Acquisition Financing: Main Types, Advantages, and Tips

You should find the right acquisition financing structures to make a seamless transition post-closing and continue to pave the way for profit and success. So, this guide will help you explore different options for financing acquisitions to maximize strategic opportunities.

What is acquisition financing?

Acquisition financing is the capital obtained for purchasing another business. This approach allows buyers to obtain adequate capital to finalize the transaction. Then, they repay their lender using the increased revenues generated by the purchase.

The main types of business acquisition financing are as follows: 

• Stock swap transaction
• Acquisition through equity
• Cash acquisition
• Acquisition through debt
• Acquisition through mezzanine or quasi-debt
• Leveraged buyout
• Seller’s financing

Later, we’ll discuss these business acquisition financing options and weigh their pros and cons. But for now, let’s clarify terms often used interchangeably despite having essential differences.

M&A financing vs. acquisition financing

Acquisition funding deals with the buyer’s side of the equation. Specifically, it is securing the money to make the transaction possible through debt, equity, or their combination.  

The main concern is on the financial aspect of the purchase, which includes the loan conditions, interest rates, and the impact of acquiring the new asset or company on the buyer’s finances.

M&A funding includes funding for both acquisitions and mergers. In an acquisition, the financing needs are mostly related to a buyer. However, the funding complexities increase in a merger, where two companies combine to form a new entity. The focus now shifts to how the assets and liabilities of both companies play a role in financing the deal or how new shares are issued if it’s a stock transaction.

In simple terms. Acquisition finance focuses on the buyer’s side of acquiring another company. M&A financing, in turn, encompasses the financial complexities of both acquisition and merger processes.

Before moving on to the types of business acquisition funding, we invite you to learn how the financing process works.

How does acquisition financing work?

The process typically involves the following steps:

1. Locating the acquisition opportunity

To obtain a business acquisition loan, you should first identify a target company. Then, conduct a business valuation. Specifically, assess the company’s financial performance, operational practices, credit score, and other relevant factors. You can also prepare a letter of intent at this stage but submit it only after you consult with lenders. By following these steps, you can increase your chances of acquiring your desired company.

2. Navigating acquisition financing costs

A regular term loan relies heavily on your business or personal credit scores and the target’s price. For example, traditional term loans in the US are only possible through a significant down payment.

So, before seeking a business loan or any other financing, know the seller’s asking price and be ready to pay part of it upfront.

3. Selecting the financing model

At this stage, you should decide on the best transaction structure and financing solution that meets your requirements. You can choose among various financing alternatives, including the ones described below.

Other steps may involve the following:

1. Engagement with lenders
2. Negotiation of financing terms
3. Due diligence
4. Finalization of the financing agreement
5. Deal completion
6. Post-acquisition integration

Next, we will explore the main types of acquisition funding and examine their advantages and disadvantages. Thus, you will explore various options and make an informed decision.

What are the main types of acquisition financing?

The most common ways of funding acquisition are as follows:

1. Stock swap transaction

When a company trades its stock publicly, an acquirer can exchange it with a target company. Private companies often use stock swaps, where a target company’s owner wants to keep some ownership in the combined company and remain actively involved in the business’s operation. An acquiring company usually depends on a target firm’s owner to operate effectively.

Pros

• Allows the acquiring company to preserve its cash reserves by using its own stock for the acquisition.
• May offer tax benefits compared to cash transactions, potentially reducing the tax burden for both parties.

Cons

• This can result in a dilution of ownership for existing shareholders of an acquiring company due to the issuance of new shares.
• Integrating the operations, cultures, and systems of the two companies can be complex.

2. Acquisition through equity

It is the most expensive form of capital in acquisition finance. When selling company shares, profits are shared for an undefined period, which contrasts with loans that are finite in terms of time frames and interest rates. Equity financing may be suitable if a target company is in a volatile industry or has no steady cash flow.

Pros

• Offers flexibility as there are no fixed repayment schedules or interest rates.
• Fosters a long-term partnership between acquiring and target companies.

Cons

• Existing shareholders may lose control if new equity investors are brought in, as they may have a say in the company’s decision-making,
• Can be more expensive in the long run since shareholders are entitled to a share of the company’s profits indefinitely.

3. Cash acquisition

Here, a buyer purchases the shares of a company with cash, keeping its equity portion of the balance sheet the same. It usually happens when an acquired company is smaller and has less cash than a buyer. Sellers often prefer this type of financing a business purchase because it provides immediate liquidity. 

Pros

• Typically involves fewer complexities compared to stock swap transactions or equity financing.
• Eliminates the risk of non-payment associated with other forms of financing, as the transaction is completed with cash.

