The manner in which an acquisition is financed is often an important factor in the ability to consummate a transaction quickly and successfully.  The number of financing options available to acquirers has expanded dramatically.  The variety of options and sources has increased borrowers’ financial flexibility relative to that which was previously available to them, making it easier to structure a transaction acceptable to both parties.  The availability of funds, combined with a prolonged period of relatively low interest rates, has created an environment which has allowed M&A to flourish.

A private company’s basic capital structure typically consists of some combination of working capital, term debt and equity.  When considering an acquisition, a company’s financing alternatives expand to include a number of additional possibilities, such as subordinated debt, government contributions and vendor take-backs (see the table below).  Mezzanine financing and vendor financing can be the bridge between debt and equity financing to allow the total price to be met and the transaction to be completed.

When considering alternative sources of acquisition financing, the purchaser’s decision (as well as the decisions of lenders and investors) will be affected by a number of factors that are both internal and external to the business, such as:

• Purchaser’s capital structure – debt-to-equity and the availability of security;
• Predictability of cash flow;
• Management’s view of risk;
• Vendor’s capital structure (if acquiring shares);
• State of capital markets;
• Relative cost of each source of funds;
• Availability of each source of funds;
• Assessment of interest rate trends.

The optimal financing mix for each acquisition is specific to each business and industry, but is most impacted by the availability of tangible asset security (supporting operating lines and traditional term debt) and a historical track record of strong cash flow (supporting term debt and mezzanine/subordinated loans).

The key step in the acquisition lending process is the preparation of a detailed financing proposal by the purchaser, and then the review thereof by the lender.  A well-documented financing proposal is critical to the negotiations with proposed lenders and also imparts a sense of confidence to the lender regarding the purchaser management and its ability.  A properly prepared financing proposal should convey, clearly and concisely, the qualitative and quantitative information about the target and the purchaser/borrower.  An executive summary should include:

• Brief narrative on the target business and that of the purchaser/borrower, including operations, product/services, management and the markets served;
• Summary of the benefits of the transaction and why it is a fit for the purchaser;
• The essentials of the proposed transaction (price, consideration, terms);
• The amount of financing required and the type;
• The security available to the lender and the means by which the purchaser intends to repay the loan.

Vendor take-backs (“VTB”) are very common in private company transactions and constitute a particularly critical component of financing small business transactions in particular.  VTB is a generic term used to describe a wide variety of arrangements in which the vendor of a business agrees to receive a portion of the price over time.  In essence, the vendor becomes a source of financing for the purchaser.  While VTB represents some risk for the vendor (because such financing is most often unsecured), it is often required in small business transactions, where the vendor is typically key to the business and the VTB gives the purchaser (and its lenders) some leverage to ensure a selling entrepreneur adequately transitions the business and its customers to the purchaser.  VTB are an effective negotiating tool and can often be used as a means of bridging a price gap between the parties.  The relative portion of the price structured as VTB varies widely from transaction to transaction.

The terms and conditions of VTB are negotiated as part of the overall transaction and are therefore unique to each situation.  Some VTB are structured as earn-outs, where the amount ultimately received is dependent upon the realization by the target business of certain pre-determined performance targets (profitability, revenue, customer retention, growth, etc).  Some earn-outs are fixed while others offer upside to the vendor.  The structures of earn-outs are restricted only by the imagination of the parties negotiating them.  Other VTB are structured as notes, normally for a fixed amount paid over time.  Some are payable at regular intervals over the term, at the end of the term, or some combination thereof.  The interest rate is negotiated and there often is no security for VTB notes.

Another financing option involves a transaction with employees.  So-called management buyouts (“MBOs”) can be structured either as majority transactions using a combination of debt, VTB and private equity, or alternatively, as buy-ins over time whereby employees purchase minority interests using bonuses or borrowed funds.