Once you have agreed on the price and terms, as discussed in a previous article, you need to finance the deal unless you are one of the rare people who has the cash to pay for acquisitions. However, even if you have the cash to pay for an acquisition I recommend that you don't pay 100% cash as your return on investment will be much higher if you leverage the transactions and if you use as much OPM (Other People's Money) as possible.
Below are some of the ways you can finance an acquisition.
- Equity. From the 1980s until September of 2008 it was possible to do an LBO (Leveraged Buy Out) with little or no equity. In fact, in the early 80s when I was living in Dallas during the boom years I was part of an investment group that bought ten apartment buildings with no money down. We even got cash back at closing as we got 115% financing. Changes in the tax laws killed real estate tax shelters and getting cash back at closing became a thing of the past. That was a good thing because, when I look back on it now, it seems ridiculous. I did an acquisition in 2001 with 92% debt and 8% equity. Those days are also over. In today's market plan on putting down at least 25% when buying a business, perhaps even more depending on the business, the niche it's in, and its condition. However, equity doesn't have to be all cash out of your pocket. See below for what I mean.
- Private equity. There are many private equity firms that will invest in a good deal. However, most will want to have control. That is always a deal killer with me but if you want a deal bad enough you may agree to their (generally onerous) terms. (See previous post about wanting a deal too badly.)
- Investor financing. You may know high net worth individuals who invest in private deals. I have found that private investors are generally not interested in control and will be more reasonable with the terms of their investment.
- Seller financing. Many times if you can't get enough capital to do the deal and the sellers are motivated they will provide some of the financing, generally at more favorable terms than banks and investors. Get as much seller financing as you can. As banks will require that seller debt be subordinated to them they will view it as equity when computing debt to equity ratios.
- Mezzanine financing. Financing that fills the gap between equity and bank debt is known as "mezzanine" debt. Most providers of mezzanine financing will want a higher interest rate (known as a "coupon") than a bank and will also generally want warrants. (A warrant is the right to buy stock at a deep discount in your company at a later date.) Most "mezz" providers want penny warrants. This allows them to buy stock in your company for a penny per share at a later date. Many times this is worth doing if you come up short on the equity required by your bank. Like seller financing, banks will require that mezz debt be subordinated to them so they will view this as equity too.
There are many other ways to finance an acquisition but these are the most common. Do you have other tips on financing an acquisition? If so, please comment below.
Jim Sobeck is president of New South Construction Supply, West Columbia, S.C. This article originally was posted on Sobeck's Biz 101 blog. Copyright 2011 by Jim Sobeck. All rights reserved. This information may be reproduced as long as full credit is given to the author.