What Is Acquisition Financing?
Acquisition financing is the capital that is obtained for the purpose of buying another business. Acquisition financing provides immediate resources that buyers can apply to a new acquisition transaction.
Key Takeaways
- Acquisition financing is the funding a company uses specifically for the purpose of acquiring another company.
- By acquiring another company, a smaller company can increase the size of its operations and benefit from the economies of scale achieved through the purchase.
- Bank loans, lines of credit, and loans from private lenders are all common choices for acquisition financing.
- Other types of acquisition financing including Small Business Association (SBA) loans, debt security, and owner financing.
How Acquisition Financing Works
There are several different choices for a company that is looking for acquisition financing. The most common choices are aline of creditor a traditional loan. The buying company might also use staple financing which is a pre-arranged financial arrangment with the same investment bank that is handling the sell.
Favorable rates for acquisition financing can help smaller companies reacheconomies of scale, which is generally viewed as an effective method for increasing the size of the company's operations.
An acquisition is a transaction in which one company, or owner, buys some or all of the shares in another company. The second company may or may not merge with the parent company.
A company seeking acquisition financing can apply for loans available through traditional banks as well as from lending services that specialize in serving this market. A bank might be more inclined to approve financing if the company to be acquired has:
- A steady stream of revenues
- Steady or growing EBITDA (a cash metric that would help the acquirer pay back the debt obligations from the loan on the acquisition)
- Substantial or sustained profits
- Valuable assets for collateral
By comparison, securing bank approval can be problematic when attempting to finance the acquisition of a company that largely has accounts receivables rather than cash flow. Private lenders may offer loans to those companies that do not meet a bank's requirements.However, a company may find that funding from private lenders includes higher interest rates and fees compared to bank financing.
Other Types of Acquisition Financing
Small Business Administration Loans
Depending on the size of the businesses involved and the nature of the acquisition, there may be financing options through the Small Business Administration (SBA). The SBA 7(a) loan program, for example, may suit these needs for borrowers who qualify. The down payment may be as low as 10% for acquisitions when using this program.
The borrower must, however, meet the SBA’s requirements on the size of the business, which includes limits on net worth, average net income, and overall loan size. There may also be extensive paperwork for the applicant that includes submitting:
- Details on accounts receivable
- Personal as well as business tax information
- Personal and business financial statements
- Any corporate charter
Debt Security
A company may use debt security, such as issuing bonds, as a means of financing an acquisition. In many cases, a company may find that selling bonds on the open market offers advantages over seeking funding from a bank or private lender. Banks generally have covenants or rules regarding their funding that companies find restrictive and expensive. Because of this, companies turn to the bond markets as an alternative source for financing mergers and acquisitions.
Other means of financing an acquisition through debt include debt that is paid back as shares and interest in the company making the acquisition. This may come into play if the buyer turns to close associates, such as friends and family, to provide financing to secure the acquisition.
Owner Financing
Owner financing is another way for a business to fund an acquisition deal. It's often referred to as "seller financing" or "creative financing." This usually entails the buyer making a down payment to the seller. The seller agrees to finance the rest of the transaction or a portion of it. The buyer will then make installment payments to the seller over an agreed-upon period.
In a buyer's market, a seller may find owner financing a good way to expedite the sale of a business. It also allows the seller to receive a steady stream of regular payments from the buyer which, if structured correctly, could provide more income than traditional fixed-income investments. The buyer, on the other hand, can benefit from reduced costs and more flexible terms when dealing directly with the seller, as opposed to funding the acquisition through a bank or private lender.
Is An Acquisition the Same As a Merger?
Both an acquisition and a merger involve one company buying another. In an acquisition, the acquired company is usually integrated into the parent company. When a merger happens, the two companies combine but create a new business entity.
What Are the Benefits of Acquisition Financing?
By seeking out financing for an acquisition, a business can access the funds it needs immediately. This saves the time that would otherwise be needed to raise capital to buy another business, which allows the transaction to be completed more quickly and smoothly.
What Is EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This is an alternate measure of profitability that is used instead of net income. EBITDA represents the cash profit created by a business and is often used by lenders when deciding whether or not to offer financing to that business.
The Bottom Line
A company looking to acquire total or partial ownership of another company will often use acquisition financing. This type of financing is specifically for buying a business. Acquiring another business allows smaller companies to increase the size of their operations, enter into a complementary market, or benefit from economies of scale.
Common types of acquisition financing include bank loans, lines of credit, and loans from private lenders. Companies may also turn to loans from the Small Business Association (SBA) loans, finance a transaction through the sale of bonds or other debt security, or make use of owner (seller) financing.
