Financing an M&A deal

Krzysztof CIESIELSKI
M&A and Corporate Advisory Director at RSM Poland

Contrary to what it may seem and what people usually think, there are different ways of financing transactions. Most entrepreneurs I work with say that cash is the source of funding. Sellers tend to assume that the buyer opts for this form of funding the deal. And indeed, it is the most popular method of payment in a transaction between the parties involved; however, it is good to know that cash is not the only option the buyer has in a transaction.

Cash

This is the most obvious source of financing an acquisition of another company. The buyer engages only its own funds, and thus has full control over the financing process and is not dependent on third parties in any way. This is an obvious advantage. The downside is that the buyer disposes of the most liquid assets it has in its possession, while blocking them in the assets that are acquired, and which are not liquid. What is important, it is always a good idea to have cash on hand for some other, more urgent scenarios, like covering the unexpected operating costs of your business. Paying in cash is the most risky form of financing, because it reflects the risk of acquisition 1 to 1. When paying in cash, the buyer shoulders all the risk related to the transaction.

Debt

Financing the deal with the most liquid assets and accepting all the risk involved in it usually does not make much sense for buyers. Therefore, for transaction purposes they often rely on external funds in the form of taking on debt. 

Please note that debt has its pros and cons, as well. The former clearly include the fact that it helps diversify the transaction risk. However, when becoming a debtor, the buyer becomes dependent on the creditor; first of all, the buyer must meet the creditor’s requirements to obtain necessary funds and handle the acquired debt in a timely manner. This final element is going to be crucial in the case of any business stumble resulting e.g. from an adverse market situation at a given point in time. If the buyer cannot handle the debt properly, it may turn out that at the end of the day the buyer will not only lose the enterprise acquired through taking on debt, but its entire business.

Other funding

This category surely includes funds from all kinds of private equity funds. This can be a good source of capital, in particular in a situation in which the buyer does not have enough funds of its own or e.g. for some reason does not want to or cannot rely on a bank loan. What is important is that the cost of such capital may be quite high. When funds get involved in investment undertakings, they tend to take up shares (or their equivalents), and this is a common practice to demand a controlling interest. To make it clear: not in the entity acquired by the buyer, but in its entire business. Thus, if the acquisition fails for some reason, there is a risk that the buyer may lose its entire business, and not just the acquired enterprise. What is more, despite the fact that the fund acquires shares of the enterprise it gets involved in, the funds earmarked for the acquisition of another enterprise are usually provided in the form of taking on debt. And that is exactly the primary advantage for the buyer in this structure involving a private equity fund. The buyer has access to funds it had not earlier had access to.

Seller financing

Sounds ridiculous, right? And yet it often works great. What is the advantage for the seller here? The most obvious one: helping to strike a deal. Most of all, you always need to remember that sellers have different reasons for making a deal. They may be interested in concluding the transaction effectively, as well. 

If the buyer finds it difficult to raise external funds in full, both interested parties may agree that the buyer will be financed by the seller, with the latter becoming a creditor to the buyer.

There are a couple of types of such financing, as discussed below.

1. The seller loans money to the buyer to help with the financing of the acquisition: ‘Seller note’. The seller agrees that the buyer pays part of the transaction price at a later time. Such a “loan” usually bears interest, and the interest is paid at regular intervals (e.g. monthly, quarterly, etc.) or calculated and added to the total debt (price + interest) and repaid when the loan is repaid. For the buyer, such an instrument is a debt, because it is borrowed capital and not equity.
2. Deferred payments, but with a bonus. Spreading payments over time often gives the buyer an opportunity to pay the price the seller wants to get. For example, it may be worthwhile to consider a scenario where instead of accepting PLN 10 million from the seller here and now on account of selling the enterprise, it would be more tempting and reasonable to get e.g. 3 quarterly installments of PLN 4 million each.
3. The payment of the sale price of the acquired enterprise is based on the earnings of the business in the future, which is known as earn-out. If the seller believes that its enterprise is worth more than it is stated in the acquisition scenario because of its expected earnings, the buyer may agree to pay a higher price, but once (and only if) the acquired enterprise actually makes these earnings. The earn-out metrics may differ, and are e.g. based on revenue, EBITDA, profit margin, profit, sales growth, etc.

Summing up, all the indicated solutions always entail some risk for the seller, because it never knows if it will get full payment in the end. Therefore, in order to reduce part of this risk, the seller should always demand an additional bonus, e.g. by setting a higher price. In addition, if you have any doubts, it is always a good idea to consult an expert who will suggest the best solution and find a way out.