As more companies turn to M&A for the first time as their strategy to develop their business, their executives understandably face many difficulties. To respond to these challenges, the M&A Community publishes a series of articles aimed at supporting executives during dealmaking and, therefore, driving further business growth.
The decision to buy a business is a complex process that involves many contributing factors. In this guide, you will discover the options to finance a business acquisition available to business owners, learn more about business acquisition loans, and explore the general practices in this subsegment of M&A.
Business acquisition financing at a glance
Acquiring an existing business is a way to grow your venture, expand to new markets, and gain access to higher financial gains. And acquisitions finance models have become an inevitable part of this process.
Whether an acquisition is part of a long-term business plan or an approach to adapting to recent trends, you must tackle several substantial challenges if you are looking to buy a business. These may include:
- Outlining the detailed profile of the virtual or existing
company you want to acquire
- Performing thorough due diligence to get a personal
guarantee that the transaction will be successful
- Finding means to process the purchase at a price
determined through a business valuation.
This time, the M&A Community decided to take a closer look at the latter.
Finding the correct acquisition financing solution can be quite demanding, especially for small businesses. Your task is to familiarize yourself with all the available business acquisition loan options, such as SBA loans for business acquisitions or equipment financing, define the standards of comfortable term loans for your company, and explore solutions beyond traditional business acquisition loans.
What is business acquisition financing?
The most straightforward way to look at acquisitions is to picture a buyer and a seller that come together to negotiate and process a purchase. Deal financing, in this case, refers to the price the buyer will pay and the money spent to facilitate the transaction.
Historically, M&A funding was financed by hard cash or a primitive form of a business acquisition loan. But as the industry developed, so did the ways to sponsor acquisitions and mergers.
Business acquisition financing definition
Financing a business acquisition refers to sourcing the funds to cover the purchase and, sometimes, the efforts invested in the process. There are numerous currently available financing solutions, including small business loan applications, business loans from banks, Leverage Buyout Loans (LBOs), and more.
All forms of business acquisition loans and other financing approaches have their conditions and peculiarities. Some lenders only offer business acquisition finance on strict terms., and others demand high-interest rates. And the intermediary structures such as SBA loans in the US (or other forms of bodies specifically aimed to offer loans to small businesses) will take a deep dive into your financial statements and other documentation.
It is crucial to understand how each financing approach applies to your case to successfully navigate through all the available acquisition funding options and make the right decision. But first, let’s discuss why businesses look for other ways to pay for their purchases other than taking the funds from the company’s pocket.
When do companies need an acquisition loan?
There are virtually limitless reasons to seek external funds for purchasing an existing business. But modern M&As practically never happen as simple buyer-paying-the-full-price transactions.
Here are a few scenarios where you might consider seeking alternatives for financing an acquisition when you buy a business:
- You are a small business owner looking to expand but need
more funds to process the purchase independently.
- Your bank offers comfortable interest rates for business
acquisition loans based on your business’s credit score.
- You are joining another buyer to finance a business
purchase or acquire the same business.
- You are aiming to increase the returns by leveraging
business acquisition loans.
- You want to acquire funding to mitigate the risks associated
with cash and equity payments.
But a business acquisition loan is not the only option, even if you aren’t willing to invest the company’s money. To find the right fund source, follow the steps described in the next section.
Business acquisition financing mechanism
Whether you own a small business or represent a large corporation, business acquisitions’ fund seeking follows a somewhat standard model.
Locating the acquisition opportunity
A business acquisition loan can only be approved with a specific opportunity on the table. That’s why you must secure a target before you explore the available financing options.
Insight: Your decision to buy a business must align with your business plan and have specific criteria for an existing business you want to take over. Most institutions only agree to finance a small business acquisition when they are convinced it has ground to stand on.
You can create your own conditions for the opportunity approval process, such as evaluating a business’s financial performance, operation practices, credit score, etc. Your main objective is to get a personal guarantee that you can acquire the target company following your vision.
At this stage, you can also begin to put a Letter of Intent (LOI) together, mentioning that you are planning to obtain financing. Submit the LOI only after you consult with lenders; just have it ready.
A conventional term loan is highly dependent on your business or personal credit reports and the price you will pay for the target. For example, in the US, traditional term loans are only possible with substantial down payments, while SBA loans are granted to companies with a minimum credit score of 680.
You must clearly understand the price specified by the seller and be willing to pay a portion of it before looking for a business loan or any other financing option.
Insight: To better understand the seller’s pricing approach, find out what factors contributed to business valuation. Typically these include earnings before interest, taxes, depreciation, amortization, revenue trends, size, growth predictions, and others.
Selecting the financing model
The final stage is clearly outlining the transaction structure and selecting the most appropriate financing solution. Before, when an acquisition loan was only possible through a bank, the most challenging part was comparing interest rates.
But now, there are many options like seller financing, loans from bodies supporting small businesses (for instance, SBA loans in the US), joint business acquisition loans, and many others, meaning that there are many more factors to consider. In the next section, we will discuss the most common ways to finance a business purchase.
M&A financing options
As already mentioned, traditional bank loans are no longer the only option if you are looking to buy a business. Below are the financing solutions you can consider, including the conventional business acquisition loan approach.
Company funds and equity
Using a company’s funds to pay for an acquisition is the most straightforward solution for both the buyer and the seller. Instead of navigating through down payment structures, comparing competitive interest rates, and negotiating the most favorable terms, established businesses leverage their cash flow to cover the cost.
