FINANCING THE ACQUISITION

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drjohn11aDr. John Psarouthakis, Executive Editor of www.BusinessThinker.com, Distinguished Visiting Fellow at the Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland, publisher of www.GavdosPress.com and Founder and former CEO, JP Industries, Inc., a Fortune 500 industrial corporation  

            You should begin planning the financing of your acquisition at the very start of your search.  This includes figuring out how much you are likely to need and where you will get it.  You help to establish your credibility with brokers and potential sellers early in the search process by providing evidence that you have the funds to carry out the deal should it go through. 

            How big a company you search for, as part of your initial search parameters is dictated in large part by the amount of funds you can access. Conversely, the nature of the deal may dictate the level of interest you can generate for financing.  The two issues are interdependent. Of course, you will not have all the details or commitments worked out from investors or lenders until they can examine the actual company you plan to purchase. On the other hand, you cannot afford to wait until you are well into negotiations, only to find that you lack a means for financing a deal.  Thus, similar to negotiations,  the process of obtaining your financing is likely to unfold throughout the acquisition process.

 Estimating Your Financial Needs

            Early in your search process, you want to figure out how much you will need.  The amount of money you need to purchase a business varies greatly by industry.  In the manufacturing sector, the price usually translates into one or two times the annual sales volume.  In distribution, the multiple is around three.  You can ask your brokers what ratios to expect in the industries you are considering.  You should get an estimate of what you need before your search so that you know what your goal is. 

Funds needed to make the deal  Figure out the expenses you are likely to incur for the acquisition itself.  As mentioned in earlier chapters, it is not unusual to spend between $50,000 and $100,000 or more, depending on size and complexity of the candidate company to close a deal, including the costs of preliminary and formal due diligence, legal fees for contractual negotiations, and so forth.  If you have a management team that can work for free, obviously you can reduce the overall cost somewhat, but it would be wise to develop a financial plan that covers not only the funds needed to close the deal, but the initial costs of the acquisition process itself.

Debt to equity ratio  Once you know the total amount of funds you will need, you also need to consider the ratio of debt to equity that you feel comfortable with.  Many highly leveraged deals took place in the 1980’s for as high as a ten to one ratio of debt to equity.  However, these are very risky endeavors, and many companies fell far short of succeeding in servicing this debt.  Psarouthakis generally tries to limit the debt-equity ratio to three or less.  In the manufacturing sector, this ratio provides a better cash flow cushion in a company downsizing scenario in case the economy suddenly takes a nosedive. 

            To keep everything in balance–your assets, debt level, cash, inventory payables, receivables–you need to be very cash flow sensitive, not just accounting sensitive.   A conservative debt-to-equity ratio will allow you to manage your assets and generate cash flow to respond to loan covenants.  Thus, resist the temptation even if the banks are willing to go higher.  Be very wary of a bank or other lender that encourages a highly leveraged position.  They may be the ones owning your business at the next business downturn, not you!  When you are too highly leveraged, even with careful management of your cash and inventory levels, you can run into serious problems servicing the debt. 

Types of Funding Available

            In addition to figuring out your funding needs, you should also figure out where you will get the funds to buy the target company.  You may have to investigate a combination of several different sources and types of funding to cover the entire price of the deal.  Funding generally falls into two overall categories: debt and equity. 

Types of debt

            Before describing different sources of financing, we will review certain basic financing terms, including secured versus unsecured debt, primary versus secondary debt, messaline debt and revolving credit or working capital debt (also referred to as an operating line) and equity.  Let’s review these terms briefly.

Secured versus unsecured debt Secured debt is a loan backed up or “secured” by some type of collateral, whether from the company to be acquired, your personal sources, or another company, if an existing company is doing the purchase. An unsecured loan is just that.  There is no collateral to back up the loan in case of default.

Primary versus secondary debt   In the case of limited funds, there is a pecking order

established from the start, as to who gets paid first.  Typically, secured lenders are also in a primary position.  In the case of liquidation, secondary position lenders are paid after primary lenders.

