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WHAT IS ACQUISITION FINANCING (AF)?
Acquisition financing is the capital that is obtained for the purpose of buying another business. Acquisition financing allows users to meet their current acquisition aspirations by providing immediate resources that can be applied to the transaction.
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 a line of credit or a traditional loan. Favorable rates for acquisition financing can help smaller companies reach economies of scale, which is generally viewed as an effective method for increasing the size of the company's operations.
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. 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.
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, which is a cash metrics that would help the acquirer to pay back the debt obligations from the loan on the acquisition, substantial or sustained profits, as well as valuable assets for collateral.
IMPORTANT: Equity financing is distinct from debt financing; in debt financing, a company assumes a loan and pays back the loan over time with interest, while in equity financing, a company sells an ownership share in return for funds.
For example, angel investors and venture capitalists—who are generally the first investors in a startup—are inclined to favor convertible preferred shares rather than common equity in exchange for funding new companies because the former have greater upside potential and some downside protection. Once the company has grown large enough to consider going public, it may consider selling common equity to institutional and retail investors.
Later, if the company needs additional capital, it may choose secondary equity financing options, such as a rights offering or an offering of equity units that includes warrants as a sweetener.
By comparison, securing bank approval can be problematic when attempting to finance the acquisition of a company that largely has receivables rather than cash flow.
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, and personal and business financial statements. The applicant for SBA 7(a) financing for an acquisition may also need to supply their corporate charter.
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 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 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.