RESOURCES

Basics

Selecting the sources of debt and equity financing for a potential acquisition is a critical step. Three primary issues to address when structuring an acquisition are:

The amount of debt that should be raised.
Creating a capital structure that is appropriate for the combined company's future.
The cost of funds.

Debt Financing

Debt is the cheapest method of financing an acquisition and can take many forms. The amount of debt that can finance an acquisition depends on the projected cash flow of the combined company. This will depend on the financial health of both the target and the acquirer.

If a company is interested in a leveraged buyout, it may be able to finance all or most of the purchase price with debt. Under this structure, the debt is collateralized by the assets and cash flows of the company being acquired. This transaction is similar to a home mortgage, where the loan is backed by the underlying asset.

Senior debt is the cheapest and most common form of debt and is usually provided by banks. There are many providers of senior debt that use different methodologies for structuring loans. Subordinated debt lenders are more aggressive in the amount of debt they provide. Accordingly, they charge higher interest rates and often require a piece of the equity of the combined company.

While debt is cheaper than equity, the interest and amortization requirements, as well as possible financial covenants, can limit a company's flexibility. Large amounts of debt are more appropriate for mature companies with stable cash flows that will not require much capital for growth. Companies that foresee rapid growth, require substantial capital expenditures and compete in turbulent markets are often better off financing acquisitions with more equity than debt.

Equity Financing

Equity is more expensive than debt because it carries the most risk since it has no claim to the company's assets. Acquisitions that have unstable cash flows, require capital for continued growth and compete in turbulent industries often require a greater amount of equity financing. Equity provides more financial flexibility because, unlike debt, it does not require scheduled payments.

Financing an acquisition with equity requires relinquishing some amount of ownership in the combined company. Additionally, equity investors will often assume some amount of representation on the board of directors. Equity investors can take the form of leveraged buyout funds, venture capital funds or corporations.

Stock Swap

It is also possible to use the acquirer's stock to purchase all or some of the shares of the target. This is very common among companies whose stock is publicly traded. A stock swap is more difficult in private transactions because the acquiring stock is illiquid (i.e. cannot be quickly sold). However, if the owner of the target would like to retain some stake in the combined company, then exchanging shares is a sensible solution.

In order to complete a stock swap, a value must be placed on the equity of both companies and a share price must be determined. The investment banker on the acquisition team will be able to provide guidance in valuing both companies. There is a variety of methods for valuing a private company, including:

Public company comparable valuation.
Comparable transaction valuation.
Discounted cash flow valuation.
Financial buyer valuation.

A stock swap is a valuable tool for retaining the involvement and expertise of the target's owner, if that is desired. If the owner is active in managing the target's operations and his or her expertise is important to the success of the combined operation, offering stock in the combined company will ensure that the interests of the two parties are aligned.

A stock swap often funds some portion of the purchase price in rollup strategy acquisitions. Financing a rollup strategy usually requires an initial equity investment in the acquirer to position it for rapid growth. Subsequent acquisitions are then financed largely with debt. Stock in the combined company is an important currency to fund the purchase price. It is also used to retain the involvement of the management of the target.

Funding an Acquisition at the Subsidiary Level

It is possible for a company to fund an acquisition through a subsidiary, although this structure raises a number of complications. The main issues relate to:

Business transactions between the parent and subsidiary.
Incentive alignments.
The parent's existing loan agreements with its lenders.

Intercompany Transactions

Under normal circumstances, a subsidiary and parent engage in intercompany transactions where they buy and sell services or products to one another. The prices for these goods and services may be arbitrary or off-market due to the close relationship between the two companies. Furthermore, capital may flow back and forth between the two as deemed appropriate by the parent's directors. If a subsidiary is the acquirer and requires outside investors, those investors in the subsidiary need to be certain that the transactions between parent and subsidiary be limited and arm's length in nature.

Incentive Alignments

Under the scenario where the subsidiary is the acquirer and requires outside investors, a critical question is whose stock the investors will receive in exchange for their investment. Because the investors are providing capital to the subsidiary, subsidiary equity would seem to be the obvious currency. However, the potential for manipulation of intercompany payments and transfers increases if the only shareholder hurt by that manipulation is the outside investor--the only shareholder at the subsidiary level besides the parent. One answer to this is to require management, at least at the subsidiary level, to invest cash for stock in the subsidiary. This way, the people closest to the business and in the best position to prevent inappropriate transfers have a keen interest in preserving and growing the subsidiary's equity value.

Alternatively, the investor can take equity in the parent, with subsidiary management holding stock at either level. The choice may ultimately turn on the extent to which the investor is comfortable with the relative contribution of the subsidiary to the overall equity value of the parent. If this contribution is very small, receiving equity at the subsidiary may be more appropriate.

Parent Company Bank Issues

When lenders are involved with a parent /subsidiary relationship, issues arise regarding the lender's security and interest in the company's assets and cash flows. The lenders will be concerned that their collateral may be transferred between the two companies and therefore out of their reach in the event of default. While this issue can be addressed through prohibitions on asset transfers and carefully structured security agreements, it is of particular concern to the subsidiary lender.

The parent lender may secure against assets being transferred to the subsidiary and out of reach by collateralizing the parent loan with the assets at both companies. Furthermore, it is likely that the parent's loan agreement will prevent capital from being pushed downstream from the parent to the subsidiary. This means that the loan at the subsidiary level will be repaid solely from the cash flows at the subsidiary level. In other words, the subsidiary lender will have no recourse from or access to the parent in the event of default.

Asking a lender to make a loan at the subsidiary level is complicated by these issues. The subsidiary lender wants to ensure that the parent is not siphoning money and assets out of the subsidiary to its detriment. Therefore, the subsidiary lender will want to restrict upstream dividends (from subsidiary to parent) and ensure that the parent is not engaging in intercompany transactions that take advantage of the parent's ownership of the subsidiary. Creating an atmosphere where lenders to both the parent and subsidiary are comfortable with the business relationship between the two companies and with their security interests in the respective companies' assets is difficult. For these reasons, structuring the financing for an acquisition at the subsidiary level complicates a transaction and lengthens the negotiation and documentation process.