The same logic applies to a company building an acquisition finance structure with its shares. And in the case of optimistic financial projections, this form of business ownership is even more preferred for the target small business owners.
Although it may appear counterintuitive, it’s not uncommon for the seller to serve as a financing company. For the buyer, this approach is beneficial on two key levels:
- Since the operational proceeds will be used to repay the loan,
the seller is less likely to vend a potentially unsuccessful venture.
- The sell-side business acquisition loan is typically offered at more
competitive rates than traditional institutions.
While sellers might prefer to avoid this approach and generate a more immediate cash flow instead, it is often the only option for non-established medium and small businesses. According to the analysis of recent financial documents, sellers typically finance business purchase ventures by covering between 5% to 25% of the transaction value.
Small Business Loans
Most jurisdictions have independent agencies that guarantee loans to small businesses; loans backed by such organizations are designed for small businesses that require a business loan to boost their expansion. For instance, in the US, the Small Business Administration (SBA) is one of those agencies, they also guarantee business acquisition loans.
Insight: Usually, those independent agencies do not finance the acquisition loan but serve as a guarantor of the borrower’s paying abilities and secure transactional safety. Many investors prefer financing a business purchase backed by one of those agencies for an extra layer of protection.
For instance, in the US, most small business loans from SBA lenders can cover up to 90% of the total price, have competitive rates, and have a comfortable term loan structure. The following example describes the terms of typical SBA-backed loans, some of the details may vary in different jurisdictions but the logic behind them is very similar.
- A credit score of 680 and up
- Minimum three years of tax records
- Ability to cover at least 10% of the cost of the acquisition.
Third-party investors and PE firms
Individual connections to private investors, such as family offices or VC firms, can help you secure the necessary funding for business acquisition without going through traditional lending mechanisms. If you have a proven track record of successful business handling and a well-performing existing business, you might be able to get multiple lenders at flexible terms.
Insight: Private investors are incredibly selective, so be prepared to revise your target’s business valuation and undergo pre-transactional due diligence.
Some micro-investors are presented as online lenders that help small companies grow faster. Although this approach involves a fast and easy online application process and doesn’t require a down payment, be extra attentive when working with investors you don’t personally know.
Banks are the most traditional lenders of acquisition loans, they have been financing acquisitions from the dawn of M&A. For small business owners, the only options are established financial institutions such as banks, credit unions, or a loan backed by the relevant government agency that supports small businesses such as the US-based SBA.
Conventional loan lenders require a minimum credit score defined by the bank’s rules, fixed installments paid according to the agreed schedule, and, sometimes, collateral to back up the loan.
Insight: If you or your business represent a minority group, look for regulated institutions that may provide comfortable and equal term loan options to that specific minority group or to minority groups in general.
Leveraged buyouts are the most popular approach to securing a business acquisition loan, as they often work in combination with other forms of lending. The main goal of a leveraged buyout is to reduce the capital invested by the buyer.
Insight: LBO models can also help established businesses acquire long-term financing for multiple projects.
This approach ensures financial protection via leveraged assets such as equipment, real estate, or inventory. But although equipment financing and other forms of leveraged buyouts might seem like the easiest way to secure an acquisition loan for an expanding small business, accumulating debt can negatively impact your financial history and cancel out the chances of taking advantage of potential opportunities.
How much money do you need to finance a business acquisition
As you know, the current variety of loan options is available because companies are no longer practicing covering the entire cost by themselves. Unless the target company valuation is less than $200,000, you will likely need a business loan or another funding source.
Insight: The amount you pay will depend on the structure of the loan process and the valuation of the company you are acquiring.
The typical down payment on most M&A transactions ranges between 10% and 15% of the total cost. It applies to businesses of any size that secured an acquisition loan on individual terms with online lenders or other private investors.
Post-acquisition operations financing
Securing a business acquisition loan will get you through the transaction. But what comes next is the lineup of operational costs associated with keeping your newly acquired business afloat.
Small and much more substantial business loans are often exhausted when the company gains new ownership. You might need to source another funding solution or negotiate additional term loans with the current lenders.
There are three ways to finance operations post-M&A.
You can always use your business or personal assets to fund the operations and avoid getting into another strict term loan. This approach is the best if you have a good personal credit score and steady cash flow.
However, just as equipment financing puts a small business at risk of debt, using your current company’s money for the new one can be unsafe. Once again urging you to consider business acquisition loans.
Traditional term loans offered by banks, credit unions, online lenders, and others follow the same general model. They will grant your business loan based on minimum credit score requirements, successful history of acquisition loan payments, and possibly equipment financing.
Your main concern at this point is the alignment of the interest rate with your new business’s earning potential.
If you are no longer considering loan options after the business acquisition and don’t wish to invest your own money, you can sell the slow invoices to factoring companies at a discounted rate. Although this is one of the fastest financing options for quick cash flow generation, keep in mind that you will lose some money cashing your invoices earlier.
Acquisition financing examples
Below are the business acquisition examples that feature the use of the company’s capital, business acquisition loans, and leveraged buyouts.
Business acquisition loans and other business financing options became inevitable elements of modern M&A. To successfully secure an acquisition loan for your upcoming business acquisitions, maintain a satisfactory business line of credit scores, grow your professional network, and remain on the lookout for promising opportunities and merger and acquisition finance trends.