Buy-Side M&A Strategy: Financing an Acquisition
The buy-side M&A process is difficult at best. It’s one thing when sell-side M&A advisors constantly serve up nicely packaged opportunities, each with a well-written, insightful confidential information memo (“CIM”) that makes a strong case for you to buy. But if you are searching for a unique target that has specific acquisition criteria, it’s an entirely different process. Because you don’t know your ideal target yet, you don’t know where valuation will land. You also don’t know what the deal structure will look like, so you need to plan your buy-side M&A strategy carefully, planning for financing an acquisition.
If you are acquisitive, but don’t have dedicated in-house people that run your buy-side M&A process full-time, you may consider what to expect from your M&A advisor.
When all the effort pays off and buyer and seller agree to valuation, terms and structure the acquirer has to come up with the agreed upon currency. Most commonly, its cash.
Finding a viable acquisition target is one thing. Finding synergies and other ways to create value through optimized M&A integration is a whole other level of complexity.
Curious about business valuation?
Financing an Acquisition
Once you have decided how you are going to structure the deal: either stock or asset purchase, then you need to agree on valuation. The next step after agreeing on asset classes and valuation is to determine how much cash and other working capital accounts are going to stay with the company at closing. This calculation differs in every deal, but is commonly referred to as Cash-Free Debt-Free (“CFDF”) structuring.
The valuation and CFDF agreement will help offer some alternatives to how you could finance the acquisition.
Unless the buyer has the cash to cover the purchase price, or the seller agrees to take stock in lieu (which they never should), financing will need to be arranged. In these situations the acquiring company needs to decide whether it will finance the deal using debt or equity.
Related: Acquisition Finance Structures
There are many ways to raise debt financing. Either a bond offering, a bank loan, or a promissory note could be viable. Convertible notes have become particularly popular in recent years. While a bond offering and a bank loan are fairly straightforward: you borrow principal from investors with an interest rate and repay the loan in the future, a note is typically held by the seller.
This means the seller does not liquidate 100% of the business in a signal transaction. Rather they hold some of the debt over a period of time. In these circumstances the seller will typically negotiate a higher enterprise valuation because he is taking on additional risk that would not be associated with an all cash purchase.
It is common to see the seller hold a note that changes in value based on the performance of the business during the term. For example, if the future cash flows turn out to be higher or lower than what were forecast, then the note may fluctuate up or down depending upon how the two parties agreed to structure the deal.
This is common when the seller agrees to remain with the company for a transition period, after the transaction is closed. The intention is to ensure the seller continues to maintain a vested interest in the company’s continued success.
Although similar in concept, a seller note is not an earn-out.
If the buyer uses its own cash as acquisition currency, by definition it is equity. If the buyer needs to raise additional cash to fund the acquisition, it can raise equity from investors by selling stock or derivatives to equity sponsors. Depending upon the size and sophistication of the buyer, the scope of potential equity sponsors may vary from (i) friends and family to (ii) private equity.
Equity financing involves selling some portion of a company (minority or majority), in some class of stock (usually preferred) to investors at an agreed upon business valuation. This causes dilution for the rest of the shareholders, but in the right circumstances raising equity works best.
Usually an equity structure will set aside a certain percentage of ownership for the investors, a certain percentage for the management team, and a percentage for the entity buying the company. For example, if a company is making the acquisition with investors’ dollars then hiring a new management team to operate the company, all three parties will usually end up with some equity.
When the seller agrees to accept transaction consideration in the form of cash in an earn-out, they are essentially accepting restricted stock. How does an earn-out work?
An earn-out is a component of the total acquisition consideration based on future financial performance of the acquisition target. An earn-out may benefit the buyer by keeping a key seller involved in the business after the transaction closes with the promise of more cash. Similarly, earn-outs can benefit sellers by allowing them to maximize the transaction value.
In some cases the existing management team and/or owners will stay with the company after the transaction, and as a result keep a meaningful amount of equity. In these circumstances they essentially participate in part of the financing. This is most common in mergers and rollups where the sellers are expected to stay on board after the transaction. Again, they need to have a vested interest in the continued success of the company.
Where the Work Begins
These two financing alternatives may sound simple but a ton of work goes into the analysis, structure, documentation and processes of shopping the deal. Investors are savvy and demand high levels of integrity for them to believe in you.
Related: How to Prepare Financial Projections
As I mentioned above, the buy-side process is rigorous. It requires an uncommon intimacy with an industry and understanding of what specific criteria will make one target better than another. Read a bit more about the buy-side M&A process here. Financing an acquisition takes hard work.
The thing is, if you want to talk to investors you have to look your best and make sense. This means you have to do a ton of heavy lifting and fit every detail into place. You have to write an impeccable investor presentation, for either debt or equity. Check out Investor Presentation Tips: 11 Steps to Writing an Effective Investor Deck.
That’s the goal: an effective investor deck. The building blocks of an effective presentation include:
Detailed financial model
Comparable financing data
Comparable M&A transaction data
Compelling picture of the future supported with data
Remember my three favorite words when it comes to making investments: “If you believe.”
Pitching a business idea to investors requires a lot of courage and conviction. It also takes a significant amount of work, time and networking to get a meeting in the first place. Once you have that opportunity in hand, you don’t want to waste it by delivering a subpar pitch presentation, one that lacks a compelling story. Without that story, you risk failing to convince your investor audience to believe in your idea — and you.