Mezzanine debt   Mezzanine debt bridges the gap between loans from traditional secured lenders and equity contributors.  Equity kickers or other arrangements might be used to attract one of these lenders.  The seller, for instance, may provide some of the mezzanine debt not covered by equity and other bank loans. Convertible bonds are a common form of mezzanine debt.  Insurance and finance companies are also often interested in this type of debt. Mezzanine debt is senior to equity, usually junior to bank debt, and often converts to equity over a period of time.

Revolving credit Revolving credit, also referred to as an operating line or working capital debt, is short term debt usually secured by accounts receivable, inventory, or both. It is always in a primary position against short term assets.

Equity 

            Equity sources are funds contributed by owners in the business.  In the event of a liquidation, proceeds are distributed to equity holders only after creditors are satisfied.  On the other hand, whereas the return for debt is usually for some specified, fixed amount, equity holders are unlimited in potential returns, depending upon the earnings and asset growth of the business. Thus, this source of financing has both the highest risk and the highest reward.

Sources of Debt Financing

            Within the general category of debt, you may choose among several types of lenders depending upon the availability of collateral and your business reputation.  Some of the most common sources for secured and unsecured debt financing are discussed in this section, including commercial banks, finance companies, insurance companies, pension funds, and the seller.

Commercial banks  Although first time buyers are probably most familiar with commercial banks, they are an unlikely source of long term debt financing unless they have a finance company subsidiary.  However, they are a primary source of working capital or revolving credit financing.  In your initial planning stages for buying the business, therefore, it is worth establishing bank relations for your new business even if you don’t use services from a commercial bank immediately.

            If you are turned down by a commercial bank, one option worth exploring is the U.S. Small Business Administration (SBA) loan. The U.S. government does not actually lend the money, but it does guarantee a commercial bank’s loan in case of default.  The SBA loan still requires collateral although it will often accept personal collateral if you lack assets in the business.  Since the laws and regulations change from time to time, it is worth checking with your local Small Business Development Center or local Chamber of Commerce to obtain the latest information.  Beware the personal loan guarantee requirement of the SBA loan however.  You are not only risking your current personal assets but future assets as well.

            Finally, consider a bank for short-term debt, if you have receivables, inventory, or real estate available for collateral and if the loan amount is under $1 million.

Finance companies Another type of financial institution, referred to as the asset-based lender, is more apt to provide you with an acquisition loan if you have hard asset collateral such as real estate, equipment or machinery.  They are also often willing to leverage the deal with a much higher debt to equity ratio than would a commercial bank.  However, be cautious.  Such companies can also be in the position to force an auction to liquidate the company for late payments.  Check out the company you are planning to borrow from thoroughly with several customers before signing a loan agreement.

            Use an asset-based lender for long term debt, where you have machinery, equipment or real estate as collateral, and if the amount of the loan is in excess of $1 million.

            Factoring companies are expensive and risky.  They have no problem liquidating the business. You should avoid factoring companies in any deal.

Insurance companies  Insurance companies can be good sources for loans and are often more patient than finance companies.  Very large companies such as Prudential or Aetna or those specializing in life insurance are worth looking into.  You probably won’t be able to approach them directly but a good merger and acquisitions consultant may be able to help you make contacts.

Pension funds Pension funds are another source of debt. Once again, you will probably need a third-party to help you approach one of these sources.  They vary in how involved they want to be with the business. Again, it is worth checking with other borrowers to see what their experience has been.

The Seller Finally, if you still have a gap between the seller’s asking price and the financing you are able to obtain from debt and equity, the seller is frequently used as a source to make up the difference.  For instance, you might provide a note secured by inventory. Typically, sellers will recognize a much higher value for inventory, as high as 75% or even 100% of its value, as security for the loan, whereas a bank typically may provide only about 50% of inventory value in a loan, if it is used as collateral.  In this type of loan, the seller can be placed in the first position before the bank, but for inventory only.  This would reduce the amount a bank might lend, but since you get a larger percentage to borrow against inventory, you increase the total amount of debt available to you to purchase the company.

Sources of Equity

            Just as with debt, several sources of equity are available to you. This section reviews the more common sources.

