The Types of Financing for a Business Purchase
If you are thinking of buying a company, there will come a time when you will need to consider how to manage the company’s payment, or as such, how you will finance the purchase. Within the market you will find a range of alternative financing options, and here we will be discussing the main ones.
Crucially, you must have in mind the current point of the economic cycle at the time of your purchase. When the economy has less liquidity, debt is going to be more expensive given the heightened demands from banks with direct respect to the increased interest rates one would face if they were to be borrowing money at the time. In turn, if the bank perceives your venture as high risk, then they will double down with even higher interest rates on top of the already increased levels. As a result, you must be confident in your ability to pay back your debt, if you choose to go down this line of financing during a time when the economy is holding less liqudity.
What does each type of financing depend on?
The type of financing you can access will depend on:
1- The operating cash flow that the company has had to date (net profit plus amortization)
2- The quality of the collateral (guarantees) that you give
3- Your prestige, along with that of your partners
4- The business plan. If you are implementing your business plan, take a look at SIX STEPS TO A GREAT BUSINESS PLAN! This article identifies six steps that entrepreneurs and companies should keep in mind when creating their business plans.
During a company purchase, there may be different bank debt tranches and they are differentiated by the preferences regarding collection and interest paid. The types of debt that are more focussed on collection will typically demand higherinterest because they incur more risk.
Importantly however, when buying a company you can use multiple levers of debt.
Short-term bank financing
If we talk about short-term bank financing you would have:
Loans to finance working capital that are obtained from financial institutions, which may be in the form of loans, lines of credit or discount of effects.
Next, you have financing through accounts receivable such as factoring (the sale of the debts of other clients) and confirming.
Long-term bank financing
On the other hand, long-term bank financing is quite frequent in leveraged purchases (with indebtedness), in which different types of debt are used depending on the excesses and cash needs foreseen for future years:
The one that charges the least interest would be the debt with mortgage guarantees. Given it has physical collateral to support its loan, the bank is reassured that if the debtor does not pay them back, they can keep the asset. The bank therefore assumes less risk and therefore is willing to lower the interest rate in comparison to when there are no assets present to support the payment. As such, it is possible to obtain financing for up to 80% of the value of the property and in turn, you can agree on a longer return period.
There is also the Sale & Lease back concept, which consists of the sale of a company asset and the simultaneous realization of a financial lease contract on that asset. Therefore, the ownership of the property is transmitted but a right to use it is maintained. This allows the seller to take the entire amount generated by a sale and continue in the same facilities, whilst paying a rent.
An option that is typically associated with higher interest levels is that of Senior Debt. It is named this way because it has a preference for collection with respect to the rest of the associated debts. There can be a deadline of agreement between a period of between 5 to 7 years, redeemable annually and with a grace period of 12 or 18 months. This type of debt already has protection clauses (also called financial covenants), which are obligations to meet certain ratios (Debt / EBITDA, EBITDA / Interest, Minimum own funds, etc.). Thes obligations are typically reviewed on a quarterly basis.
If the company does not comply with these ratios, economic penalties or accelerated depreciation clauses can be activated. Moreover, you will often be asked to pledge the shares of the company you buy. Given that these clauses that the banks require are mainly based on compliance with the business plan, it is recommended that you are conservative in your construction of the plan, because a failure to comply can lead to the bank demanding a renegotiation of conditions that will often charge you more commissions and higher levels of interest. Some additional covenants that can be imposed on you are that of the prohibition to pay dividends, repay loans to the owners or carrying out further corporate operations.
Banks can also add further debt limitations in the contract to that provided in the Business Plan and in turn, require you to contract the lines of financing of the currency with the same financial institution. They can also put limitations on fixed asset investments, by way of not letting you exceed what is established in the Business Plan. They may demand that there be no changes in the shareholding during the life of the debt and negotiate for early repayment formulas, so that you use the excess cash that is generated to repay the debt, instead of allocating it to the growth of the company. All of this will be possible depending on your negotiation strength and the risk of the project.
Participative loans consist of the contribution of funds to a company in exchange for remuneration, which is based on a variable interest rate that depends on the evolution of the borrowing company. The advantage to this strategy is that it is based on an order of priority for repayment, which typically sees the associated bank put behind on that list, with the investors placing participative loans considered the priority. Importantly however, the investor that grants the loan does not get included in the capital structure of the company.
Mezzanine Debt is another form of financing, which perhaps can be considered as subordinated by the previously mentioned types. However, there are funds that are specifically specialized in granting this type of financing. It is called a mezzanine because it is ahead of shareholders in collection rights, but behind with respect to the other creditors. As the borrower assumes more risk, it is a type of financing with higher interest rates (between 15 and 25%), which usually has 100% amortization at maturity and a longer repayment term: 8 or 10 years. It allows the Company to have free cash flow during the life of the debt, in order to implement growth and development strategies. The restrictions (covenants) imposed by the lender are also relatively minor.
This type of debt allows the grantor the possibility of accessing capital through the purchase options released, so that if the project goes well, the borrower can also earn a lot of money. In other cases, the investor also acquires a percentage of the capital and accepts only to charge interest when there are benefits in doing so.
It is usually agreed that the repayment of the loan and its interest must be made in full before the shareholders receive any dividends.
Along with the different types of debt, you can also choose to give out preferential shares: these shares do not usually have the voting rights associated with them, however they are placed ahead with respect to collection rights in comparison to the other shareholders. Importantly however, they are still behind any type of debt financing in the event of liquidation.
There are infinite models of preferred shares because they are issued according to each company and their individual circumstances. There are preferred shares that give your holder the right to receive a certain dividend and if it can not be paid, accumulate it when possible. Other preferred shares are convertible, so if the company goes very well, they can convert it into normal shares, whilst if it goes poorly they can accumulate their right to dividends until they can be paid, given that they have collection priority. Resultantly, this holder has more upward travel and is considered to be more protected.
Within a more globalized world, the sell and purchase of companies is a great way to approach a new market or reinforce a competitive position. The main difficulty involved in this type of operations is knowing how to approach them so as not to be deceived and maximize our value. If you are considering buying a company and looking for advice, do not hesitate to contact us!