What Is Acquisition Financing and How Does It Work?
Companies grow either organically or inorganically. Organic growth means a company uses its own operations to scale up, i.e., it rises from strength to strength through its own business and internal R&D. On the other hand, inorganic growth implies that a company acquires another company offering synergies to scale up and boost the profits of the joint entity post-acquisition. Acquisition financing is the funding obtained by the acquirer specifically to undertake an acquisition.
Why is Acquisition Needed?
While organic growth is one way of increasing profits, it takes substantially more time to achieve. Therefore, companies prefer inorganic growth routes, acquisition being one of those. Apart from rendering rapid growth, the other advantages include:
1. Transfer of synergies
The acquiring company acquires those companies which add value to the existing operations and expertise. So, the acquirer achieves expertise that it didn’t possess earlier, which will boost its profitability multi-folds.
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2. R&D Savings
It is never advisable to reinvent the wheel. Therefore, if a company has already developed some expertise with years of R&D investment, doing the same in-house all over again will only result in unwanted duplication. Further, it will also delay the use of this technology which might lead to increased competition or technology obsoleting. So, to avoid all such delays, companies go into acquisition.
Why is Acquisition Financing Needed?
The time value of money implies a dollar has more value today than it will have tomorrow. So, suppose the target company receives the payment today. In that case, it will quickly finalize the acquisition, and the sooner it completes the acquisition, the sooner the acquirer can start reaping from the synergies.
How Does Acquisition Financing Work?
Acquisition financing can be achieved from several sources, each with its own benefits and drawbacks. So let’s look into each and understand which is better for a given acquisition:
1. Equity Acquisition Financing
As the name suggests, equity acquisition means that the acquirer issues its own stock to the target company and uses the money raised to buy out the target company’s stock.
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Although there can be many other types of Equity Financing, they are all essentially similar.
Pros of Equity financing:
- The acquirer can acquire volatile target companies.
- The acquisition terms and conditions are mutually decided
- The payment schedule is flexible as per the acquirer’s requirement
Cons of Equity financing:
- Equity financing is expensive
- The target companies can be unstable and could lead to lower-than-expected profits.
- It results in control dilution for the acquirer as even the target company’s shareholders own the acquirer’s stock post-acquisition
When to opt for Equity Financing?
Equity financing is best when the acquirer needs the target’s expertise post-acquisition and firmly believes that the acquisition will be worthwhile post-acquisition.
2. Cash Acquisition Financing
In this mode of acquisition, instead of giving the acquirer’s stock to acquire the target, a cash payment is made to buy the target company.
Pros of Cash Financing:
- No control is relinquished to the acquirer
- It is simpler and cheaper than equity financing
Cons of Cash Financing:
- Valuation-based payable cash
- Requires large cash reserves
When to opt for Cash Financing?
Cash financing is best when the acquirer doesn’t need the target’s expertise post-acquisition.
3. Debt Acquisition Financing
Now coming to the most popular form of acquisition financing—debt financing— As it is the most popular method of acquisition financing, there are several modes of debt financing. Some common ones are:
A. Bank Loan
Bank loans are the easiest way to finance an acquisition if you have to make a single payment for the acquisition. You get a fixed amount at a fixed interest rate for a fixed period.
B. Line of Credit or Overdraft
A bank loan modification is a line of credit that defines a cap on how much loan you can take over a period of time. This is useful when the acquirer needs to pay a series of payments over an extended period to complete the acquisition.
The acquirer only pays interest on the amount it actually borrows and can pay back the loan periodically to minimize the interest costs. Therefore, the acquirer partially obtains the target’s assets, starts profiting from them, and simultaneously pays off the borrowed money.
C. Bonds or Debentures
Bonds are debt instruments issued by the acquirer in the debt market to raise funds for the acquisition.
Pros of Debt Financing:
- It is much cheaper than equity financing
- Defined interest payments
- Tax is deductible.
- Reassured of payments by the targeted company
Cons of Cash Financing:
- Fixed interest rate
- The acquirer is profiting from the acquisition
- Fixed Payment Schedule
- A default can lead to penalties or collateral forfeiture
When to opt for Debt Financing?
As there are various forms of debt financing, each has its own USP and should be opted for the proper acquisition. The below table gives some clarification:
|Form of Debt Financing
|When to opt?
|When is it possible or advisable?
|What is the cost of debt financingIf the acquirer is stable while the target is slightly unstableLump-Sum Bank LoanWhen a single payment needs to be made for the acquisitionWhen the target company has stable financialsRiskier the acquisition, the higher the interest rateBanks put a specific lien on the acquirer’s assets to ensure that in case of the acquirer defaults, it can sell the assets and recover the loaned money.
|Line of CreditWhen a series of payments need to be made for the acquisitionWhen the target company has stable financialsRiskier the acquisition, the higher the interest rateBanks put a specific lien on the acquirer’s assets to ensure that if the acquirer defaults, it can sell the assets and recover the loaned money.
|Useful in both single payment and series of payment acquisitions
|It is cheaper to raise funds through the debt market compared to banks when banks refuse to give the loan
|Riskier the acquisition, the higher the interest rate
|Debt instruments can be secured or unsecured by specific or general assets.
4. Vendor Take-Back Loan (VTB) or Seller’s Financing
Although it may sound counter-intuitive, sometimes. The target, or the company being acquired, offers to finance the acquiring company. The acquirer, in return, has to pay annuity payments to the target company at a predetermined interest rate.
It occurs when the target company owners are sure that the acquirer is in a steady financial position and will be able to pay off the annuity payments.
Summarizing Acquisition Financing
Acquisition financing is a means of raising funds to complete an acquisition transaction. Several modes of raising funds exist, each with its pros and cons. However, most of the time, a mix of these modes is used to benefit from the pros of each or minimize the cons.