Cons

• Requires a buyer to use its cash reserves or raise external financing, which may impact its liquidity position.
• May limit the acquiring company’s ability to pursue other investment opportunities or maintain adequate cash reserves for future needs.

4. Acquisition through debt

Debt financing is a popular way for companies to finance acquisitions, as most cannot afford the costs out of pocket or need more money on their balance sheets.

When a bank provides funds for an acquisition, it will examine the target company’s cash flow projections, profit margins, and liabilities. Analyzing the financial health of the acquiring and target companies is also necessary.

Asset-backed financing is one type of debt financing method in which banks lend funds based on the collateral provided by the target company. Collateral may include fixed assets, receivables, intellectual property, and inventory. Debt financing also offers tax benefits.

Pros

• Often more cost-effective than equity financing, as the cost of debt is typically lower than that of equity.
• Allows a buyer to retain full ownership and control of the business.

Cons

• Increases a buyer’s leverage and debt burden, which may impact its financial flexibility and ability to meet debt obligations,
• Carries the risk of default if a buyer cannot generate sufficient cash flows.
• Lenders may require collateral to secure the debt, limiting a buyer’s ability to use its assets for other purposes.

5. Acquisition through mezzanine or quasi-debt

It is a type of funding that combines elements of equity and debt. It’s suitable for companies with a strong balance sheet and stable profitability. Also, this type allows the conversion of debt into equity. 

Pros

• Offers more flexible terms compared to traditional debt financing.
• Involves minimal dilution of ownership for existing shareholders.

Cons

• Typically more expensive than traditional debt financing because lenders often require higher interest rates and equity participation in exchange for the additional risk.
• Involves complex financial structures and agreements, which may require extensive negotiation and documentation.
• May only be readily available for some companies since lenders require a strong track record of profitability and cash flow generation.

6. Leveraged buyout

It is a popular way of financing an acquisition using a combination of equity and debt. The strategy involves considering the assets of both the acquiring company and the target company as secured collateral.

Usually, companies participating in leveraged buyout transactions are mature, have a solid asset base, generate consistent and strong operating cash flows, and require little capital. The basic concept behind an LBO is to ensure that companies generate steady free cash flows that can be used to finance the debt incurred to acquire them.

Pros

• Maximizes the use of capital by combining equity and debt financing to fund the acquisition.
• Generates high returns for equity investors if buyer’s cash flows exceed the cost of debt financing.
• Aligns the interests of management and shareholders since managers typically have a significant equity stake in the acquired company.

Cons

• Involves taking on a significant amount of debt to finance the deal.
• The high debt levels can restrict a buyer’s financial flexibility.
• Integrating the acquiring and target companies’ operations, cultures, and systems can be complex and lead to disruptions.
• The success often depends on the target’s performance, making LBOs vulnerable to market volatility and economic downturns.

7. Seller’s financing

It is a way for a buyer to obtain acquisition financing from the target company instead of seeking external sources. This method is commonly used when obtaining capital from outside sources is difficult. The funding can be structured in various ways, including delayed payments, seller notes, or earn-outs.

Pros

• Simplifies the financing process by allowing a buyer to obtain financing directly from a seller.
• Offers flexibility in structuring the financing arrangement, as the terms can be customized based on buyer’s and seller’s preferences.

Cons

• Carries the risk of default if a buyer cannot meet its repayment obligations, which may strain the relationship.

For your insight: Explore more types of acquisition financing here.

Conclusion

There are many different ways how to finance a business acquisition. However, it is vital to plan the acquisition financing carefully, ensuring that it aligns with the goals and nature of the deal. This approach guarantees effective funding and improved chances for a successful outcome for all parties involved.

FAQ

1. What is the acquisition method of finance?

Acquisition financing is a popular method to secure funds for buying a company or assets. It involves using multiple financial instruments such as cash, equity, and debt to make the purchase.

2. Is an acquisition the same as a merger?

Both deals involve one business buying another. In an acquisition, an acquired entity is usually integrated into a parent company. In a merger, two parties combine and create a new business entity.

3. What are the benefits of financing a small business acquisition?

A small business acquisition loan can lower the capital needed to buy a business and offer potentially quick turnaround times and flexible collateral requirements. However, it can be challenging to qualify for, may require a down payment, and potentially have high interest rates.

4. How do companies finance acquisitions?

Companies usually finance acquisitions through debt or equity. Debt involves borrowing funds, while equity entails issuing new shares to investors.

5. What does M&A stand for in finance?

M&A stands for mergers and acquisitions. It is the process of consolidating companies or assets through financial transactions.