How to finance acquisitions

Potentially the simplest method to finance acquisitions: using existing cash reserves. This involves the acquirer utilising its existing cash without the need to incur additional debt or issue new equity. 

Cash reserves, when available, allow an acquirer to avoid incurring debt or diluting equity, which can be particularly advantageous for businesses aiming to balance the trade-off between maintaining a stable financial position and maximising shareholder value. 

A cash buyer is often viewed favourably as opposed to a buyer in need of financial aid from the vendor or a bank, which can ramp up execution risk and cause delays. 

The immediate and full ownership transfer facilitated by cash payment on completion means that the acquirer can instantly assume total control of the acquired entity without the complexities associated with external debt providers or equity participators. 

Moreover, the absence of interest payments lowers the cost of the acquisition – without the risk of fluctuating interest rates impacting financial projections, return on capital is easier to forecast and there is no need to negotiate loan covenants or collateral, making it the least cumbersome option.  

Without external financing, an acquirer can solely focus on the planned synergies increasing the likelihood that the acquisition thesis will be achieved.  

However, it is essential to balance the advantages against the potential downsides, such as depleting company savings and the risk of liquidity issues, which could limit the resources available for other investments or operational requirements. 

• Pros: No debt incurred, so reduced cost, no equity dilution, less execution risk, simplified transaction and immediate ownership transfer. 

• Cons: Depletes company savings, potential liquidity issues, and may limit resources for other investments. 

Acquiring firms seldom possess sufficient cash reserves to finance transformative acquisitions. Therefore, bank loans are a popular option for SMEs for several reasons: one of the main advantages is the flexibility in repayment terms, which allows businesses to work with the bank and tailor loan schedules according to their financial capabilities and cash flows.  

Acquisitions allow quick growth through an informed plan; however, flexibility is desirable. With the pressures of not only maintaining a business but delivering synergies to make the acquisition a success, interest pressure can add an extra layer of complexity – therefore, the ability to work with the bank and negotiate favourable terms is important.  

Interest on loans to fund acquisitions is normally tax-deductible, providing a financial benefit and potentially reducing the acquirer’s overall cost of capital. The assets of the target business being acquired can also be leveraged and used as security for the debt funding, which helps to reduce the burden. For a well-performing acquirer with good credit history, unsecured loans without the collateral burden may be an option, however, interest costs will increase due to the bank taking on more risk. For unsecured (cashflow) loans, we would typically expect up to 2.5x EBITDA to be an achievable overall debt quantum depending on the deal structure, lending terms, debt serviceability, etc.   

Using bank loans helps SMEs preserve cash reserves, ensuring liquid assets are available for other operational needs or unexpected costs. 

However, as with all advantages, it is important to consider the cons associated with bank loans. These include the bank’s potential requirement for collateral, which may put company assets at risk, and the obligation to pay interest, arrangement fees, and other costs such as third-party due diligence for the lender. Furthermore, taking on debt increases financial risk if the acquisition does not generate the anticipated returns, or indeed if the transaction aborts before completion. The reduced cost of capital should therefore be balanced with the increased chances of financial distress.  

Leverage magnifies outcomes – good or bad.  

Typical requirements before speaking with the bank are a strong credit history, a solid business plan, and potentially collateral or personal guarantees. Solvency tests which we frequently see are loan to value ratios and debt coverage ratios – for more information about these tests, reach out to us using the form at the end of this page.  

• Pros: Flexible repayment terms, interest may be tax-deductible, and cash reserves are preserved. 

• Cons: Requires collateral, interest and fees, and potential for increased financial risk. 

Asset-based lending (ABL) is a financing method where loans are secured against the company’s specific assets, such as premises, stock, trade debtors, or equipment. SME businesses often choose ABL to help finance acquisitions for several key reasons: firstly, ABL can be easier to obtain than traditional bank loans, particularly for SMEs that may lack the credit history for unsecured loans. Lenders are often more willing to provide funding when they have the security of tangible assets. 

Therefore, ABL can be arranged quickly and typically with reduced arrangement fees because of the lender’s reduced risk and little need for due diligence. 

