Companies require capital to complete financial transactions and the method they choose to secure funds can influence their growth, financial health, and ability to navigate business complexities.
Imagine a fast-growing startup that takes on a big loan to expand but doesn’t thoroughly assess its repayment capacity. When unforeseen challenges arise, it’s no longer able to repay the debt, jeopardizing its financial well-being.
The article below explores various financing methods, outlines their advantages and disadvantages, and provides guidance on selecting the most suitable approach for specific business cases. This will help you make sound financial decisions and ensure your company’s future is safe.
What is M&A financing?
M&A financing refers to the various methods and strategies to fund mergers and acquisitions (M&As).
M&A, in turn, takes place when one company seeks to acquire another or when two businesses decide to merge. Depending on strategic and deal objectives, there can be different M&A types (horizontal, vertical, or conglomerate) and structures (hostile takeover, joint venture).
To facilitate the deal and cover the purchase price of the target firm, significant capital is required and the acquiring company’s own cash reserves may not be enough. To be able to finance the transaction, it may utilize various financing options, including equity and debt financing, stock swap transactions, leveraged buyouts, mezzanine financing, and bank loans.
Each financing structure has its advantages and disadvantages, and the choice depends on various factors, such as:
- Deal size. Larger transactions often require a mix of financing options, like equity and debt to cover substantial capital needs, while smaller deals may use simpler financing structures, such as cash reserves or a bank loan.
- Company’s financial health. The financial stability of the acquiring company is critical in M&A financing. Strong financial health may allow for more flexibility, including the ability to take on debt for financing. A company with weaker financial health might need a more conservative approach, like equity financing.
- Control level. The level of control the buyer wants over the target company can influence the financing choice. For example, equity financing and stock swap transactions may dilute ownership but provide more control, while debt financing doesn’t dilute ownership but limits the acquirer’s operational flexibility.
In a recent survey involving senior executives from 240 corporate and 90 private equity firms, findings show that 24% consider private equity the primary source for M&A funding. Following closely, 21% of respondents favor credit funds, while 16% opt for cash reserves.
Still, choosing the right acquisition financing option requires understanding their differences, advantages, and disadvantages. Let’s begin by exploring the primary sources — equity financing and debt financing.
Debt vs equity M&A financing
Debt financing involves borrowing money, often through loans or bonds, with an obligation to repay the borrowed amount and interest. For example, Company A might obtain a $15 million loan with a 3% interest rate for 2 years.
Equity financing involves raising capital by selling a company’s ownership stakes or shares to investors. For instance, Company B might sell 15% ownership, granting the investor voting rights and a share in profits. In return, it receives capital which it can use to acquire another business.
Let’s compare the advantages and disadvantages of two financing options and learn more about each in more detail.
|No dilution of ownership. Lenders have no control over the company. Profit is also not shared.
Tax advantage. Interest payments are tax-deductible, providing a financial benefit.
Fixed repayment costs. Interest payments are predictable, allowing for easy expense forecasting.
|No repayment obligation. Repaying the acquired money is not required, making cash flow management easier.
Risk sharing. Investors share the company’s financial risks, which reduces pressure.
Expertise. Equity investors can contribute knowledge, networks, and resources to support the company’s growth.
|Interest costs. Regular interest payments for a set period impact profitability and strain cash flow.
Impact on credit ratings. Insufficient planning for debt repayment can lead to late or missed payments, negatively impacting credit ratings. This, in turn, makes future borrowing more challenging.
Bankruptcy risks. In the event of business failure, the obligation to repay the debt persists, which can lead to financial distress, loss of assets, or even bankruptcy.
|Dilution of ownership. Selling equity results in ownership dilution as investors gain voting rights and a share in profits.
Potential conflicts. Granting investors a voice in business decisions can lead to conflicts.
Long-term commitment. Equity financing may lead to long-term partnerships with investors.
Generally, debt financing can be recommended for companies that have stable cash flows, a clear repayment plan, and a desire to maintain full ownership and control. On the other hand, equity financing is suitable for companies with high-growth potential, a lack of sufficient collateral for debt, and a willingness to share ownership and risks with investors.
Also, acquiring companies may choose to combine debt and equity financing. For instance, a company looking to raise $100 million could sell a 20% equity stake to a private investor, securing $50 million in capital, while also obtaining a $50 million loan with a 3% interest rate.
Other types of M&A financing
Explore five more options to finance the acquisition deal.
1. Stock swap transaction
In a stock swap transaction, two companies exchange their shares to complete a merger or acquisition and form a new entity. In this case, the acquiring company communicates its offer directly to the other company’s shareholders. If the offer is accepted, two firms should carefully value their shares to determine a fair swap ratio.
As a rule, only a part of a merger is completed with a stock swap transaction, while the rest is paid with cash or alternative methods.
Example: Disney acquired Pixar Animation Studios in a stock-for-stock transaction. Pixar shareholders received 2.3 Disney shares for each Pixar share.
- Risk sharing. Risks are shared between the two businesses, which leads to more cautious management from both sides.
- Market value advantage. If the buyer’s stock holds a higher market value, they receive more of the seller’s company stock, compensating for the difference in market value.
- Equitable ownership. After the merger, existing shareholders retain an equivalent value of stock in the newly combined company.
- Control dilution. Stock swaps may dilute ownership, reducing existing shareholders’ percentage and influence over the new firm.
- Hold-out complications. Deals with more shareholders in the target company may face complications with hold-outs, as convincing individuals to accept stock in a new entity is often more challenging than offering cash.
