Mergers and acquisitions take a significant amount of capital. For example, in January 2023, Emerson Electric Co. acquired National Instruments for $7.6B. While no two transactions look exactly the same, these deals take millions (if not billions) in capital.
The question is–how are companies covering the cost of their acquisition aspirations?
Most commonly, it’s not just one source. Aside from a small pool of cash-based buyers, these deals are financed through a combination of debt and equity.
Debt vs. Equity Financing
The two main types of financing are categorized as either equity-based or debt-based. Equity financing uses the value of the company to attract investor dollars. On the upside, there is no interest and no immediate repayment obligation. However, it is the most expensive source of capital.
Selling shares is giving up ownership in your company in exchange for funding. It gives investors more influence over big decisions as well as a percentage of profit distributions and proceeds from the sale of the business. It works well–in moderation.
The other type of financing is debt-based funding which looks more like a traditional loan with interest and repayment schedules. The upside to debt is that it doesn’t dilute the company. However, debt comes with certain restrictions called covenants. These covenants and terms need to be negotiated upfront and managed throughout the term of the debt.
In today’s climate–it’s more common to see acquisitions financed with a mix of both equity and debt. This combination is adding a little more wiggle room that’s fostering growth around the globe.
According to PwC’s Global Growth Survey, CEOs are not slowing down on deals despite the doom and gloom in economic forecasts. Across all industries surveyed, 60% of CEOs will pursue acquisitions as planned for 2023.
Let’s take a look at who’s funding debt-based financing and how it works:
The Small Business Administration (SBA) is a federal agency designed to support small businesses. While the agency doesn’t make loans directly, they do manage a program that works with banks and financial institutions to provide funding for small businesses.
SBA loans are designed to promote economic growth by funding competition and diversity among small businesses. These loans are guaranteed by the federal government–bridging the gap between the risk a small business presents and the risk that a particular bank or financial institution is willing to take.
Loans made through an SBA lender can be used to finance acquisition costs. Some businesses may find this option appealing because government-backed loans tend to come with lower rates and fees. And, because the US government facilitates the SBA lending program–there is less of a risk of predatory lending practices.
There are different types of SBA loans. If you’re funding an acquisition, look for a general use (7a) loan. The program offers limits up to $5M, which is typically enough for small or medium-sized acquisitions. However, individual limits are based on what the business can afford to borrow.
Keep in mind that 7a interest rates are variable and markups negotiated by individual lenders are common, so the rate of a 7a loan at one bank may not be the same at another even though both loans are offered through the same federal SBA program.
Lastly, similar to your credit card, the SBA loan requires a personal guarantee. So, if the acquisition or the business fails, the borrower is still on the hook to repay the debt.
How to Use an SBA Loan for an Acquisition
Let’s say that a small business with $4M in annual revenue is owned by two partners. Over the course of the business, one partner has become substantially more invested in the daily operations and now the other partner is looking to exit.
The partner facing the acquisition has limited cash reserves. While they could buy out the partner with cash, it might create unnecessary financial strain–especially in the short term. Alternatively, the partner can apply for a general use (7a) SBA loan and spread the cost of the buyout over multiple years (up to 10 years in some cases).
Low rates and generous repayment terms help protect the cash reserves of the operating business, making debt an appealing alternative to finance a partner buyout or a small tuck in acquisition.
Where to Get SBA Loans
Loans guaranteed under the SBA program are offered through select participating lenders. This means that your existing bank may or may not be able to provide an SBA loan. To find a participating lender, visit the directory at SBA.gov.
|Lower Interest RatesLong (10 year) Repayment TermsGenerous Eligibility RequirementsAccessible Funding Up to $5M
|Restrictions on Use of FundsRequires a Personal GuaranteeApplication & Approval Process is Lengthy
When SBA loans aren’t an option–or aren’t enough, the next type of financing is traditional bank debt–like commercial loans from banks or credit unions that specialize in high-risk funding.
Most banks shy away from funding risky business growth. From startups to acquisitions, it can be challenging to qualify for any type of a conventional commercial loan. That is–unless you work with banks that specialize in debt financing.
For example, Silicon Valley Bank is well-known in the debt financing arena. For the past two decades, SVB has been funding unicorns–to a sum of $8.8B assets under management (AUM).
Banks like SVB have to look at the bigger picture when assessing risk. Instead of determining repayment ability based on a financial track record alone, they often look at factors like:
- Growth Rates
- Investor Syndicate
- Potential Risks
While Banks may fund acquisitions in certain cases, it is rare. The business track record, relationship with the bank and explicit (and implicit) guarantors are all important factors.
|Approval and Funds Distribution can be QuickLow Interest Rates Compared to Debt Funds
|Many Banks do not Finance Acquisitions for SMBs and StartupsCan be Challenging to Meet Eligibility RequirementsBorrowing Limits can be Strict
Direct lending refers to middle-market loans that are underwritten directly by the lender and held by the lender. When a bank underwrites a large loan, it’s common for them to syndicate the debt–or share it with multiple investors or banks.