Additionally, similarly to bank loans, asset-based lending can offer flexible terms tailored to the company’s needs. The borrowing capacity under ABL can grow with the company’s assets, particularly if linked to the value of the debtor book (in the case of Confidential Invoice Discounting for example) or stock finance, providing a scalable financing option that supports future growth and acquisitions. 

• Pros: Based on company’s assets, can be easier to obtain, and flexible terms. 

• Cons: Higher interest rates, depends on asset value, and may still require personal guarantees. 

Vendor financing offers valuable flexibility to acquirers, which can be essential for maintaining cash flow stability during transitional periods and has the potential to accelerate the acquisition process by reducing the complexity of due diligence, facilitating more efficient negotiations compared to conventional bank loans or equity issuances. However, such terms have to be agreeable to the vendor and therefore may require a quick deal and/or fair compensation.  

Whilst this method necessitates a willing and cooperative vendor, it addresses funding gaps that may arise when alternative sources are insufficient or inaccessible. If vendor financing is pivotal in finalising a transaction, vendors may demonstrate greater willingness to negotiate and provide support to the buyer. Selling shareholders should be motivated to see the continuation of the business and their hard work and may therefore be willing to support the right buyer.  

Moreover, vendor financing is a viable option for SMEs lacking the required credit history or sufficient collateral for bank financing, or size and growth potential for equity investment. 

The structuring of the deal represents an additional aspect for negotiation when considering vendor financing. Under a straightforward arrangement, the consideration could simply be deferred and spread evenly over several months or years; however, more complex options are available. One such example, is an earnout structure, whereby the amount paid by the acquirer is partly contingent on the target meeting defined performance criteria following the deal. Earnout performance metrics we commonly encounter range from turnover and profitability to customer retention and occupancy levels. For more detail on earnouts, see our article. 

In addition to financial support, the ongoing relationship with the vendor can provide vital stability and backing during the transition period, as the vendor will have a vested interest in the continued success of the business. Taking this one step further, an exiting shareholder may be willing to reinvest part of their proceeds into the acquisition company – known as an equity rollover – receiving cash and a minority equity stake, enhancing deal affordability and alignment with the achievement of the post-acquisition group. 

However, the vendor may seek a higher purchase price to offset the additional risk they assume. For instance, by agreeing to provide partial financing, the vendor accepts the risk of default, which may result in legal complexities and impact business relationships. Accordingly, it is reasonable for the vendor to expect compensation that reflects this increased level of risk. Additionally, an earnout structure may create adverse incentives, as the acquirer then has an interest in the target company failing to achieve the previously agreed performance criteria. 

• Pros: Flexible terms, preserves cash flow, and can be quicker to arrange. 

• Cons: Vendor may demand higher purchase price, ongoing financial relationship with vendor, and potential for default. 

Mezzanine financing is a hybrid form of financing that combines elements of debt and equity. Riskier businesses, which don’t have access to financing through traditional routes as discussed above, can access capital by offering lenders a higher interest rate and the potential for equity ownership, with some or all of the debt being convertible for equity in the borrower, also known as an equity kicker. Senior debt presents lower risk to lenders, which positions mezzanine financing as a higher-cost option for SMEs seeking to optimise their capital structure without compromising existing lending arrangements. The equity kicker acts as an incentive for the lender and can reduce the interest burden.  

Under most convertible loan agreements, the mezzanine debt converts to equity when a defined event takes place – for example, in the event of default. The conversion feature brings flexibility and reduces the immediate cash flow burden on the SME business, providing an incentive for lenders to support the company’s growth and success. Moreover, the interest paid on mezzanine financing is normally tax-deductible, making it a cost-effective option compared to pure equity financing methods. 

In line with the higher risk for the lender, mezzanine financing typically requires higher interest rates and more complex arrangements. Furthermore, with conversion agreements, the potential for equity dilution is also a consideration, as converting to equity reduces the ownership stakes of existing shareholders. As the conversion rights are to the benefit of the lender, their presence can lower the required interest rate compared to non-convertible agreements, to the benefit of the borrower. With an acquisition involved, a lender may offer more favourable interest rates with a convertible security if they see the potential for the combined operation.  

