Buyers' Strategies To Minimize Cash Outlay During Acquisitions

Buyers can reduce their cash investment in an acquisition by using stock instead of cash to pay the seller. This allows the buyer to preserve their cash reserves and avoid the need to borrow money to fund the deal. Using stock also enables the seller to potentially defer tax payments on the gains from the sale. However, stock deals can lead to dilution of shares, reducing profitability and valuation metrics, and thus a decrease in share price.

Using equity to fund an acquisition

Equity financing is a common method used by buyers to fund an acquisition. This involves issuing new shares to either the target company's shareholders or offering cash generated by the proceeds from an equity offering. While equity financing is more expensive than debt financing, it is often preferred due to its flexibility.

• Benefits of Equity Financing: Equity financing offers several advantages over debt financing. It does not require mandatory interest payments, there is no principal amount to be repaid, and it does not impact the company's credit rating, allowing them to issue debt in the future if needed.
• Drawbacks of Equity Financing: The higher cost of equity is a notable disadvantage. Issuing new shares can dilute earnings per share and reduce the company's leverage, impacting its return on equity. Additionally, volatility in the company's share price can create uncertainty about the acquisition valuation, potentially delaying the closing of the deal or even derailing it.
• Rights Issue: This method involves offering new shares to existing shareholders in proportion to their current holdings. Shareholders pay for these new shares in cash, typically at a discount to the market price. This approach compensates shareholders for the dilution resulting from the new share issue.
• Placing: In this method, shares are offered in return for cash to selected investors, who are usually institutional shareholders making a long-term investment. This offer is not proportional to existing shareholdings and may include new investors.
• Cash Box Placing: This is a special type of placing involving companies with multiple types of share capital, typically incorporated in Jersey. The structure is designed as a share-for-share exchange to avoid statutory pre-emption rights. The sole asset of the cash box company is cash, provided by an investment bank through a subscription of shares.
• Vendor Placing: This involves the buyer allotting shares to the seller in exchange for shares in the target company. The seller then works with an investment bank to place these shares in the market for a cash sum.
• Public Companies' Preference: Public companies often prefer equity financing as their primary form of payment in acquisitions. However, debt still plays a significant role due to its cost-effectiveness and the advantages of leverage.
• Combination of Debt and Equity: Many buyers use a combination of debt and equity financing to fund an acquisition. An experienced M&A advisor can help determine the optimal mix of debt and equity for a particular transaction.

Overall, using equity to fund an acquisition provides flexibility and avoids mandatory interest and principal payments associated with debt financing. However, it is important to carefully consider the potential drawbacks, such as higher costs and dilution of ownership.

Debt financing

When providing funds for an acquisition, banks will usually analyse the target company's projected cash flow, profit margins, and liabilities. This analysis is done for both the acquiring company and the target company.

Asset-backed financing is a method of debt financing where banks lend funds based on the collateral offered by the target company. Collateral may include fixed assets, receivables, intellectual property, and inventory. Debt financing also commonly offers tax advantages.

Mezzanine financing is a layer of debt between senior debt and pure equity that a company can use for its growth needs. It is a mix of debt and equity financing, and if there is a default, mezzanine finance allows the lender to convert debt into equity in the company. Mezzanine financing is suitable for target companies with a strong balance sheet and steady profitability.

Senior debt is secured against the company's cash flow instead of fixed assets. The term senior debt implies that it must be paid before any other debt if the company defaults.

A leveraged buyout is a unique mix of both equity and debt that is used to finance an acquisition. It is one of the most popular acquisition finance structures. In an LBO, the assets of both the acquiring company and the target company are considered as secured collateral.

Companies that involve themselves in LBO transactions are usually mature, possess a strong asset base, generate consistent and strong operating cash flows, and have few capital requirements. The principal idea behind a leveraged buyout is to compel companies to yield steady free cash flows capable of financing the debt taken on to acquire them.

Equity financing

In an acquisition through equity, the buyer uses equity as currency instead of cash to acquire shares in the target company. This involves paying the target company's shareholders with equity in the acquiring company or the new, combined entity. This method is used when the seller wants to retain some control.

A stock swap transaction is a similar method, where the acquiring company uses its own stock to buy another business, allowing it to expand without draining its cash reserves. This also demonstrates faith in the new mega-company being created.

