While many predict consolidations will be a major trend this year, familiarising yourself with business acquisition loans is of timely importance.
You need to prepare yourself in advance and have a strategy. Let's see how to implement that.
Why go through a Business Acquisition Loan?
A business acquisition loan can help you achieve growth via the following M&A strategies:
- Buy and build strategy: buying a well-established company in the area that your company intends to expand to
- Rollup strategy: buying and merging smaller companies in the same industry to consolidate into a larger company
- Targeted acquisitions
- Additional growth capital alongside acquisition
As we will go on to illustrate below, tapping private lending for M&A growth amongst all the options, is attractive. However, it is not for everyone, especially in the technology industry.
Traditionally, business acquisition loans are only available to borrowers with a strong reputation, an established customer base, proven track records and high-quality assets that can serve as collateral.
However, as the modern technology business does not have many assets in the traditional sense, there is less to fall back on for lenders. Hence, besides the aforementioned qualities, your technology business must have sustainable, recurring cash flows to be able to secure a business acquisition loan.
Business acquisition loans are financing options used to purchase an existing business and similar operations. When considering this kind of loan, it is important to look out for the following factors:
- Loan terms and interest rate: Look for a loan with favourable terms and a reasonable interest rate.
- Collateral requirements: Determine what collateral is required and whether you are comfortable providing it.
- Loan repayment: Ensure you can afford the loan repayment and understand the consequences if you are unable to repay the loan.
- Prepayment penalties: Be aware of any prepayment penalties, which can add cost if you pay off the loan early.
What are the financing options?
Familiarise yourself with the options available to you: What's on the menu?
There are quite a lot of them, but we'll zero in on the best later on.
This loan type evaluates whether your future cash flows can cover the debt load. The main benefit of a private business acquisition loan is that it is much more flexible and can be executed faster compared to other sources of financing. Though interest rates may be higher, it is still low in the absolute sense.
This is typically the first port of call for most businesses, but also the most difficult, especially for fast-growing small-mid-size technology companies. As mentioned earlier, the modern technology business model (i.e. negative cashflows and few tangible assets) does not bode well with traditional bank underwriting models and banking ratios.
Further, stricter lending requirements post the Global Financial Crisis in 2008 have meant that bank lending is a lot more conservative today. Business acquisition loans are made to larger and not smaller firms, and dealing with banks can be a long, drawn-out process with very strict terms and structure.
Equity can either be given to the seller or to a third-party financier (e.g. private equity, family office etc.) in exchange for financing.
It is a costly option in the long term but can be worthwhile if you wish to retain the seller’s expertise, or if a third-party financier can provide certain expertise which you do not have.
This is also an attractive option for publicly listed technology companies which enjoy high valuations and has been commonly used in 2021.
However, it may not be as easily used by private companies.
A company’s cash is typically used to finance part of a transaction, but it is very rare to finance an entire deal with it. Firstly, the buying price is typically a multiple of a company’s cashflow, and few companies will have years of profits kept as cash unless the target company is a much smaller one.
Secondly, using too much cash will pose a liquidity risk, especially as capital is needed for post-merger integration.
These loans are made on the basis that in the worst-case scenario, the company pay off the loan even if its assets are liquidated. However, as mentioned, asset-backed loans are typically not viable for fast-growing, small & mid-sized technology companies.
This type of loan involves a smaller upfront payment and a promissory note for the remaining to be repaid over the next 3-5 years. As this is advantageous to the buyer, not many sellers may accept it.
An earnout structure involves paying the seller a smaller upfront payment and a % of reviews in the following years post-acquisition. This can be used in situations when the seller wants to retire or exit and wants to pull forward the medium-term revenue to the present, but still retain some longer-term upside.
Joint venture (JV)
You can also enter an acquisition with a JV partner who has the financial muscle power, but this introduces a lot more complexities in terms of operations.
Let’s focus on two specific ways to finance your business, namely, Equity and Private debt
Benefits of financing business acquisition with equity include:
- No debt repayment: There is no debt repayment required with equity financing.
- Flexibility: Equity financing can provide more flexibility in terms of ownership and control.
Disadvantages of equity financing include:
- Dilution of ownership: Raising equity financing can dilute the ownership of the existing shareholders.
- Loss of control: Bringing in equity partners may result in a loss of control for the existing business owners.
Private debt financing for business acquisition offers the following benefits:
Funding acquisitions with private debt funding will often reduce the cost of capital and equity dilution.
- Predictable repayments: The loan repayment schedule is fixed and predictable, providing stability for the business.
- Tax advantages: Interest paid on debt financing may be tax-deductible.
- Cost of capital acquisition: Financing with debt is much cheaper at any given exit for founders.
Disadvantages of private debt financing include:
- Interest payments: The business must make regular interest payments on the debt, which can impact its cash flow.
- Repayment risk: If the business is unable to repay the loan, it may result in a loss of collateral or even bankruptcy.
In conclusion, we can see that private debt makes the most sense for fast-growing, small-mid-sized technology companies today as it is much more flexible, takes less time to secure and is cost-effective.
Navigate the process
The only way to sail through the process is to prepare in advance.
Determine the reason for borrowing:
This is very important and will be the driving force towards completing the whole process. You’re expected to be transparent and well-informed about the business you will acquire, as well as the benefits and fit with your own company.
Key criteria for loan approval:
- Credit score (min. 640 for SPA loans)
- Revenue (debt service coverage ratio of 1.25x the size of the loan or more depending on your profile)
- Down payment (10-15% or higher based on credit and cash flow)
- Use of funds (why you want to acquire this loan, what’s the value of the asset you want to acquire, what will be the impact on your business…)
Pick the right funding type for your business's circumstances:
You can refer to previous parts of this article for this.
Pick a lender specializing in that type of financing
Not every fund is always available for the kind of deal you want to make. Market experts know who to call depending on your company profile/type of preferred deal.
Go through the application process
This is a long and tenuous process, you need to make sure you can answer these questions:
- What did you generate in the last three years? You’ll need to show financial statements
- How much do you want to borrow?
- What’s your debt/equity ratio?
- What’s your churn rate (for SaaS)
- What’s your cash flow projection
- Is there a backstory, for example, of losses or reduced revenue?
Negotiate loan terms
Once you have received loan offers, compare the terms and interest rates to determine the best option for your business.
Secure additional funding
Consider other sources of financing, such as angel investors, grants, or crowdfunding, to support the acquisition and ensure the success of the business. This is not always required but is a good option if you can spare the time, energy, and if it’s financially sound.
Before finalizing the loan agreement, conduct thorough due diligence on the target company to ensure it is a good investment opportunity. This is similar to due diligence you’ll need to go through while securing the loan itself.
By following these steps, a small to medium-sized tech company can successfully navigate a business acquisition loan and secure the financing needed to grow and expand.
Make sure you know what you're getting into, and make the most of this guide to stay on top of your operations during this process.
From assessing your need for the loan to building your case. From choosing the best lender to negotiating the best terms, there are many things to keep in mind in mind.
So make sure to come back to this guide whenever necessary. You can also talk to one of our advisors who can talk to you about the best options for your business. We'll always be there for you.