• Pros: Sub-ordinated debt, can allow access to higher levels of funding, and tax-deductible interest. 

• Cons: Higher interest rates, complex arrangements, and potential for equity dilution. 

Cash reserves and bank loans are helpful, but what does a business owner do if they already have significant liabilities and wish to maintain a stronger balance sheet? 

By issuing new equity, SMEs can raise the necessary capital without the immediate burden of capital repayment or interest obligations, thus enabling a focused effort on integrating the acquired business and achieving growth objectives, as opposed to financing debt repayments and maintaining bank covenants. 

Furthermore, equity financing can bring in strategic investors who may offer more than just capital, i.e., investors can contribute expertise, industry connections, and other resources that can be invaluable during and after the acquisition process. This strategic partnership can enhance the company’s competitive edge and foster long-term success.  

It is fair to say that issuing equity to fund an acquisition is relatively unusual as it adds a new layer of complexity and risk to the transaction, and that’s just for the acquirer. From a vendor’s perspective, the external financing requirement adds to the execution risk, as equity fundraising is a more complex process than other forms of finance. 

Downsides include dilution of ownership for existing shareholders, potentially leading to a loss of control, and the not insignificant requirements for equity investment to be feasible. For smaller and early-stage companies (typically with £500k to £2m of annual revenues), friends and family, angel investors and crowdfunding platforms can be suitable funding sources, so long as the business portrays a robust business plan with strong growth potential. Key requirements include a compelling market opportunity, a clear route to scale, and a team with relevant industry experience and credibility.  

• Angel Investors: Invest in earlier-stage businesses and startups with innovative ideas, demonstrating passion, vision, market differentiation and an exit plan. 

• Equity Crowdfunding: Crowdfunding works best for consumer brands with strong community appeal, a persuasive pitch, and a marketing plan, are strong recommendations for any business seeking such funding. 

It would be unusual for a small/ early stage company to make an acquisition, especially using equity funding in the process. But as companies grow, more equity options appear, although the key principle persists: equity investors expect returns that match their risk. For the option to be feasible, acquisition plans should outline realistic synergies and a strategy to return both capital and profit to investors. 

We have discussed private equity investment as a separate option, below.  

Issuing equity requires a level of market interest, recognition, and development, which many SME businesses have not yet achieved. Whist the acquisition trail is part of the growth journey, debt financing may be more feasible for businesses at an earlier life cycle stage.   

• Pros: No debt, improves balance sheet, and may bring in strategic investors. 

• Cons: Dilutes existing shareholders’ equity, potential loss of control, increases execution risk and may be unavailable to certain smaller owner-managed businesses. 

For stable companies, with EBITDA typically greater than £1m, private equity (PE) investors can provide access to capital to fund acquisitions beyond the reach of traditional financing methods. PE investors may also provide strategic input, including experience, industry contacts, and direction, which can play a role in supporting a company’s growth plans. This strategic backing can drive organic growth alongside the inorganic, making private equity an attractive option for SMEs looking to expand their market presence, diversify offerings, and gain a competitive edge. 

However, it is important to note that utilising private equity comes with its own set of challenges. SME owners face the potential for loss of control, as PE investors usually require a significant stake in the company, in addition to high return expectations which bring pressures to meet performance targets. Furthermore, as we know from our own experience advising on PE deals, the due diligence process involved in securing investment can be detailed, rigorous, costly, and time-consuming. 

Ultimately, SME companies opt for private equity to leverage the substantial capital and strategic advantages it offers, despite the trade-offs in control and return expectations. When the PE approach aligns with acquisition targets and supports long-term growth, such costs can be worthwhile. 

• Pros: Access to significant capital, strategic support, and helps drive growth. 

• Cons: Potential for loss of control, high return expectations, increased professional fees and detailed due diligence. 

By understanding and weighing the pros and cons of each option, acquirers can choose the most suitable balance of methods to support their short-term acquisition strategy and longer-term acquisition journey, whilst always maintaining financial stability.