Financial: Financing Acquisition Growth and Profits

By Mark E. Battersby / Published November 2015

 

Encouraged by many factors, mergers and acquisitions (M&A) appear to be on the upswing, with most of the recent action involving smaller deals. Obviously, not everyone is in a position to buy, but for many small pressure cleaning business owners/operators, acquisitions or mergers are a way of cutting overhead costs, increasing efficiency, or battling a larger competitor.

There are always many key factors that should be considered when pursuing an acquisition, such as the continued growth opportunity provided by the target business, its purchase price, and, of course, financing. Securing capital and the best financing terms for an acquisition can be daunting, challenging, and expensive.

Outside the Box

Fortunately, there are numerous funding sources that can provide capital for the acquisition of an established business. In fact, largely because of the recent credit crunch a lot of alternative financing sources have surfaced. However, while private lenders are coming to the forefront, the cost of capital is often higher than a traditional bank loan.

A key to the type and availability of funding is the structure of the business that is being acquired. A business with little debt, significant assets, and strong cash flow is a good candidate for an acquisition—with a significant portion of long-term debt financing usually available.

Paying For It All

Today, buyers are seeing acquisitions that are 20 percent self-financed, seller financed by around 30 percent, and bank financing at, or even less than, 50 percent for the balance of the purchase price. Among the financing strategies that a contractor, distributor, or manufacturer can use to finance an acquisition are:

Using the seller’s assets. So-called asset-based lending has become an increasingly popular source of financing. Asset-based loans are revolving loans secured by the available collateral, such as inventory, accounts receivable, equipment, and fixed assets. Finance companies and banks often lend money on inventory. Equipment can also be sold, and then leased back from equipment leasing companies. The amount that can be borrowed is typically between 65 percent and 80 percent of the asset’s book value making it a useful tool in acquisition financing.

Seller Financing. It is quite common for the seller to finance part of the transaction. The simplest way to provide seller financing is for the buyer to make a down payment and for the seller to carry a promissory note for the balance of the purchase price. The business and its assets provide the primary collateral for the note.

The terms (interest rates, length, principal payments, and so on) will vary depending on the negotiated agreement. For a pressure cleaning business that sells for $500,000, for example, the transaction might be structured as $150,000 down from the buyer and $350,000 in seller financing. The seller’s note might run for five to seven years and carry an interest rate of eight percent to 10 percent. Monthly payments usually start 30 days from the date of sale.

Joint Venture. Where an acquisition may be out of reach for one pressure cleaning business, buying in conjunction with another party may make the acquisition affordable. To find a likely partner, ask the seller for a list of those who were interested in the business, but did not have enough money to buy.

Paying for the Targeted Business with Stock. Issuing stock allows a buyer to make an acquisition without using its own cash or borrowing money (or by using less cash and borrowing less money). And no, issuing stock isn’t limited to the stock exchange listed, big businesses. However, although a pressure cleaning business might be tempted to issue more stock to finance its purchase, careful consideration should be given to the dilution of the value of the waterjetting operation’s stock. Is issuing more stock really the best course of action, or does borrowing money to finance the acquisition make more sense?

Assume Liabilities or decline receivables. The sales price can be reduced by either assuming the business’s liabilities or having the seller retain the receivables—if any.

Bank Financing. If the targeted business has a lot of assets, positive cash flow and a strong profit margin, bank financing may be available for the buyer. Unfortunately, there has been a significant decline in cash flow-based loans with the quality of the business’ cash flow, debt load, and insufficient collateral frequently cited as the primary reasons for rejection. In fact, the type of collateral pledged is emerging as the most important factor in a number of lender’s decisions to approve—or shoot down a loan.

Finding a bank with a history of financing the type of business being acquired quite often will increase the chances of successful bank financing. If the seller has a strong banking relationship, talking with the seller’s banker might prove successful. Talking to a number of banks in order to secure acquisition financing might be another strategy.

Getting Sophisticated With Mezzanine Financing

Mezzanine Financing is a hybrid of debt and equity financing and, not too surprisingly, it is often sponsored by the SBA. A mezzanine deal involves a number of technical terms: senior and subordinated debt, private-placement transactions, and equity investment. Senior debt refers to loans from sources such as banks and secured by liens on specific corporate assets, for example, property or equipment. Equity is usually in the form for preferred stock. As a buyer, the pressure cleaning business owner or operator won’t have to give up as much control; frequently it appears footing the bill for 20 percent of the price of the target company.

Naturally, with mezzanine financing or when funding any acquisition, to get the best possible financing terms and improve the likelihood of success, the acquiring business should ensure their offer or business plan is based on the combined business not just the current business. It should illustrate how the combined operations will provide more collateral, more cash flow, and greater growth.

Do-It-Yourself Funding

For many pressure cleaning businesses borrowing means a loan from the operation’s owner or shareholder. Our tax laws create a number of obstacles that must be overcome in order to avoid the penalties and corresponding higher tax bills that can result when IRS auditors restructure loans that don’t meet their criteria.

Whenever a loan is made between related entities, or when a shareholder makes a loan to his or her incorporated pressure cleaning business, our tax laws require a fair-market rate of interest be included. If not, the IRS will step in and make adjustments to the below-market (interest) rate transaction in order to properly reflect “imputed” interest. How large the tax impact depends on the effect of added interest income to the lender and the bite of an offsetting interest expense deduction felt by the borrower.

Insurance

The use of Warranty and Indemnity (W&I) insurance policies in M&A deals is becoming increasingly popular. W&I insurance will protect either the buyer or the seller from a financial loss that might arise from a breach of the warranties and indemnities given by the seller. It essentially removes the risk in whole, or in part, from either the seller or the buyer in the sense that the insurance company will be standing behind the warranty claim.

With a buyer policy, if the seller commits fraud, (for example, if the seller has been fraudulent in representing any aspect of the sale), then the policy would still pay out. This is because the buyer is the insured party and it has not been fraudulent nor has it run afoul of the obligation to make full disclosure to the insurers. This provides an extra layer of protection for buyers that they wouldn’t otherwise have.

For those worried about the credit worthiness of the seller, or if the seller is not prepared to offer much in the way of contractual protection, W&I insurance might be necessary. In fact, more buyers are purchasing insurance to sweeten the deal for potential sellers and to supplement the sellers’ existing means for indemnification. Negotiations over indemnification will also be less difficult, because certain aspects of risk can be offloaded using the insurance.

Bring In The Pros

When seeking financing for an acquisition, every buyer should be both prepared and informed. But, there are some things in life that should never be done without the help of a professional, and buying another business is one of them. A good investment banker, or a merger and acquisitions professional are usually worth every penny spent. They can help a buyer research the industry, find appropriate candidates, qualify the best options and structure the final deal.

Despite current economic conditions, numerous sources for funding the acquisition of an established business remain. Naturally, each lender or capital source has its own unique and frequently modified criteria for financing, making it necessary for a buyer to spend whatever time is necessary to research and explore all of the available financing options and strategies. The reward could be an affordable acquisition that will help the pressure cleaning business grow, prosper, and better compete.