October 12, 2021
With world economies gradually reeling back from the uncertainties caused by the Covid-19 pandemic, even bigger business deals are eyeing for non-traditional sources of financing. Banks are seen as a bit restrictive in lending – especially when it comes to cashflow loans unless the lending is asset-based. So, it’s safe to say that buyers vested in acquiring a business are facing some difficulties. However, there are quite a few commercial debt products used in mergers and acquisitions. In light of this, here are some common debt instruments you can consider.
In seller financing, when the buyer of the acquisition is unable to fully finance the deal, the seller steps in to finance a part of the business. You can think of it as a loan given by the seller which is to be paid back in full in the stipulated period of time agreed upon by both parties. The form of repayment is also referred to as an installment note.
Seller financing in an acquisition will, at most times, also be backed by an earn-out, which will act as a safeguard for the seller against specific organizational complications. However, it’s important to keep in mind that when the buyer can’t fully finance the acquisition, he will no longer be in a strong position to negotiate the price of the deal. The seller won’t have an incentive to reduce the price. But on the flipside, the window of earning interest in seller financing can be considered an effective investment.
After seller financing is implemented, it needs to cultivate a long-lasting relationship with the business up until the deal is successfully closed and the seller is paid back in full. At times, this relationship can offer an employment opportunity with the newly acquired company. And depending on one’s perspective, this relationship could have its ups and downs. This is increasingly why it’s vital for the seller to find a potential buyer that they are willing to partner or collaborate with in the future.
Bank lending or lending through a syndicate can also be a flexible way of developing a customizable solution to fund the acquisition. There are a couple of broader aspects of senior debt, which can be categorized into the following.
In a fixed term loan, the bank is going to fund a certain amount for the acquisition, which the buyer will have to pay back according to a stipulated schedule. This timeline is going to be pre-determined by the bank.
Revolving loans enable the buyer (borrower) to acquire a specific yet capped amount of funding, which he can pay back and then re-borrow. It is a credit that the buyer can acquire, pay out, and re-acquire at their own discretion.
Asset based loans are another effective option for acquisition financing and can potentially be an advantageous option for borrowers in specific scenarios. In an ABL, the total amount of funding available in the loan is based on the overall value of certain assets of the company. Asset-based lenders usually opt for liquid assets – for example, inventory, mutual funds, accounts receivables, or other cash equivalent assets. The lender will then make the funds available for the borrower by agreeing on a certain percentage of the total value of the assets.
Asset-based loans can be an attractive commercial debt product for businesses that are consistently expanding or are optimally leveraged, and require quick, hassle-free funding. However, there are certain prerequisites of acquiring an ABL that buyers should keep in mind. For example, you must show proof to the lender that the business has topnotch and consistent receivables along with proficient financial reporting.
Subordinated Financing for Mergers and Acquisitions
Also referred to as sub-debt, this type of financing is essentially similar to a bank loan. Sub-debts are also backed by collateral assets. And in case the buyer of the acquisition defaults, the loan will only be payable to the lender when other senior debts have been paid off. It is a bit riskier than unsubordinated debt, but the lender will only be willing to front the junior debt if the bank guarantees them a higher rate of return.
Mezz or mezzanine debt is a good example of subordinated financing and is a form of commercial debt that typically has different types of equity components tied to it. This could also be in the form of a legally-backed warrant that entitles the lender to buy stocks in that company at a reduced price.
There are a myriad of commercial debt products that M&A buyers can lean towards. However, when it comes to financing an acquisition, it’s important to keep in mind that almost all methods of acquisition financing take a lot of time to commence and can consist of varying degrees of complexity.