Funding an acquisition
You have the opportunity to grow your business by acquiring another one: how are you going to fund the deal?
17th August 2022
Mark Neath See profile
How or why, you might want to make an acquisition is the subject for another article, here we are just concerning ourselves with where the money is going to come from.
A lot of the principles of finance apply equally to organic growth or management buy-outs and so on, but we’re looking here in the context of buying a business.
Let’s start with busting a couple of (contradictory) myths:
- To make an acquisition you need to have the cash for the purchase price
- Your bank will lend you all the money to do the deal
Yes, these are kind of opposites, but some people think they’ll not be able to buy another business unless they have all the money; whilst others assume that their bank will happily fund everything. The reality, as with so many things, is somewhere in between.
Banks generally won’t lend you 100% of the money because of risk, which in banking terms really means ability to repay.
As my colleague Tom Downes explained in his article on valuation, a business is usually valued as a multiple of profit. If you are paying someone, say four- or five-years’ worth of profit to buy their business then after you take into account tax, need for investment in assets, working capital and interest, the business isn’t going to be generating enough cash to repay the bank over a typical term loan period.
There is also a difference between what we call “equity risk” and “debt risk”. Borrowing is appropriate for a debt risk and should be matched to reliable streams of cash flow. The equity risk is different – this is about risk and reward, what we might think of as entrepreneurship. Banks don’t take equity-type risks, so you must be prepared to put some of your own (your business’ own) money into a deal. It’s not all bad news though, because the bank’s return is fixed (interest) whereas your return is variable (down as well as up!) but the upside is uncapped.
If a straightforward term loan isn’t the whole of the answer, what is?
Other sources of finance are available and there is potential for the target company to help to buy itself. Sounds good!
The business that you’re buying will have some assets and assets can be financed.
Property can be mortgaged, probably only to around two-thirds of its value, but a helpful sum might be raised. The advantage of mortgages is they tend to be over longer terms than a business loan, so spreading the repayments (making them smaller)
Many items of plant and equipment and vehicles can be financed, releasing part of their value into cash
The money owed to the company by its customers can be released to cash through invoice discounting or factoring. This is a one-off advance, but has the advantage that it continually recycles and so doesn’t have repayments like a loan would
Although much less established than invoice finance, and generally not possible in isolation, there are a limited number of stock finance providers who can advance a portion of the stock value alongside a debtor facility
It is rare for an acquisition to be entirely self-funding, unless the seller’s price is too low!
Obviously, your own business’ cash or borrowing capacity would be the first port of call, but that isn’t always available to the extent needed.
If that’s the case, then you need someone else’s money.
The two most common solutions here are deferred consideration and private equity.
This can take a variety of legal forms, but in simple terms, it is getting your seller to part fund the deal by accepting some of their payment spread over a number of years.
This links back to the concept of equity risk that we were discussing earlier. If the cash need goes beyond what is borrowable, then an equity investor could bridge the gap. If I say “private equity” you probably immediately assume I mean some kind of “venture capitalist” but there are a number of things that fall into this category. Although we rarely think of it as such, putting in your own money is in a sense a form of private equity. It could also mean an individual investor, or a minority investor or growth fund. Letting someone else have a share of your business might sound scary but if it enables you to take a leap forward, it can be worthwhile.
Both of these are good subjects for detailed articles in their own right, so the above is just an overview.
Funding an acquisition isn’t a simple proposition and will likely involve a mix of different solutions to get to the amount you need.
If there’s a key message, it is not to assume it is impossible (we can usually work something out) but equally, don’t assume that it’s easy.