Acquisition Financing Explained: Types, How It Works & Key Benefits

Definition

Acquisition financing is the capital that is obtained for the purpose of buying another business.

What Is Acquisition Financing?

Acquisition financing is the funding that a company uses to buy another company.

Common acquisition financing options include bank loans, lines of credit, and private lender loans. It provides immediate resources that buyers can apply to a new acquisition transaction.

Advantages of acquisition financing include achieving economies of scale and expanding business operations, particularly for smaller businesses looking to grow.

Read on—especially if you run a business interested in acquiring others—to learn more about acquisition financing, including the different types available and how they work.

Key Takeaways

Acquisition financing is used specifically for buying another business, allowing companies to expand operations or enter new markets.
Common acquisition financing options include bank loans, lines of credit, and loans from private lenders.
U.S. Small Business Administration (SBA) loans can offer favorable terms like low down payments for qualifying acquisitions.
Debt securities, like bonds, provide an alternative to traditional bank loans, often avoiding restrictive covenants.
Owner financing involves a seller-financed transaction, where the buyer makes installment payments to the seller over time.

Understanding How Acquisition Financing Operates

There are several different choices for a company that is looking for acquisition financing. The most common choices are a line of credit or a traditional loan. The buying company might also use staple financing, which is a prearranged financial agreement with the same investment bank that is handling the sale.

Favorable rates for acquisition financing can help smaller companies reach economies of scale, which is generally viewed as an effective method for increasing the size of the company's operations.

Important

An acquisition is a transaction in which one company, or owner, buys some or all of the shares in another company. The second company may or may not merge with the parent company.

A company seeking acquisition financing can apply for loans available through traditional banks as well as from lending services that specialize in serving this market. A bank might be more inclined to approve financing if the company to be acquired has:

A steady stream of revenues
Steady or growing EBITDA (a cash metric that would help the acquirer pay back the debt obligations from the loan on the acquisition)
Substantial or sustained profits
Valuable assets for collateral

By comparison, securing bank approval can be problematic when attempting to finance the acquisition of a company that largely has accounts receivable rather than cash flow. Private lenders may offer loans to those companies that do not meet a bank's requirements. However, a company may find that funding from private lenders includes higher interest rates and fees compared to bank financing.

Exploring Alternative Acquisition Financing Methods

Leveraging Small Business Administration Loans for Acquisitions

Depending on the size of the businesses involved and the nature of the acquisition, there may be financing options through the U.S. Small Business Administration (SBA). The SBA 7(a) loan program, for example, may suit these needs for borrowers who qualify. The down payment may be as low as 10% for acquisitions when using this program.

The borrower must, however, meet the SBA’s requirements on the size of the business, which includes limits on net worth, average net income, and overall loan size. There may also be extensive paperwork for the applicant that includes submitting:

Details on accounts receivable
Personal as well as business tax information
Personal and business financial statements
Any corporate charter

Financing Acquisitions Through Debt Securities

A company may use debt security, such as issuing bonds, as a means of financing an acquisition. In many cases, a company may find that selling bonds on the open market offers advantages over seeking funding from a bank or private lender. Banks generally have covenants or rules regarding their funding that companies find restrictive and expensive. Because of this, companies turn to the bond markets as an alternative source for financing mergers and acquisitions.

Other means of financing an acquisition through debt include debt that is paid back as shares and interest in the company making the acquisition. This may come into play if the buyer turns to close associates, such as friends and family, to provide financing to secure the acquisition.

Utilizing Owner Financing in Business Acquisitions

Owner financing is another way for a business to fund an acquisition deal. It's often referred to as "seller financing" or "creative financing." This usually entails the buyer making a down payment to the seller. The seller agrees to finance the rest of the transaction or a portion of it. The buyer will then make installment payments to the seller over an agreed-upon period.

In a buyer's market, a seller may find owner financing a good way to expedite the sale of a business. It also allows the seller to receive a steady stream of regular payments from the buyer, which, if structured correctly, could provide more income than traditional fixed-income investments. The buyer, on the other hand, can benefit from reduced costs and more flexible terms when dealing directly with the seller, as opposed to funding the acquisition through a bank or private lender.

Is an Acquisition the Same as a Merger?

Both an acquisition and a merger involve one company buying another. In an acquisition, the acquired company is usually integrated into the parent company. When a merger happens, the two companies combine but create a new business entity.

What Are the Benefits of Acquisition Financing?

By seeking out financing for an acquisition, a business can access the funds it needs immediately. This saves the time that would otherwise be needed to raise capital to buy another business, which allows the transaction to be completed more quickly and smoothly.

What Is EBITDA?

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This is an alternate measure of profitability that is used instead of net income. EBITDA represents the cash profit created by a business and is often used by lenders when deciding whether or not to offer financing to that business.

The Bottom Line

Acquisition financing enables businesses to quickly secure the funds necessary for purchasing another company, allowing for swift and efficient completion of the transaction.

The benefits of acquisition financing for smaller companies include expansion, entering new markets, and achieving economies of scale.

Various forms of acquisition financing are available, such as bank loans, lines of credit, and private lender loans. Small Business Association (SBA) loans, debt securities, and owner financing are other options suited to different acquisition scenarios.

Acquisition financing provides immediate financial resources, enabling businesses to seize market opportunities and enhance their competitive positions.