July 16, 2024
finance for small busesses

How to finance a business acquisition

Negotiating the best possible finance arrangement is essential in completing a successful transaction. An ideal finance strategy will allow for a seamless ownership transition and allow your firm to grow in the years ahead.

To discover the correct balance of finance, it might be tough to comprehend how each sort of financing works.

BDC’s Development & Transition Capital team Vice President Robert Duffy says, “When correctly designed, the financing package will provide you the flexibility to effectively integrate your purchase and support your future growth.

A typical acquisition financing package, as described by Duffy, has financed a large number of business purchases.

Determine the acquisition target’s worth

Determine the value of the firm you’re interested in purchasing before securing finance. Earnings before interest, taxes, depreciation and amortization (EBITDA) are commonly used to estimate a company’s worth (EBITDA). In order to effectively depict the company’s future profits potential, non-recurring expenditures and revenue should be removed from EBITDA.

For an acquisition price, the company’s normalized EBITDA is multiplied by a multiple reflecting the stability of its profitability and future growth potential. Vendors have agreed to sell for five times annual EBITDA, or $15 million, in our hypothetical situation.

An investment in equity is a sign of long-term commitment.

When a buyer contributes a portion of the purchase price, the funds might come from a variety of sources, such as the purchasing company’s excess cash. A third-party investor, who then becomes a shareholder in the merged firm, might also provide stock. This sort of equity financing can be obtained through a BDC.

In addition to reducing borrowing costs, equity involvement shows lenders that shareholders are committed to the acquisition’s success through their financial investment.

Most of the company’s financing comes from senior debt.

A loan from the company’s assets is provided by the senior lender in an acquisition agreement. Amounts such accounts receivables, inventories, real estate and equipment may not be fully secured by particular assets, but this debt is referred to as senior debt since the lender has a first charge against these assets in a recovery situation.

Duffy argues that the senior lender normally sets the EBITDA multiples it is ready to offer for acquisition financing. Three times EBITDA, or $9 million, is the senior lender’s maximum loan amount in our case study.

It is common for senior lenders to have the most stringent repayment conditions, including the need that the loan be repaid in a short period of time. You’ll likely be required to make monthly payments and adhere to additional terms of the loan, known as financial covenants, such as maintaining a specific debt-to-income ratio. Cash flow term loans are offered by the Business Development Corporation (BDC).

Using vendor debt as a transitional tool

Vendor takebacks, or vendor notes, are common in acquisitions where the seller is helping to fund the sale. Essentially, the buyer agrees to pay a portion of the purchase price to the seller in installments over a certain length of time, with interest added in. In our scenario, the vendor agreed to receive $3 million, or 20% of the purchase price, over time.

Vendor notes, according to Duffy, can take on a variety of shapes and sizes. It may be depending on the company’s success, with the amount of EBITDA it generates over the payback term growing or decreasing. An “earn-out” is the term for this segment.

They’ll do whatever to make sure the company continues to prosper and they’ll be rewarded with $3 million if they don’t succeed.

The buyer benefits greatly from vendor notes since they often have fewer restrictions and a lower interest rate. In addition, if the organization has financial difficulties, the vendor will probably be patient in seeking payment.

Because “oftentimes one or both sides want the vendor to remain in some manner,” Duffy explains, “the other compelling argument.” In order for the vendor to be incentivized to make sure that the business survives the transition and continues to prosper, they will be owed $3 million after the close.”

Offering a wide range of options, mezzanine financing

Mezzanine finance is frequently utilized to bridge the funding gap between the acquisition price and other sources of funding.

Mezzanine financing carries a higher interest rate than senior debt because of the greater risk it represents for the lender. However, its repayment terms are quite flexible and may be adjusted to suit the demands of a particular firm.

A good illustration of this is when BDC Growth & Transition Capital’s mezzanine loan repayment might be patient after an acquisition. Repaying the senior lender and the vendor debt while also implementing a growth strategy may need this.

As a result, “we are the ultimate gap filler because we are able to accommodate everything else that is going on in the transaction.”

For companies looking for a financing solution that is tailored to their specific situation or that want to diversify their financial providers, Duffy says BDC is a good option for acquisition financing because of its ability to provide senior debt, mezzanine financing, and minority equity portions of a financing package.

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