Personal investment You must weigh several factors in deciding how much of your own funds to invest.  On the one hand, you may want to maintain personal control over your company. On the other hand, you need to evaluate how much of your own capital you want to risk. If you are young, and have no one depending upon you for financial support, you are obviously in a better position to take risks than an older person with family obligations. However, you also want to consider that if the venture is so risky that others do not want to be a part of it, you may be foolish to put all of your own funds into the venture.

Investment from family and friends One of the most common sources of capital for entrepreneurs is funding from family and friends, whether as a loan, equity or both.  You need to consider this source carefully.  First of all, if these relatives provide part of your own financial safety net, you want to be careful not to overextend their personal commitment to the total business either.  You also want to be sure that a complete loss of equity will not jeopardize important personal relationships in your life.  Approach family and friends as you would a stranger — with a formal business plan, an accurate portrayal of the risks involved and a clear proposal for how the investment will be returned to the investor.  By treating friends and family in a business like manner, you reduce the chances of misunderstandings that might jeopardize your friendship in the future.

Venture Capital Firms Increasingly, venture capital firms today manage funds for wealthy investors. Although discussed frequently, venture capital is a source of funds for a very small percentage of entrepreneurs.  Venture capitalists expect a very high rate of return.  If you plan to purchase a rapid growth, high potential company, it may be worth investigating this avenue.  Venture capitalists also look very closely at the experience of the management.  They will be more interested in someone with previous entrepreneurial experience. However, many venture capitalists today prefer acquisitions to start-up companies, with the former being viewed as lower risk.  It is worth checking into, especially if you are in need of a very large sum (half million dollars or more).

Small Business Investment Companies (SBIC) SBIC’s are venture capital companies licensed by the federal government.  The program began in 1958 as a way to make money available for small company investment. SBIC’s actually can provide either debt, equity, or both. 

Angels and other private investors  Angels are a much more common source of equity than venture capital firms.  Angels are likely to be wealthy individuals interested in investing their own funds in an entrepreneurial venture. Area doctors, dentists and successful business people may be angels.  Business opportunities are often screened for such individuals by lawyers, accountants, brokers and business associates in the area. You may contact your network of business associates.  Venture capital clubs in the larger business communities also often attract angels and/or their representatives. That is why you often see so many attorneys and accountants at such meetings, listening for good opportunities to recommend to their clients.  As with a venture capital firm, you will need to prepare a

detailed business plan to present at such events, or to share with these contacts.

Investment banks  Investment banks are a rapidly growing source of both debt and equity.  Investment bankers increasingly serve roles other than that of intermediary in the purchase of the target company.  For instance, many also assist in putting together a financing package for an acquisition.  For instance it may pull in funds from other sources such as an operating line from a commercial bank or long-term secured debt from a financial institution.  The investment bank might also provide some of the mezzanine financing and/or equity, itself. Investment banks should not be confused with venture capital firms however.  The latter  are rarely interested in a debt position. Nor are venture capital firms likely to provide financial consulting.   Try to find the right sized investment banker for your size of firm.  Although investment banks are not interested in very small firms, they are becoming a growing resource of funds and expertise for many entrepreneurs.1

Earn outs and seller employment fees  Earn outs and seller employment fees are some other techniques used to close the gap between the agreed upon sales price and the available debt and equity.  An earn-out is an agreement whereby part of the seller’s compensation for the business is based on the performance of the business after the deal is closed.  It may be based on a percentage of gross sales , net sales or net profits.

            Consulting and employment fees may also make up some of the gap in the difference between other financing and the purchase price.  In this case, the seller is paid a salary or consulting fee for his or her assistance in the transition of ownership.  If you use such a fee, you should review current tax implications carefully with a tax consultant. 

            Sometimes the mere timing of the deal might affect the net cash to the seller–for instance whether the sale is closed at the beginning or end of a tax year. 

Dealing with the Banks

            Since most deals include a bank loan for at least a portion of the overall financing, it is worth examining some issues related to bankers’ relationships in greater detail.

