There are many different ways that a company can raise the money it needs to finance M&A. All these financing methods fall into one of two categories — debt and equity financing— and most of them can be combined. Read on to learn more about the details, pros and cons of different M&A finance strategies.
What is M&A financing?
When a company raises funds to buy another, they are doing M&A financing. And it’s important to do it correctly — to choose the best financing strategy among the many possible ones. Choosing the right M&A financing method is crucial for the acquirer to guarantee the success of the acquisition and the stability and growth of the new company.
The first step to making a good choice in acquisition finance is having the right information — about the buyer’s and the seller’s financial situation, their productivity, target’s assets, market trends, and so on. At this stage of collecting and analyzing data, both sides can work with data rooms for M&A, as these are the best platforms for storing and sharing sensitive data.
What are the most common ways of financing mergers and acquisitions?
Once the due diligence process is over, and all the important corporate data is gathered, organized and analyzed, the buyer should assess the different financing methods available to them. These methods will fall into one of three categories: all cash, equity financing or debt financing.
- All-cash financing happens when the acquiring company has subsequent cash reserves to simply buy the other company without having to raise money from outside.
- Equity financing is when the company uses its shares as capital to buy the other company.
- Debt financing is what happens when the buyer takes loans from third parties.
In most cases, the buyer will combine two or more methods — for instance, taking a bank loan to cover 60% of the funds needed, and covering the remaining 40% by issuing new shares and selling them.
Debt financing vs equity financing comparison
In equity financing for M&A — also known as stock acquisition — the company either:
- Issues new shares and sells them in order to raise funds, or
- Uses the shares it already has as capital, offering them to the owner or target company’s shareholders
In debt financing, the company raises funds for the acquisition by taking loans from different third parties — usually a bank or a private equity company.
|A company issues shares to raise funds for the acquisition or does an equity swap.
|The buyer saves cash. Seller’s shareholders benefit from the new company’s profits.
|It dilutes ownership of existing shareholders because additional shares are issued.
|Buyer wants to keep their cash reserves.
|Involves borrowing money to raise funds.
|A good source of funding when interest rates are low.
|Harder for startups and less mature companies to get approved for than equity financing.
|Interest rates are low. A company has a solid cash-flow track record with consistent profits.
Other methods of acquisition financing
As stated above, there are several different methods of financing the acquisition of one company by another. Now let’s look at them in more detail. Note that some of the methods on this list are subcategories of others, and that many can be combined among themselves.
Also known as company profits or company funds, this financing method consists in the buyer paying the seller with money from the company funds. The buyer takes no loans, nor sells any stock. This is advantageous for them, as they neither will have to repay debtors, nor are diluting the ownership of the existing shareholders by selling new shares.
The disadvantage of cash transactions is that the money spent in the acquisition leaves the company, and cannot be used to guarantee the continued functioning and growth of the combined company.
In this financing method — also known as company equity — the buyer gives the seller a percentage of shares in the new company. For the buyer, this method offers two advantages:
- It reduces the amount that the buyer must pay upfront, which means they save capital which can be important to help the combined company operate as desired.
- It keeps the seller involved in the future of the company, since they are shareholders too — which is advantageous for the buyer if the seller has experience and expertise that will help the new company.
For the seller, the advantage is that they will benefit from the profits of the new company — the disadvantage is that they receive less money upfront.
Stock swap — or company equity, or equity-only — happens when the companies agree to trade equities. Both companies are valued, and the values of their shares are calculated accordingly. If for instance, the buying company corresponds to 80% percent of the value of the combined companies, its shareholders will own 80% of the new company, while shareholders of the target company will receive 20% of shares.
The advantages of this financing method is that the buyer needs no money to buy the target company, so they can save their capital to put it into the financial transactions of the combined entity.
Mezzanine or quasi-debt
In mezzanine financing, a private investment firm buys the acquirer’s private shares or junior debt, paying for them in cash. This method is used when the buyer has difficulty raising capital. The disadvantages of this method are twofold:
- Since private shares and junior debt are not secured, they are more expensive i.e. the buyer receives less money for them from the mezzanine finance firm.
- The return rates for investors are higher, which means higher costs for the acquiring company.
Also known as seller note, or Vendor Take-Back Loan (VBL), this acquisition financing method is used when the buyer is finding difficulty getting capital from outside the company to conduct the acquisition. The seller agrees not to take all their payment upfront, which allows the buyer to commit less of their capital to the transaction. There are different ways one can use seller’s financing, one of which is the earnout.
When companies agree on an earnout, the seller receives a percentage of their company’s value, plus a percentage of the earnings of the new company for the first five years after the acquisition.
This way of financing mergers is used when the seller is a person who wants to retire from their company and does not make a point of receiving all the money immediately. The advantage is that the buyer needs less capital to carry out the acquisition.
Leveraged buyout (LBO)
In the leveraged buyout, the buyer borrows money from third-party lenders and uses assets from the acquired company — and in some cases, from the acquiring company as well — as collateral for the loans. This is combined with equity payments, usually at a rate of 90% debt and 10% equity.
