FINANCING FOR BUYERS
Prospective buyers need to ensure that financing is lined up before any acquisition can occur. Financing can come from many different sources, each having their pro’s and con’s. Traditionally, the consideration that forms the basis of acquisition of a business can be any combination of cash, stock, notes and contingent payments. Taking a creative approach to structuring a deal based on these virtually limitless combinations is key to arriving at some mix of consideration that is mutually beneficial for both buyer and seller.
CASH
Cash is King! Or is it? The most obvious source of capital for a buyer is to use their own money. However, money doesn’t grow on trees and an acquisition paid for in cash will tie up money that may be needed for other important expenses like payroll or other operating expenses. A buyer that uses their own capital to finance a purchase also means that they are assuming 100% of the risk. Bringing in other sources of capital will help to spread that risk.
BORROWED MONEY
One way that buyers can spread risk is by borrowing money to help finance the transactions. Borrowed money usually comes in a few forms: senior debt, subordinated debt, and lines of credit. The benefit of less risk to the borrower is clear. However, this comes at a cost to the borrower who may have to navigate a number of hurdles to obtain the capital and will be responsible for ensuring they do not default on the loan in the future.
Senior Debt: Senior debt is a loan from a senior lender. Senior lenders are usually a financial institution such as a bank, that lends money often for the purpose of financing an acquisition. This is debt that takes priority over all other lenders. The senior lender gets paid before the junior lenders in the case that a borrower goes bankrupt.
Subordinated Debt: Subordinated debt is another form of capital similar to senior debt, however it ranks after other debts in the case that a company falls into liquidation or bankruptcy. Lenders that are willing to loan money and subordinate itself to the senior lender will do so in exchange for a higher rate of return, which means more interest for the borrower.
Lines of Credit: A line of credit is a loan from a bank that is often used to finance acquisitions. The difference between a line of credit and senior debt is that a borrower only has to pay interest on the amount of the loan actually used. A borrower that has a $3 million LOC and only uses $1 million to finance an acquisition will only pay interest on the $1 million used, not the full $3 million available.
SELLER FINANCING
In some cases, a motivated Seller may offer financing to a buyer. This means that instead of paying back a third-party lender, a Buyer would simply pay the Seller instead. Seller financing has benefits for both Buyer and Seller. It can be a way for a Buyer to complete a transaction if obtaining outside capital is a challenge. Doing so can also mean that a Seller can begin the next phase of their life while still receiving compensation as a result of the sale. Buyers should never count on the Seller to provide financing, but thorough knowledge of the available options can certainly help during the negotiation process.
Seller Note: The Seller will essentially “loan” money to the Buyer to assist with financing the acquisition. Money does not actually leave the Seller’s pockets and into the Buyer’s hands, and then back again. Instead, the Buyer is simply agreeing to pay a certain amount of the purchase price back to the Seller at some future date. These notes will typically earn interest, which will either be paid back on a regular schedule or accrued and added back to the loan, to be repaid when the loan gets repaid.
Earn-out: An earn-out is a contractual agreement between Buyer and Seller in which a portion, or all of the purchase price, is paid out and is contingent upon some future measure of the acquired company’s performance. They may be based on such things as total revenue, operational profit, EBITDA, gross profits and so on. Earn-outs confer a range of benefits, for both parties, who utilize them.
Delayed Payments: One way to bridge a valuation gap is by delaying payments. A Buyer that has been granted the option of making payments over time can afford them the ability to pay the Seller the price they are asking.
