Acquisition Financing: What It Is and How It Works

Mergers and acquisitions (M&A) are important tools for inorganic business growth, bringing numerous advantages to the purchasing firm. One company may acquire another in order to expand its client base or move into a new geographic area. An acquisition may be an opportunity to bring on an established, turn-key technology system rather than building one from the ground up. Increasingly, acquisitions are being used to bring specialized talent into the company and deal with staffing shortages.

Acquisition financing is an umbrella term used to describe the many different methods companies can use to obtain capital for purchasing another firm.

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Acquisition financing options

Purchasers have a variety of acquisition financing options to consider. Which one is best depends on several factors, including the creditworthiness of the buyer, the size of the purchase, and whether or not the seller will remain involved with the business after the sale. The final choice usually will come down to which option provides the lowest cost of capital.

Some of the acquisition financing options available include:

1. 1. Loans
   2. Debt
   3. Equity
   4. Leveraged Buyout (LBO)
   5. Owner financing

→ Watch Now: Debt vs. Equity: Which is Better?

Acquisition financing through loans

Loan financing is familiar to most people who have bought a car or a home. Loan financing for a business is more complex but is based on the same general idea: the borrower asks a lender to provide the funds necessary to make the purchase, then repays the money over time at a given interest rate. With a business loan, however, there are several other considerations that don’t come into play with a vehicle loan or a mortgage.

The lender will look closely at the financials of the buyer’s business and those of the target company. They will try to determine if the combined business will have adequate cash flow to make its debt payments and still remain profitable. The lender will determine an appropriate interest rate for the loan based on the level of risk involved. Some lenders, including those providing SBA-backed loans, may require a personal guarantee which can put the buyer’s personal assets and home at risk.

Oak Street Funding approaches lending differently. Because we have had decades of experience lending to CPAs, RIAs, and independent insurance agents, we know how to structure loans that provide adequate capital to complete a deal while protecting the borrower’s personal assets. We understand how to put a value on the cash flow of a business and project future profitability. Oak Street Funding regularly makes acquisition loans to companies in several industries based upon anticipated increases in cash flow resulting from a purchase.

How much do lenders cover?

A general rule of thumb is that lenders will contribute between 50 and 80 percent of the purchase price of the business, but this percentage will vary across lenders, buyers, and the characteristics of the deal. It all boils down to risk; the lender will be unlikely to lend an amount that represents an uncomfortable level of risk.

Using debt for acquisition financing

Companies that have difficulty qualifying for a commercial loan – or are unwilling to meet the expectations and covenants of the lender - may seek capital by issuing securities (such as bonds) and selling them on the open market. This method entails some complexity, but it may be a good option for some borrowers. In some cases, bonds issued may be convertible into equity shares after a given period.

Issuing equity to obtain capital

In this approach, the buyer offers shares of the company to investors in exchange for capital to make the purchase. The investors then have an ownership role. This method requires the buyer to give up some control over the operation of their business and may be more costly than other approaches, but it may be a good choice for purchasers who cannot qualify for a loan.

Acquisition financing through leveraged buyout

Leveraged buyouts (LBOs) are another form of loan financing. The difference between LBOs and more conventional loan-financed deals is that LBOs depend on a much higher percentage of debt. For this reason, they were once associated with so-called junk bonds. They may include the issuance of equity shares in the combined company as well. LBOs are usually associated with larger companies and are seen as riskier deals due to the high debt-to-equity ratio they create.

Owner financing

More and more acquisition deals now include owner financing (AKA seller financing) along with other capital provision strategies. With owner financing, the seller provides part or all of the capital needed for the transaction – in a sense, becoming the lender themselves.

This approach may be a simple installment loan, where the buyer makes payments over time to the seller. It can also be a good way for a junior member of a firm to buy in over time while learning the skills of ownership. It also offers advantages to the seller as it spreads out capital gains rather than having them hit all at once.

A slightly different format is the earnout, in which the seller agrees to a percentage of the company’s future earnings. This approach has advantages for the buyer, because the seller is motivated to keep the business in growth mode in the time leading up to the sale. It’s also a great avenue for buyers who want the seller to stay involved in the business after the sale.

Many lenders like acquisition deals that combine a loan with some owner financing. When the seller has skin in the game, there is motivation to keep the business healthy and profitable.

How to obtain acquisition financing

While it may be exciting to go “shopping” for a business to buy, it’s wise to start the process by talking to lenders first. Most lenders are happy to talk with potential borrowers about what their goals are and how acquisition financing can help. It also helps the borrower get a handle on what their purchasing budget should be. Talking with the firm’s accountant and attorney is another valuable step to take before identifying a business for purchase.

Before speaking with a lender, make sure to have at least three years of financials, including tax returns, and a clear growth plan. Lenders favor borrowers with steady or increasing revenues, strong management, and efficient use of working capital.

Choosing a lender

Not all lenders are the same. Borrowers should look for a lender with solid experience in their industry. Ask about using cash flow as collateral. Find out if the assets of the company principals could be encumbered. A reputable lender will be happy to discuss those issues and all other terms of a loan, so don’t hesitate to ask. Ideally, a lender becomes a trusted partner – someone who is as invested in the success of your business as you are.

Oak Street Funding has built its business on helping companies make successful acquisitions using cash flow as collateral. OSF recognizes that the right acquisition will drive increases in revenue which will more than cover repayment of the loan. Contact Oak Street today to learn more about how acquisition financing can fund your expansion plans.