Leveraged buyouts are a good option when the buyer doesn’t want to commit a lot of their capital in the acquisition, and if the transaction is successful, it means a considerable payoff. The risk is that if things don’t go as planned, the new company will find itself in a seriously dangerous situation due to the borrowed money and the growing debt.
This is self-explanatory. With this debt financing method, the buyer takes a loan from a bank. This cannot be done in just any circumstances — the bank has to like the industry, the company team, its cash flow etc. Also, the buyer has to repay the loan in 1-2 years, making it senior over any other notes. And in some cases, the buyer is required to provide personal guarantees — but usually they can avoid this, if the company has enough cash flow and assets.
Bank financing works best when interest rates are low.
Private equity firms
In this method of third-party financing, private investment companies invest in the acquisition by buying shares of the company. Since the new stakeholders will be involved in the management of the new company, this can be advantageous if they are professionals with experience in the industry.
The disadvantage of this equity financing method is that the investment firms usually prefer to invest in acquisitions that have over 3-5 million of combined cash flow — so smaller companies may have to look for other methods instead. Also, selling stock to new shareholders dilutes ownership of the company.
When a company uses this equity financing method, they issue bonds and sell them to investors, who will then receive periodic interest payments. This makes it possible for the buyer to carry out the acquisition even if they don’t have enough funds, or if they want to save capital and put it into the new company’s operations. The risk is the buyer not planning the payment of the interest installments correctly.
In this form of debt financing, the buyer takes a loan and uses target firm assets such as machinery or commercial property as collateral, with the guarantee that they can be liquidated if the worst-case scenario happens.
This method can be used when the target company has valuable assets — but agreeing with the financer on the valuation of the assets can pose challenges.
For US businesses, a possible method of acquisition financing is raising a loan that is backed by the Small Business Association. The SBA can back up to 90% of the value required for the acquisition. However, it requires mandatory personal guarantees, which means if the company defaults, the owner will find himself in a difficult situation. This is why this financing method should not be used if there are other financing options available.
|The company uses its cash reserves to buy the other.
|Requires no outside capital.
|A buyer may need to save for some time before they are able to buy.- It leaves the new company vulnerable because it has less capital to conduct daily operations.
|Buyer who has enough cash reserves.- New company that has the required capital to continue daily operations.
|Gives the seller a % of the new company so they need less cash upfront.
|Buyer saves capital.- Seller’s shareholders benefit from profits of the combined company.
|Buyer who wants to save some of their cash.- Buyer who wants to keep the seller involved in the company.
|Both companies agree on a trade rate and trade equities.
|No capital or cash is needed.
|When the acquirer needs to save their capital or cash for future operations.
|Mezzanine or quasi-debt
|A private firm pays cash for the acquirer’s private shares or junior debt.
|Can be combined with seller’s notes.
|More expensive because it’s unsecured.- Higher rate of return, so the deal is more expensive.
|The seller receives a percentage of the company, plus a percentage of the new company’s earnings for the first five years.
|The buyer needs less cash to carry out the acquisition.
|Seller who wants to retire from the company and is flexible about payments.
|When a buyer borrows money and uses assets from both companies as collateral, combining equity and debt.
|Buyer needs to commit considerably less capital.- Considerable payday if the acquisition is successful.
|This type of transaction can easily sink a mismanaged company.
|For a buyer who doesn’t want to commit a lot of capital.
|With a seller’s note, a seller agrees to a payment schedule.
|A buyer needs to commit less capital.
|For a buyer who has difficulty securing financing.
|The buyer borrows money from a bank.
|The buyer saves their capital to fund operations of the new company by using borrowed funds.- Personal guarantees can be avoided if the company has enough cash flow or assets.
|Business relationships may come into play, so loan approval may depend on the bank liking the industry, team, cash flow, etc. – Needs to be repaid within 1-2 years, and repayment supersedes other notes.
|Makes the most financial sense only when interest rates are low.
|Private equity firms loan
|Private investment companies invest in the acquisition.
|Allows for the possibility of gaining from experienced professionals involved in management.
|Bias for companies with over 3-5 million of combined cash flow.- Results in diluted ownership.
|Investors buy bonds and receive periodic interest payments.
|The buyer saves capital to fund operations of the new company.
|Buyer needs to plan for paying interest and repaying the principal in scheduled installments.
|Financer provides money on the assurance that assets of the target company can be liquidated if worst comes to worst.
|The buyer saves capital to fund operations of the new company.
|It can be difficult to find a financier who will agree on the buyer’s valuation of the target company’s assets.
|When the targeted firm has adequate valuable assets.
|The Small Business Association backs the loan.
|The SBA backs up to 90% of the value required for the acquisition.
|Requires mandatory personal guarantees, meaning if the company defaults, the borrower must pay back the loan.
|When a buyer has no other option.
- Unless you have enough capital to carry out an all-cash acquisition, you will have to go into debt or dilute company ownership.
- In order to find the best acquisition financing method for your case, it’s essential you gather and analyze relevant data from both companies.
- Aim to combine financing options so that you reduce risks and boost opportunities for the new company.