Direct lenders are often private equity funds that invest primarily in debt instruments vs. equity. They seek higher returns than Bank Debt but are cheaper than equity. Direct lenders are filling the gap between these two traditional sources of capital.
So, what exactly is direct lending? It’s a type of private debt that is held by a single firm or investor. Because they are private, these firms have flexibility in how they structure each loan, allowing them to fund a broad range of companies and situations.
The private lending term sheet is where you’ll find all the details, like:
- Loan Summary & Purpose
- Loan Amount
- Interest Rate
- Prepayment Options
- Offering Period
- Reps and Warranties
- Default Terms & Actions
- Fees and Expenses
- Warrant Coverage
No two transactions are ever identical. Each business is unique in the opportunities and levels of risk that it presents. While private firms have more flexibility to take on risk and tailor financing, there can be more gray areas in these transactions. Ultimately, it’s the responsibility of the borrower to work out any ambiguities before closing the deal.
|Can be More Flexible than Bank Debt (Broader Eligibility)More Room to Negotiate the Loan Term SheetAvailable to fund a diverse range of companies and situations
|More Risk Comes with Higher Interest Rates (Compared to Commercial Bank Loans)More Variation in Financing Terms and Options
The US Government’s Small Business Administration (SBA) distributes $4B annually in private equity funds through the Small Business Investment Company (SBIC) Program. The program is designed to increase access to capital funding for small businesses in order to support job creation, innovation, and economic growth.
While this program is provided with federal oversight, the funds are managed by partnerships with highly-qualified private firms. Some SBICs specialize in specific industries or within certain regions, while others provide funding across a broad spectrum of middle-market businesses.
You can increase your chance of success with SBIC funding by networking to find out who provides funding in your market or industry and begin building relationships with those firms. For example, Saratoga Investment Corp typically works with healthcare, technology, and SaaS companies looking for SBIC funding.
|Long-Term StructureOften No Collateral Needed (Unsecured)Cheaper than Raising Equity
|Higher Interest Rates (Compared to Bank Debt or SBA/SBIC)Strings Attached in the Form of Warrants/Equity Requirements
Another lesser-known type of private debt is called mezzanine debt. It’s a type of hybrid financing that gives the lender the right to convert debt to equity interest in the event that the company cannot repay the loan.
Mezzanine financing is common in acquisitions and buyouts. For investors, mezzanine financing provides greater returns (typically between 12-20%) and while they are typically unsecured, they are structured with warrants that allow the debt to be converted to equity and even have priority over some stocks in the event of bankruptcy.
|Long-Term StructureNo Collateral Needed (Unsecured)Cheaper than Raising Equity
|Higher Interest Rates (Compared to Bank Debt or SBA/SBIC)Strings Attached in the Form of Warrants/Equity Requirements
How to Choose the Right Type of Debt for your Acquisition
With multiple options for debt financing–how do you choose the right solution? Start by understanding all of your options. Debt is just one of them. If you will use debt in the mix to fund your acquisition, look at all the options closely.
Here’s what you need to understand:
- Debt Structure
- Interest Rate(s)
- Repayment Terms
- Restrictions on Use of Funds
- Who Provides Funding (Bank, Specialty Firm)
- Priority in Multi-Tiered Debt Obligations
- The After-Tax Cost of Capital
The right answer depends on the company’s unique situation and outlook. If you’re questioning your next move, a qualified M&A advisor can help you weigh your options and choose the right mix of debt with confidence.
How Embarc Advisors Can Help
With an all-star team from some of the biggest firms in M&A–like Goldman Sachs and McKinsey, Embarc Advisors has the big talent you want with the flexibility that you need. We have worked with all types of debt instruments and lenders, so we can provide rock-solid advice based on our personal experiences.
Even before you have a specific acquisition target in mind, we can help you engage the right lenders and investors so that you are prepared to take action when the right opportunity comes along. Our team can provide support for your strategic goals, like acquisitions, growth, capex, and working capital.
We do more than make introductions and give advice. Through financial analysis, Embarc can help you ensure the debt is sustainable. You might wonder what magic tricks we have up our sleeves to do this. That’s a fair question–we have decades of experience in business and finance across a team of well-rounded professionals that provide a deep level of firsthand experience in different industries and situations.
We put our experience together with your numbers on paper by creating a pro forma financial projection. The goal is to combine your business with the target business–again on paper, using realistic projections to ensure the combined entity has the wherewithal to sustain the potential debt payment obligations.
The bottom line–understanding debt takes a lot more than terms. It’s more than the total amount of principal times the interest rate. At Embarc Advisors, we can help you navigate all of the options with a clear understanding of the terms, covenants, and ancillary economics of the debt term sheet.
Get in touch with Embarc Advisors today–it’s never too early to start strategizing!
Learn more about how to choose an advisor in our blog: How to Choose an M&A Advisor