What Are M&A Sources of Capital?

When raising money to fund mergers and acquisitions, there are several ways that capital can be sourced. First, the financing needs to be raised with consideration of the company's operating cash flows. For example, if the business uses debt financing, it should have sufficient funds to cover the interest and repay the debt.

Another detail that should be considered in M&A financing is the control of the newly formed organization. If the target company is a much more significant portion of the combined company, equity financing could result in a loss of control. Companies can use any financing options, or even a mix of them, to fund an M&A transaction depending on their existing financial situation and how much control leadership wants to maintain.

Equity Financing
M&A equity financing does not involve any cash. Instead, it means that a company is selling its equity to raise funding for the deal or is using the equity in place of money to buy the shares of the target company. Using equity helps the acquiring company preserve cash, so a business that does not have large cash reserves can save on borrowing costs. In addition, the target company's shareholders get the opportunity for future gains from the combined business. The seller also gets to defer tax payments on profits from the sale of their shares. It should also be noted that equity financing includes the issuance of new shares, which dilutes ownership for existing shareholders.

Debt Financing
Debt financing is the raising of funds from lenders that must be repaid. This tends to be a better option for well-established businesses because startups and younger companies have more difficulty getting debt financing. But when interest rates are low, it can be a more affordable funding source.

In M&A deals, the amount of debt financing is contingent on the consolidated company's debt capacity, which is usually based on an EBITDA multiple. The interest rate is decided by the amount of consolidated risk of the combined business. It should be noted that debt financing might hurt the borrowing company's credit rating.

Mezzanine Debt
Raising capital is similar to debt financing, but mezzanine financing is subordinated debt. Therefore, mezzanine interest rates are often much higher than debt financing rates. Additionally, many mezzanine lenders require an equity component to increase their returns. Therefore, this form of financing is a good option for a company that is buying a cash-flowing business but cannot give a lender a senior position.

Stock
Under this financing exchange, the acquirer gives the target company a certain number of shares in the acquiring company to pay for the transaction. There are two reasons why the target company should be cautious when accepting stock financing. First, payment in stock shares can lead to a phantom tax, a tax liability without any cash compensation (this depends on how the deal is structured, of course). Additionally, unless the buyer is a publicly-traded company, it will be hard for the target company to liquidate its shares, sticking them with a significant tax liability.

Stock payment can also be used to incentivize employees or leadership of the target company to stay on at the newly formed entity. This works because employees will get stock options at specific benchmarks following the transaction. Again, this can be structured in various ways, including marking of periods or reaching sales targets.

Leveraged Buyout
A leveraged buyout (LBO) is when a company is acquired using a large amount of borrowed money to cover the acquisition. The assets of both the target company and the acquiring company are often used as collateral for the loan. LBOs often use the standard ratio of 90% debt to 10% equity.

Cash on Hand or Company Profits
If a company has cash on its balance sheet or is generating material profits, an M&A deal can be funded with that cash using no outside sources of capital. However, because companies are usually valued in EBITDA multiples, it could take several years of profits for an acquirer to be able to afford to buy the target company unless the target is a much smaller firm.

Seller Notes
This is one of the easiest ways to fund an M&A deal. The target company agrees to not take all of their cash payment up front, but instead a percentage at closing and the rest in a seller note at some prescribed point in the future. This is commonly used when a seller is confident in their business's future performance.

Seller Equity
Sometimes, having the seller of a company involved with the future of the newly formed company can be helpful for the buyer. This can occur if the buyer is not familiar with the company's sector or the ownership has skills essential to operations. Or maybe you, as a seller, still want to be involved. Seller equity can help the seller gain some upfront liquidity while still participating in the business's long-term growth.

Banks and SBA Loans
Banks are commonly used to fund M&A deals, even though many requirements must be met. The bank will want to feel confident in the industry, the leadership team, the cash flow history, and any underlying assets that can be secured. The more cash flow a combined company will have, the better its chances are of obtaining lending through a bank.

Banks often offer loans that are backed by the Small Business Association (SBA), in which the bank will lend anywhere up to 90% of the transaction. However, these loans can be pricey and carry mandatory personal guarantees that put the borrower on the hook if the company defaults on the loan. These types of personal guarantees can be avoided for companies that generate enough annual cash flow.

Public Offering
An initial public offering, or IPO, includes payment that is received in the form of stock, but it provides liquidity to both companies. Once the buyer has acquired the target company, trading begins, and both companies' holders can sell shares on the public market.

Revenue Sharing or Earnouts
Revenue share and earnout structures are typically not the primary forms of funding for an acquisition but are usually part of a larger compensation package. These situations can occur when the buyer wants to make sure that certain financial achievements will be met over some time after closing.

Private Equity and Family Offices
Private equity and family offices are commonly used in sourcing capital for M&A. These investment companies are eager to invest in quality companies with high potential and a lot of cash flow.

Are You Ready to Sell?
If you are ready to sell your company, please get in touch with our Benchmark International experts. We can help you arrange the most beneficial and profitable M&A deal for your business while meeting your personal goals for your future.

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