"Show Me The Money!": Financing An M&A Deal
How a buyer plans to pay for a business it is acquiring must be decided early on in the process because it can have a significant impact on the timing and complexity of the deal. A buyer may use cash, debt, equity, stock swaps, mezzanine financing, leveraged buyout, seller financing, or a combination of any of these methods to pay the purchase price.
There are risks and benefits associated with each of these types of financing methods, and it is important to keep in mind the nature of the transaction and the overall goals of the parties when evaluating ways to finance a deal. Financing your deal is not a cookie-cutter, one-size-fits-all approach, and it is crucial to work with experienced legal and financial advisors who can ensure that the acquisition financing is structured to fit the circumstance of each individual transaction. Flexibility and cost of financing are important aspects to think through as you are structuring financing. There should be enough flexibility to alter the financing to fit the circumstances and the cost of such financing should be appropriate for the acquiring company in its current financial condition.
Highlighted below are the most common methods through which buyers finance M&A transactions.
Financing an acquisition through an all-cash method requires the Buyer to pay the Seller with cash. An all-cash deal is the simplest form of financing an acquisition because the parties don’t have to navigate the added complexity and costs associated with using debt and/or equity to finance the purchase. It also allows the Buyer to continue its business without changes to its management or potential dilution of its ownership that often accompany equity-based financing. Sellers may prefer cash because it has a fixed value (unlike an equity interest in the Buyer, which can fluctuate over time). However, Sellers must consider the tax consequences associated with a cash transaction as capital gains taxes are generally going to be triggered for the Seller in an all-cash or mostly-cash deal (whereas the Seller may potentially defer tax consequences under other financing structures).
Debt to finance a transaction can come in various forms from either a bank, hedge fund or other institutional lender, or from the owners of the Seller by exchanging their ownership interests for certain debt instruments (e.g., promissory notes). If a Buyer plans to use debt to finance all or a portion of the purchase price, the issue of a “financing out” in the purchase agreement (i.e., the ability of the Buyer to walk away from the deal if it is unable to obtain financing) is a key sticking point that ideally should be agreed-upon while the parties are negotiating the letter of intent. The loan process can be time-consuming and add an additional layer of complexity to the deal, but using debt to fund all or a portion of the purchase price is often favored by Buyers because it doesn’t require a large cash outlay and it is typically cheaper than issuing equity.
With equity financing, the Buyer exchanges an ownership share in the Buyer in return for funds to be used to complete the acquisition. Financing acquisitions through an equity offering may be more flexible than using debt, due to the lack of hard commitments to periodic loan payments, but equity financing is subject to federal and state securities laws which can add an additional regulatory hurdle.
In recent years, equity rollovers have become more popular. Rolling equity is when an owner of the Seller is either required or chooses to roll a portion of the purchase price into a stake in the post-closing business instead of receiving cash proceeds at closing. An equity rollover may be especially useful if a Buyer wants to ensure that a key person at the company continues to participate in the business after closing and is incentivized for the business to continue to do well, since further growth of the business results in an increase in value of the rollover equity. Rollover equity is also a way to bridge a valuation gap when the Seller values the business higher than what the Buyer is willing to pay.
Stock Swap Method
In a stock swap, also known as a stock-for-stock deal, the Buyer’s stock is exchanged for stock of the Seller company at a predetermined rate. A stock swap can constitute the entirety of the consideration paid or it can be a portion of the purchase price accompanied by a cash payment. During a stock swap, each company's shares must be accurately valued in order to determine a fair swap ratio between the two shares. Stock swaps postpone capital gains taxes until the Seller’s shareholders eventually dispose of their swapped-for shares in Buyer.
The Buyer’s shares can come from two different sources: (1) the issuance of new stock or (2) treasury stock (which is stock authorized by the corporation’s incorporation documents that hasn’t yet been distributed to shareholders). The issuance of new shares may improve the Buyer’s debt rating and cost of debt, but there are also costs associated with creating and documenting the new shares (i.e., amending the incorporation documents, shareholder approval of the new shares, registration with the SEC, etc.).
Mezzanine Financing Method
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right, in certain circumstances, to convert its loan into an equity interest in the borrower. Mezzanine loans are generally unsecured and subordinate to senior debt, but have priority over both preferred and common stock. They normally carry higher yields than ordinary debt and may be structured as part fixed and part variable interest. Flexibility and convenience makes mezzanine financing appealing, but Buyers considering mezzanine financing should be aware that their ownership interests will be diluted should the mezzanine debt be converted into equity.
Leveraged Buyout Method
A leveraged buyout is the acquisition of another company using a mix of both equity and debt and using a significant amount of borrowed money (bonds or loans). The assets of the company being acquired are often used as collateral for the loans, along with the assets of the Buyer. Leveraged buyouts allow a Buyer to make large acquisitions without having to commit a lot of its own capital. Sometimes called a “bootstrap” acquisition, the principal idea behind a leveraged buyout is that the bought-out business will generate the cash used to pay the debt taken on to acquire it. The most obvious risk associated with this approach is financial distress of the newly-acquired business - if the Buyer can’t pay the debt, this triggers default under the loan documents and potential restructuring or bankruptcy.
Seller Financing Method
If a Buyer cannot pay or finance the full purchase price of a deal, a Seller may be willing to fund a portion of the purchase price, which is known as seller financing. Seller financing can take the form of bridge financing (in which the Seller provides short-term financing with the expectation that the Buyer will obtain bank financing to repay the amount in a single lump sum) or a seller note, which is either subordinated to the Buyer’s bank financing, or, if the Buyer is unable to obtain bank financing, a note that is the primary debt obligation of the business. Since business owners are generally not in the business of competitive lending or evaluating credit, why would a Seller agree to finance the acquisition? There are two advantages from a Seller’s perspective: (1) seller-financing vehicles generally have a higher interest rate, and (2) the Seller does not have to reduce the asking price if the Buyer cannot fund the acquisition in full. However, seller financing requires a long-term relationship between Seller and Buyer after closing until the debt is paid off.
A key component of buying or selling a business is the method by which the Buyer will pay the purchase price. Depending on the structure, financing the deal can add complexities that can stall, or even crater, closing the transaction. There are also tax implications to consider when structuring the transaction and the payment of the purchase price. Reach out to a member of our M&A or Financial Services Groups to discuss thoughtful, creative structuring for your next deal that is individually tailored for each situation.