unique set of evaluation criteria, cost of capital, expectations, deal terms, and covenants.
How to Finance an Acquisition: Bank Financing
If the target company has a lot of assets, positive cash flow and strong profit margin, the buyer should be able to find bank financing. But say you want to buy a service company that has a lot of receivables and short-term assets, the level of difficulty of securing bank financing increases, say industry experts. Recent studies show a significant decline in cash flow-based loans. Quality of cash flow, debt load, and insufficient collateral were cited as primary reasons. Collateral type is emerging as the most important factor in a lender's decision to approve a loan.
"In today's more austere credit market, a buyer has to have good credit scores and assets. There are very few unsecured loans being made," says Fekkes. "It is either going to be secured by the company's assets, cash flow, and/or the buyer's own personal assets."
The Small Business Jobs Act of 2010 changed some of the lending limits for Small Business Administration (SBA) loans. The limit for the SBA 7(a) loan program has increased from $2 million to $5 million. For mainstream businesses (under $5 million) SBA financing remains a viable avenue for buyers.
To help improve your chances, find a bank that has a history of financing the type of business you are buying. If the seller has a strong relationship, then talk to seller's banker. Talk to a number of banks in order to secure financing, suggests Fekkes. "What most buyers or prospective borrowers don't understand is that each bank's requirements are different." So, you may go to one bank and get turned down for a convention loan or SBA financing. You are left with the impression that you don't qualify for a loan. But that could be further from the truth, Fekkes explains.
He recommends as a resource Diamond Financial Services, which structures and packages loans, working with over 100 banks and non-banks that do SBA lending. "They know which banks are lending for which types of loans."
Dig Deeper: How to Choose the Right Bank for Your Small Business
How to Finance an Acquisition: Seller Financing
For small and middle-market transactions, it is quite common for the seller to finance part of the transaction. The simplest way to provide seller financing is for the buyer to make a down payment and for the seller to carry a promissory note for the rest of the purchase price, says Sherman. The business itself and the significant business assets provide the primary collateral for the note.
The terms (interest rates, length, principal payments, and so on) will vary depending on the negotiated agreement. For a business that sells for $500,000, for example, the transaction might be structured as $150,000 down from the buyer and $350,000 in seller financing. The seller note might run for five to seven years and carry an interest rate of 8 percent to 10 percent. Monthly payments usually start 30 days from the date of sale.
Dig Deeper: Financing When Buying a Business
