What Are the Different Types of Financing in M&A?

Finding the right business to acquire is only part of an M&A transaction. A buyer must also decide how to pay for it.

The structure of the financing for an M&A deal can affect the buyer's cash flow, ownership risk, and ability to close. It can also influence the parties' negotiating positions and determine which approvals or conditions must be satisfied before closing. That means buyers should consider financing early on in the M&A process.

Most acquisitions are financed with cash, debt, equity, or some combination of the three. The right structure depends on the size of the transaction, the buyer's readily available resources, the target company's financial performance, and the buyer's long-term goals.

Cash Financing

In a cash-financed acquisition, the buyer uses cash on hand to pay all or part of the purchase price. Those funds can come from the buyer's balance sheet, retained earnings, or personal resources, depending on how the purchasing entity is structured.

Benefits and Drawbacks

Cash financing can be one of the simplest ways to fund a transaction. The buyer doesn't need lender approval or capital from new investors, meaning there are few outside parties involved in the deal. Using cash will also avoid interest payments, loan covenants, and ownership dilution that come from other financing methods.

The biggest drawback to using a cash method is the effect on liquidity. Committing significant cash to an acquisition will leave fewer resources to operating expenses, integration costs, unexpected liabilities, or future investments.

Why Choose Cash Financing?

Cash financing makes sense when the buyer has substantial funds available, the acquisition is relatively small compared to the buyer's resources, or the buyer wants to avoid obligations to lenders or investors. A cash-financed offer may be more attractive in a competitive process because it reduces the risk of uncertainty that comes with outside financing.

The buyer must also consider whether it will have enough working capital after closing. Professional fees, integration expenses, capital improvements, and unexpected operational needs may require funds beyond the purchase price.

Debt Financing

Debt financing is when a buyer borrows some or all of the money needed for an acquisition through a third party like banks or commercial lenders.

Benefits and Drawbacks

Debt financing can allow a buyer to complete a larger acquisition while still preserving cash for any operations or integration costs post-closing. Generally speaking, debt financing will also allow the buyer's existing owners to retain their ownership interests rather than bringing in new equity investors.

Loan documents can impose financial covenants, restrict additional borrowing or distributions, require lender consent for certain decisions, and give the lender rights to collateral if the borrower defaults. The financing process can lengthen due diligence, because the lender will independently evaluate the parties, collateral, and proposed transaction.

Why Choose Debt Financing?

Debt financing is useful when the buyer wants to preserve liquidity and ownership control, and the acquired business is expected to generate a dependable cash flow. The main question when considering debt financing is how much debt the business can support while continuing to fund ordinary operations, integration, and growth.

Equity Financing

With equity financing, a buyer raises capital by giving investors an ownership interest in the acquiring company or another entity formed for the transaction. Investors could include existing owners, private equity firms, family offices, strategic partners, or individuals.

Acquisitions might also include rollover equity, where the seller reinvests part of the sale proceeds into the post-closing company. The seller then retains an economic interest in the business's future performance.

Benefits and Drawbacks

Unlike traditional debt financing, equity generally does not require scheduled principle and interest payments. This can preserve cash flow and make a larger transaction possible without placing excessive debt on the combined business. The right investor can also contribute industry experience, operational resources, or valuable relationships.

In exchange, the buyer's existing owners give up part of the economics and potentially part of the control of the business. Investors may request voting rights, board representation, veto rights, preferred returns, access to financial information, or approval authority over significant decisions.

Why Choose Equity Financing?

Equity financing can be a good fit when the acquisition is too large to fund with cash alone, the buyer wants to limit debt, or the target's cash flow isn't predictable enough to support fixed loan payments. It may also be attractive when an investor can provide strategic value in addition to funding.

The Takeaway

There is no single financing method that works for every M&A transaction. Cash can be more simple, but it reduces liquidity. Debt may preserve ownership, but it creates fixed payment obligations and lender restrictions. Equity may reduce payment pressure, but it requires the buyer to share control and future returns.

Transactions can also use a combination of these methods. A buyer might contribute cash, obtain a commercial loan, and get an investment form a private equity firm. The best structure is one that gets the transaction to close and leaves the business positioned to operate and grow post-closing.

Financing decisions should be coordinated with the transaction's legal, tax, and financial advisors from the beginning. Lockaby PLLC can help business owners evaluate deal terms, coordinate with lenders and other advisors, and prepare documents needed to move an acquisition toward closing. Contact us to learn more about how we assist buyers and sellers throughout the M&A process.