Shop around to different banks  First of all, in spite of the ratios and numbers, you will find a wide variation in ratios across banks, whether it be debt to equity, earnings to interest ratio or some other yardstick.  It is worth shopping around at different banks to see what they expect.

Minimize your personal risk Secondly, although it is a common practice to do so, we feel it is a mistake to use your house as collateral in a business loan.  A bank asks for your house as collateral when they do not feel you have enough equity.  The banks should say this directly, but they do not always do so.  Rather than put yourself and/or your family at greater financial risk, you should seek other sources of equity to balance the debt.  Decide on your limit and then inform the bank that this is all the money you are going to put in. If this approach doesn’t work, you should consider searching for another bank.

Limit the bank’s involvement in the business Third, some banks try to get too heavily involved in the operating aspects of the business.  Ask the bank what requirements they have with respect to performance and outcomes but don’t allow them to get involved with issues that pertain to the management of operations.  Management at JPE, Inc., at times has had to say point blank to a banker, “Look friends, you know how to manage a bank.  Just do that.  We know how to manage operations and we will take care of that.  Tell us what covenants you don’t want us to violate or what your requirements are in terms of performance so that you feel comfortable giving us the loan.”

Be sensitive to the banker’s needs Fourth, try to realize that sometimes the individual loan officer might be faced with internal issues that affect his or her behaviour toward you.  For instance, Tuller (1990) shares an anecdote about a loan applicant for a business that waited two months impatiently for a banker’s answer. Annoyed, he almost walked away from the deal.2  Tuller, who is an experienced business broker, contacted the banker, to learn that the banker was concerned about meeting his quota for the coming month and was trying to push more business into that month.  Tuller patched things up between the banker and his client, the client got his loan and the banker was happy, too.

Beware banks with liberal policies Fifth, be cautious about banks and other lending sources that are too liberal in their policies, for instance in the debt-to-equity ratio.  Sometimes a poorly run bank will call in their good loans before their bad ones because they need the money.  Or they may be less understanding if and when you miss a payment.  Check out your banker thoroughly to be sure that you feel comfortable with the type of business relationship that you will experience

Financing when You Have an Existing Company                  

            Most of the guidelines described so far pertain whether you are a first time buyer or own a pre-existing company.  However, there are differences.  In providing a loan to an existing company, a lender will examine the impact that the target company will have on the balance sheet of the existing company.  You may be able to secure some of the debt with collateral from your existing company.  And of course, you may have some cash or other assets available to invest in the target company from the existing company.  Finally, you may have a longer track record and thus have an easier time obtaining a loan from the bank, although commercial banks may still be wary of providing a loan for the direct purpose of purchasing a new company. However, the other sources of debt and equity, and most of the other general remarks are still applicable, even for those who already own a business.

Summary

            Financing the acquisition requires thorough and careful planning.  You need to consider the different sources of funding accessible to you.  The amount required for purchasing the company may dictate the types of sources that you seek out.  Some combination of debt and equity is likely. Be wary of overextending yourself with too much debt. On the other hand, be careful to protect your immediate family by not taking too great a risk with your personal assets.  It should not be necessary to put your entire life’s savings up for collateral.  If the deal makes sound business sense,  if a bank or other lending institution starts making unreasonable demands, check out another bank, review your business plan, or try some other approach.  Lending institutions vary from the unscrupulous to the impeccably correct.  You need to be especially cautious with any lender that is likely to take your company away from you if you fall behind on a few payments.  Check out your sources, both equity and debt, as thoroughly as you check out the seller.  Are you dealing with honest individuals?  Have you reviewed the fine print for hidden commitments that might jeopardize your ownership?  The earlier you begin to develop your financing plan, the more likely you will be ready to close, when the purchase agreement is finally negotiated and signed.

                                                                    Footnotes

1.A New Source of Money: Financing Through Investment Banks, in Tuller, Lawrence, Buying In: A complete guide to acquiring a business or professional practice, Chapter 12, Liberty Hall Press, pp. 175-186.

2  Tuller, Lawrence, op cit

General Reference:; How to Acquire the Right Business, John Psarouthakis and Lorraine Uhlaner, Xlibris, 2009

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