Updated July 21, 2023
Introduction to Acquisition Financing
Acquisition Financing refers to the act of a business entity obtaining capital or funds to facilitate the acquisition of another business entity.
This allows the acquirer to expedite the acquisition process, ensuring a smooth transition and enabling them to quickly reap the benefits of the acquisition.
Explanation of Acquisition Financing
In a way, all kinds of financing produce funds when needed and create time value for the borrower. Acquisition Financing is no different. Acquirers may have a plan of benefitting from the synergies emerging from the acquisition; therefore, delaying the acquisition is never desired. Having the required resources at disposal eases up this burden for the acquirer, and they incorporate the costs of such funding into the cash flow estimates from the given acquisition.
The company undertakes the acquisition only when it has a positive NPV and incorporates the cost of acquisition financing into the discount rate. The funds obtained specifically for the acquisition are designated and allocated for this purpose.
How Does it Work?
Most financing is primarily obtained through borrowing, commonly achieved by utilizing a line of credit, also known as an overdraft facility in certain regions. It doesn’t disburse actual funds when establishing the line, but it sets up an upper limit on the amount that can be withdrawn.
The borrower incurs interest charges on the withdrawn funds starting from the date of borrowing rather than from the date of establishing the credit line. The interest rate determination occurs when the borrower retains an outstanding balance of the principal amount and the accrued interest. This method eases the borrower’s burden by allowing them to make incremental repayments and only pay interest for the duration in which the funds are borrowed. The acquirer may acquire the assets it wants to sell off in the first phase to pay off the loaned amount immediately and keep the interest burden minimal.
Types of Acquisition Financing
Apart from the most common bank loan method, there can be other ways of receiving capital.
1. Bonds or Debentures
In those markets where the debt market is quite established, acquirers often use debt instruments such as bonds or debentures to obtain acquisition funding instead of a bank loan. This might give the issuers the flexibility to customize the bond contract according to their needs, but it also depends on the number of takers for such an instrument. So considering the market sentiment, the issuer has to oblige with the covenants of the debt instruments.
2. Owner Financing
The target company owner sometimes provides the funds for the acquisition in exchange for an annuity payment inclusive of interest over a predetermined period. The target company owner or seller, being reasonably confident in the company’s ability to generate the necessary annuity payments, decides to cease working due to personal circumstances or other challenges encountered, such as reaching a certain stage in life.
3. Sources of Acquisition Financing
The source of acquisition funding may vary based on various factors. One of these is the financial position of the target company. The Target company consistently generates a reliable cash flow stream that is projected to continue in the foreseeable future. In that case, it is easier to obtain funding, and several banks, lending organizations, or non-banking financial corporations can provide the funds. In such a case, the interest rate is also slightly more affordable.
The larger banks may decline to provide funding if the target company is experiencing financial distress or has not yet achieved a stable cash flow state. In such cases, the acquirer may approach a private lending firm because their lending criteria are more relaxed. However, the interest rate is generally higher as the acquisition involves higher risk.
Another critical factor is the financial position of the acquiring company. Suppose the acquirer is in a stable financial position, and the size of the acquisition funding is not too high. In that case, even if the target is not an established player, banks might offer the funds but still at a higher interest rate, considering the target a riskier investment but overall risk being lower considering the asset base of the acquirer. The lender might put a specific lien on some of the acquirer’s assets in such cases.
Benefits of Acquisition Financing
- Speedy Acquisition: We have all heard to strike the iron when it is hot. If the acquirer fails to complete the acquisition within the desired time frame, competitors may seize the opportunity to enter the market and erode the acquirer’s first-mover advantage. Therefore funding makes resources available as per the need of the acquirer.
- Enables Phase Wise Acquisition: A line of credit assures the seller that he will receive the required payment and is ready to enter into a staggered acquisition. This enables the acquirer to keep the interest cost minimum and follow the most optimized acquisition sequence.
Acquisition financing involves actively seeking and obtaining capital specifically designated for a particular acquisition or general acquisition purposes, catering to companies that frequently engage in such activities. It adds value by providing the required funds when they are most needed, preventing the delay in the acquisition process.
There are various modes of acquisition financing, as in any financing; therefore, choosing the right option may help the acquirer keep the funding cost to the minimum. Further, it incentivizes the acquirer to go for only those targets, which can lead to a positive NPV, but it may also make the acquirer more risk-averse. So it is a trade-off that the acquirer needs to weigh before entering into financing.
This is a guide to Acquisition Financing. We also discuss the introduction and how acquisition financing works with its types and benefits. You may also have a look at the following articles to learn more –