2. Mezzanine financing
Mezzanine financing combines the characteristics of equity and debt and is therefore considered a hybrid form of financing. Typically, it involves the issuance of subordinated debt which means that this debt holds a lower priority than senior debt but carries more risk than traditional loans. Specialized funds or investment companies are commonly mezzanine finance providers.
The method is usually chosen by mature companies that need to raise capital quickly. It’s also suitable for target companies with a strong balance sheet and steady profitability.
Example: The acquisition of Woodstream Corp. by Brockway Moran & Partners involved senior debt and $17 million in subordinated notes with cash and pay-in-kind interest, as well as warrants. This hybrid financing structure aimed to achieve a 27% rate of return for equity investors.
- Ownership control. In contrast to equity financing, mezzanine financing allows existing owners and shareholders to maintain control over the company.
- Cash flow focus. Lenders prioritize a company’s cash flow over collateral, making the method accessible even when tangible assets are limited.
- Long-term option. Mezzanine financing usually lasts for 5+ years, offering a long-term solution without the immediate need for short-term repayment.
- Higher interest rate. Mezzanine interest rates are usually higher than, for example, senior debt financing rates and can reach 20% to 30%.
- Warrants and equity requirements. In mezzanine financing, lenders may include warrants, known as “equity kickers,” enhancing their return if the deal succeeds. These warrants are attached to a subordinated loan, providing an ownership percentage between 1% and 5%.
3. Leveraged buyout
A leveraged buyout (LBO) is an acquisition finance structure in which a significant portion of the purchase is funded by borrowed money. The ratio is typically 90% debt to 10% equity. This allows a buyer to complete a large transaction using relatively little of its own capital. LBO is also considered one of the best buyout scenarios.
The vast majority of companies suitable for LBOs have substantial operating cash flow, effective product lines, strong management teams, and carefully planned exit strategies.
Example: Founder Michael Dell, along with Silver Lake Partners, conducted an LBO to make Dell a private company in a deal worth around $24.4 billion.
- Higher returns. LBOs can generate higher returns for buyers compared to other acquisition methods. This is because buyers use less equity and more debt, benefiting from the lower cost of capital.
- Tax benefits. LBOs provide tax advantages as interest payments on the debt are tax-deductible, lowering the tax rate and increasing after-tax cash flow.
- Operational improvements. As a rule, private equity buyers have expertise in managing diverse businesses and can implement changes in a company’s performance, strategy, or governance, resulting in operational improvements and enhancing profitability and growth.
- Minimal financial cushion. Acquiring a company through an LBO may leave the business without a sufficient financial cushion, creating challenges if issues arise after the acquisition.
- Layoffs. To turn around the acquired company, the buyer might have to adopt aggressive cost-cutting, leading to employee layoffs.
An earnout, also known as contingent consideration, is a mechanism used in M&A transactions where, in addition to an upfront payment, future payments are promised to the seller based on achieving specific milestones.
For example, a seller wants to sell its business for $100 million, but the buyer is willing to pay only $90 million. In this case, they might agree on an earnout — an extra $10 million — but the seller gets it only if certain goals (like reaching specified revenue) are achieved after the deal is done.
While less common in smaller deals, earn outs often make up to 25% of the purchase price in mid-market transactions.
Example: In 2020, Mastercard acquired Finicity, a financial data provider, for $825 million. The seller was also promised an additional $160 million through an earn-out for meeting specified performance targets.
- Extended payment period. An earnout allows the buyer a longer timeframe to pay for the acquired business.
- Risk mitigation. If earnings aren’t as high as expected, the buyer’s payment is adjusted accordingly.
- Transaction fee contingency. For a selling company, the advantage of an earnout lies in the fact that the transaction fees are tied to the ongoing success of the company. This means that it only pays fees if the business continues to perform well after the deal.
- Uncertain future earnings. Sellers risk earning less if the business’s future earnings don’t meet expectations.
- Ambiguity. Earn-out payments are uncertain as rely on future business performance, which may lead to potential disagreements on metric interpretation between the buyer and seller.
5. Cash acquisition
Cash financing is a straightforward method in mergers and acquisitions, where the buyer directly pays cash for the target company. This approach ensures quick and uncomplicated transactions, providing a simpler management process compared to stock transactions.
Cash deals suit cash-rich companies like Microsoft, Google, or Apple and smaller companies that have less cash on hand.
Example: Microsoft acquired LinkedIn in an all-cash deal valued at $26.2 billion, driven by its robust financial position.
- Instant and simple transactions. Cash payments ensure swift and uncomplicated deals.
- Certainty. Acquiring another company with cash ensures a fixed purchase price, reducing the transaction’s risk for both parties. Unlike stock acquisitions, where the value can fluctuate with stock prices, cash deals provide stability and a guaranteed price.
- Exchange rate challenges. Dealing with multiple currencies can result in challenges due to fluctuating exchange rates. Also, additional expenses may arise from currency exchange fees.
- Financial limitations. Not all companies have extensive cash reserves or immediate access to significant cash.
- M&A financing refers to the methods and strategies employed by companies to secure the necessary capital for completing mergers or acquisitions.
- Two primary sources of M&A financing are equity and debt financing. Equity financing involves selling ownership stakes or shares to investors, while debt financing involves borrowing money through loans or bonds.
- Other financing methods include stock swap transactions, mezzanine financing, leveraged buyouts, earnouts, and cash acquisitions.
- Many companies combine several financing methods, such as debt and equity.
- The choice of a financing method depends on factors like the transaction size, the financial health of the acquiring company, and the desired level of control over the target company.