An equity acquisition involves the acquirer issuing new shares of its own stock to the target company's shareholders. This is similar to a stock swap but focuses on expanding the ownership base to include the shareholders of the acquired company. This method dilutes the existing shareholders' stakes but avoids increasing the company's debt load.

Large financial institutions like banks and private equity firms can be involved in equity financing. Private investors can also cover all sizes of acquisitions and can be structured in various ways, including private investors coming in as shareholders in the new entity.

The downside of equity financing is that it requires sharing control of the company, and investors will take a share of the profits. However, this can be offset by the value investors bring in terms of experience and expertise.

Using borrowing to fund an acquisition

Borrowing to fund an acquisition is a common method of acquisition financing. This approach involves taking on debt to purchase another company or its assets. Here are some key considerations and options for using borrowing to fund an acquisition:

• Debt Financing: This is the most common form of acquisition financing. It involves taking out loans or issuing debt securities to fund the acquisition. Debt financing is typically cheaper than equity financing and has tax advantages as interest payments are tax-deductible.
• Loans: Companies can borrow from traditional banks or alternative lenders, such as business development companies (BDCs), depending on their financial situation and the nature of their business. Loans may be secured by the assets of the acquiring company or the target company.
• Debt Securities: The acquiring company issues notes or bonds to investors, promising to repay the amount with interest. These debt securities are usually transferable and can be traded on debt capital markets.
• Leveraged Buyouts (LBOs): This type of financing combines debt and equity. The acquiring company uses the assets and cash flow of the target company as collateral to secure financing. LBOs are high-risk, high-reward, and were popular in the 1980s due to junk-bond mania and the influence of private equity firms.
• Mezzanine Financing: This type of financing sits between senior debt and equity. It involves a mix of debt and equity, and lenders can convert debt into equity if needed. Mezzanine financing is often used when companies have maxed out their senior debt capacity but still need additional capital.
• Bridge Loans: These are short-term loans used to quickly secure funding until long-term financing can be obtained. For example, if a company needs to increase its budget for an acquisition, it can use a bridge loan to cover the gap.
• Considerations: When using borrowing to fund an acquisition, companies should be mindful of their cash flow and ability to service the debt. Taking on too much debt can impact a company's credit rating. Additionally, banks will analyse cash flow trends, profit margins, and liabilities before lending.

Using cash to fund an acquisition

Firstly, let's look at the benefits. Using cash can give the acquiring company an advantage in a bidding war for a target company. An all-cash transaction also means a simple acquisition where the buyer fully owns the target company. Cash deals tend to close faster and face fewer hurdles to getting the deal done. The failure rate of all-cash deals is also lower compared to other forms of acquisition financing.

In the background, the company negotiates the target price before the deal's announcement, and if Wall Street approves of the deal, the acquired company's share price will likely rise. Most acquisitions come with at least a 30% premium attached, and Wall Street will vote for their approval by increasing or lowering the share price of the acquired company.

Now, let's discuss the drawbacks. Financing can become a challenge for the acquirer. If the company doesn't have enough cash, it must decide how to raise it. While bond offerings are cheaper, they take longer, and equity offerings are more expensive but quicker to fulfill. Using cash from operations or reserves could deplete those reserves or cash flows and impair the company.

Additionally, taxes become an issue in all-cash transactions. When the seller receives the cash, it becomes a taxable event, and the seller has to pay taxes on at least one level of the capital gain, which could be quite expensive.

When deciding whether to use cash to fund an acquisition, it's important to consider the availability of cash reserves, the potential for a bidding war, the timeline for the acquisition, and the potential tax implications.

Other Options for Funding an Acquisition

While using cash is one option for funding an acquisition, there are several other methods to consider. These include:

• Equity financing: Offering the seller shares in the newly merged company (Newco) can be a good option, especially if the expertise of the seller is valuable for the success of the merged business. However, this method dilutes the ownership of existing shareholders.
• Promissory note: Partially paying for the target company in cash and issuing a promissory note for the rest can be an option if the seller is keen to sell and confident in the buyer's ability to operate the business.
• Borrowing: Bank finance or loans can be used, but the company will need to demonstrate sufficient cash flow to fund the borrowing, and the merged company will need to meet ongoing financial covenants. Debt financing also incurs interest expenses, which can impact the company's cash flows.
• Equity offerings: Offering new shares to existing shareholders or selected investors in return for cash can be a way to raise funds, but this method dilutes existing shareholdings and increases the number of investors entitled to dividends.

Frequently asked questions