When buying a business, one of the most important factors to consider is how you will finance the acquisition. Often, business acquisitions are financed through multiple sources, such as a cash down payment, debt, and vendor financing. When evaluating a transaction, it is important to understand how each type of financing works and the implications they will have on the business.
Bank loans are a common way to finance part of a business acquisition. This kind of loan usually has a set repayment schedule and relatively low interest rate compared to other options. The terms and conditions will depend on a variety of factors, including the size of your down payment, available collateral and expected business performance.
While the interest rates on bank loans are generally better than other types of financing, their fixed payment schedules and terms can negatively impact a cash-strapped business. These types of loans are best suited for acquisitions of established businesses that are expected to generate cash as soon as the acquisition has been completed.
Mezzanine financing, also known as “junior” or “subordinate” debt, is used to bridge the gap between a traditional bank loan and equity. Typically, this type of debt has a higher interest rate than bank loans, and often has an equity component, such as warrants (a type of security that offers the holder the right to purchase new shares of the business at a predetermined price, often a few cents, for a fixed period in the future).
This type of debt offers better flexibility that can be tailored to suit your cash flows in the first months or years after the acquisition, while still providing a better return on investment to the lender than typical bank loans.
Mezzanine loans rank below secured debt (bank loans) in repayment priority in case of default.
Also called “vendor financing”, this is an attractive option to further add flexibility to your financing structure. In this case, the seller of the business offers to lend a portion of the purchase price to the buyer by accepting payment later on in the future.
That balance is usually secured through a lien on the property and assets of the company. If the buyer does not meet the payment obligations, the seller can step back in and take over the business, in some cases.
Often, seller and bank financing are combined. In this case, the seller’s lien is subordinate to the bank’s.
Another type of seller financing involves conditional payments, such as additional payments (earn-outs) or stock options, if specific performance targets are achieved. Earn-outs help keep the seller tied to the company’s future success, which can be useful to ensure a successful transition.
Considering an acquisition? Watch our free on-demand webinar on buying a business here.