“How Are We Paying for This?” – Funding Sources for Business Acquisitions

Acquisition finance is crucial to any successful merger. With the COVID-19 pandemic raising new possibilities for business consolidation, how can prospective purchasers ensure they are prepared?

Jason Varney, Corporate Partner at Thomson Snell & Passmore LLP, explores some of the most useful funding sources for business acquisitions.

Although pursuing an M&A transaction may not currently be on every company’s “key priorities” list given the current economic uncertainty as a result of the COVID-19 pandemic, such times do inevitably bring about a number of consolidation opportunities – whether that be as a result of a company insolvency and subsequent fire sale of its business and assets, or through the need to take better advantage of economies of scale by merging two similar businesses.

Whatever the reason behind the proposed business acquisition, a share or business purchase agreement is unlikely to be touched by ink until the acquirer has secured acquisition finance.

There are numerous ways that an acquiring company can secure funding for a business purchase, but the key sources we tend to see in our M&A and finance practice are as follows:

Cash reserves

As the old saying goes, “cash is king” – and this is still the case when acquiring a business. Although the vendor of said business will likely, if well advised, require evidence proving the availability of cash reserves to fund the acquisition before signing any documentation; the fact that third party funders do not need to be involved in the acquisition itself means that this is by far the simplest way to fund an M&A transaction.

As the old saying goes, “cash is king” – and this is still the case when acquiring a business.

Debt finance

Debt finance comes in a variety of forms but in essence it involves the borrowing of money and paying it back with interest. The issues to consider when entering the market for acquisition finance are what debt products are available and what is affordable for your business. Incurring debt means providing for the regular expense of loan repayments and will invariably involve a certain amount of control by the financier. In addition, any already existing finance facilities may contain restrictions on further borrowing which may make it difficult to borrow enough money to finance a large acquisition entirely through debt.

Typically cheaper in the long term than issuing equity and advantageous from a tax point of view (as principal and interest repayments are usually tax deductible), issuing debt has many other benefits. Ultimately, the borrower retains control and ownership of its business; once the loan is paid back the borrower’s relationship with the lender ends and the company ceases to be subject to the financier’s restrictions. The lender’s return is fixed, any profit after repayment of debt is for the shareholders.

Depending on the complexity of an acquisition transaction, borrowers may choose the path of incurring senior debt, which typically carries lower interest rates depending on the collateral. Another way of raising finance is issuing bonds or raising mezzanine finance, which is used to fill the missing gap in acquisition finance structures. The riskier a transaction is, the higher the interest rate a lender will typically charge. Interest rates are currently at historic lows, so the cost of borrowing can be low.

Equity finance

A key benefit of raising finance through the issue of further shares in the acquiring company/corporate group (rather than through debt finance, as detailed above), is that in the majority of cases such an investment would not need to be paid back to the relevant investor. The downside, of course, is that the new shareholder(s) will want to see a return on their investment (by way of a preferential dividend, ordinary dividend and/or a capital gain) and most will want some input into the management of the company (whether by way of voting rights or a shareholders’ agreement containing veto rights).

If the newly acquired business which was funded through equity finance is a success, both the existing and the new shareholders are likely to benefit from such success; but it is in situations where such an acquisition fails to provide the benefits that were envisaged (or where the “failed” acquisition starts to put the wider corporate group under financial pressure), that tensions between the investors will start to emerge. In such circumstances, it is imperative to have a detailed shareholders’ agreement in place to manage any disputes between the investors should the company or its group take a turn for the worst.

How best to fund my acquisition? 

Ultimately, the final decision as to how best to fund an acquisition really depends on a number of considerations – such as the market, availability and cost of debt, investor appetite, the company’s current gearing (being the ratio of a company’s debt to its equity), etc.

When considering acquisition funding it would be wise for companies to seek advice not only from lawyers but also, in regards to larger acquisitions, from a corporate finance house; as most companies would benefit from corporate finance input at some stage during their life-cycle.

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