Raising Finance for Acquisitions
Surprisingly, most SME business owners (approx. 70%) only look to their bank when looking for a loan to acquire a business. (Source: British Business Bank).
There are two types of borrowing: Secured and Unsecured Borrowing. Unfortunately, in general, most banks do not support acquisitions for SMEs, unless there is additional security, personal guarantees and cash from either the Director(s) or company proposing the acquisition.
The cash to loan value of the proposed purchase price will normally determine the bank’s attitude to the proposal.
Banks, almost certainly, will only be interested in funding an acquisition if the proposer/acquirer has a history of success in a similar company or where the borrower is already established within the industry they are buying into.
And typically, where there is no cash, there is no deal.
Fortunately, the Alternative Finance Market takes a different view of experience and will take comfort if the new owner of the acquisition is competent to run the business. They will also take comfort if the management and staff have the experience in the company & market, to bridge any industry experience that the new owner may lack.
Using a lender in the Alternative Funding Market using multiple funding options, is usually a far more effective way to acquire a business, which will usually take place in the form of a Leveraged Buy Out (LBO) through the funding of assets.
An LBO is therefore, an acquisition that uses borrowed money i.e. “leveraging” or borrowing money against the assets of the business.
An asset for an acquisition loan does not normally include property. To leverage an asset, the asset must have a make, model and serial number and a date of manufacture.
It may be surprising to note that to use property as security, in nearly all cases, would need to be a domestic property. There are some lenders that will accept a commercial property, but the problem here is, should they have to foreclose, there are restrictions with the use of the property. A factory for instance, will only sell to a small market, meaning a more difficult sale or lower value. A domestic property however, will ensure a much greater loan to value ratio, as it is within a much larger market and therefore, much easier to sell.
In addition, a commercial property would need to be owned by the company and not the shareholder or their pension fund, which is often the case.
Most assets will have two values: a “market price” and a “trade-in” or “fire sale” price. The latter will be the value a lender will apply to the asset. In the case of having to foreclose, the lender will want a quick sale or may wish to auction the asset, so the lower value is what they are likely to receive.
In addition to borrowing money against the assets, it may be possible to raise money through debt finance against the debt due from invoicing i.e. invoice financing (sometimes known as Accounts Receivable Financing or Receivables Financing) which can be obtained from money owed to the company from normal invoicing, once products or services have been supplied. Debt finance cannot be used for pre-payments and contracted recurring revenues.
For instance, Tech or software companies have a high proportion of their income in contracted recurring revenues or pre-payments from their customers, from which debt finance cannot be used. So, unless there are some other assets owned by the company, an LBO alone, would not be suitable as an acquisition vehicle; in these cases, a secured loan may be the only alternative to the buyer.
To help provide a real-life example of how acquisition might work, our Finance Specialist (Nigel Cowdery) needed to raise £2.6m for an acquisition, which was achieved as follows:
Unsecured loan supported by an equitable charge*:
*An equitable charge is a charge against the equity in a property. Not a second mortgage and an equitable charge only shows up on Land Registry NOT credit references.
**Borrowed from the company being acquired.
There are many ways to structure a deal and each one is individual, depending on what’s agreed between the buyer and seller. Very often, deferred payments are made for acquisitions and represent part of the total price of the transaction but delayed for a set time. Such as:
Paid on completion:
Deferred to the 1st anniversary of completion (end of month 12):
Deferred to the 2nd anniversary of completion (end of month 24):
£5m over two years
NB a “Vendor Loan” could be agreed with the seller i.e. £2m with interest payable.
An alternative way of acquiring a business is where 100% of the shares are not purchased on day 1 but over the period of an “earn-out”. In other words the shares are paid for gradually, over a period. For example:
£3m paid for 60% of the shares.
Monthly (or quarterly/six monthly/annually) payments of £1m annually over 2 years, for the pro-rata share value.
£5m over two years
(This can also add to the value, as the share price should or might increase. However, the value might decrease, so the Share Purchase Agreement (SPA) needs to be very clear about the parameters being set from the beginning (this is an upper and lower limit for a performance related earn-out). The same can be said for a deferred payment regarding the performance. For example, should 10% growth be achieved will the seller receive 10% more and how will it relate to Net Profit or Gross Profit or EBITDA or whatever the measurement is deemed to be? The same applies if the performance drops too.
It should be noted that there is a difference between “earn-out” and “deferred payments”. An earn-out is usually where the shares are purchased over time, whilst deferred payments are where all the shares are purchased but the payment is spread over time.
It is still possible to obtain unsecured borrowing as part of acquisition funding. It might even be possible to achieve 100% borrowings for the acquisition, but very unlikely. This is mainly because unsecured borrowing is expensive, typically 1.5% to 2.5% per month, (sometimes up to 4%).
Some lenders will reduce the interest rate if the Directors offer some form of security, such as an equitable charge or even applying for a secured loan against their domestic property or rental properties that they own.
With acquisition funding, there is little chance of obtaining the funds for an acquisition without offering a personal guarantee (PG). If you are not prepared to offer a PG you are expecting a lender to take all the risk, in effect giving the company (your company) money with the Director or owner of the company, making ALL the company decisions, without a promise to pay it back.
Special Purpose Vehicle (SPV)
A company CANNOT borrow money and give it to the shareholders. THIS IS IMPORTANT. An acquirer will need another company, either their own existing company or a new one specially set up to do this transaction, known as a special purpose vehicle (SPV).
The process normally involves the target company borrowing the money from the lender.
The target company then lends the money to the SPV. The SPV then uses that money to pay the shareholders for their shares. The SPV and target company set up a loan arrangement as the SPV owes the target company the amount that was used to purchase the shares.
Please note that where financing a deal is concerned, no one deal is the same and that there are many options, variants and exceptions! For further help and advice on acquisition funding, simply complete the form below and we will put you in touch with our Finance Specialist (without any obligation):
Article produced with kind assistance from Nigel Cowdery, Finance Specialist