This article is written by Vinay Yerubandi who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Introduction
Mergers and Acquisitions (M&A) are typically those transactions which transfers Ownership, Assets, Business Units, Control and various other rights between two companies. Mergers are those transactions where two entities combine to form a single entity whereas acquisitions are those transactions where an entity acquires shares, voting rights, control, assets business units or any other right in another entity. These Transactions were part of the life cycle of business as they opened new horizons of opportunities for both the buying and selling sides of the deal.
These transactions were primarily of four types:
- Horizontal Mergers – In this transaction both the buyer and the seller are competitors to each other and serve the same customers with the same products lines and market.
- Vertical Mergers – This was a kind of transaction where both the companies were at the different stages of the supply chain of the same product. For Example: A Manufacturer integrating with the company which supplies raw materials to it.
- Congeneric Mergers – In this transaction, two companies which serve the same market with different related products are integrated. Best Example to this is an integration between Company manufacturing Televisions and Company providing cable services.
- Conglomeration – In this case, the business areas of the parties were nowhere related to each other.
Importance of Financing in M&A Transactions
There are numerous routes available to a buyer for financing the deal. Every such route comes with its own pros and cons which will actually vary with multiple other factors like share situation, liabilities, Net worth, liquidity, existing leverage and many other financial dimensions of both the buyer and seller.
To adopt the best possible financial strategy the businesses were required to analyse and assess all these dynamic parameters at the same time keeping in mind their central purpose behind the transaction. This many times results in a very complexly structured transaction to create a perfect win-win situation to both the sides.
As mentioned earlier there were many alternative methods to finance the deal. Read down for some most common ways in which financing of M&A deals happens.
Equity or Exchange of Stocks
It was the most common way in which majority of deals happened. Here, the buyer will exchange the equity of it or its subsidiaries or any other entity or any combination of them for the acquisition of the seller’s stock. Normally, Companies prefer this when the Financials of both the companies are strong.
Pros
- The experience, knowledge and relations of the promoters of the seller continues to contribute to the entity as the seller also gets stake in the newly formed business.
Cons
- There always exists a risk of volatility in stocks in these kinds of transactions especially when market rumours about the deal adds up to it.
- There may be chances of having more concerns regarding valuation of stocks as both the entities were dealing only in stocks.
Cash
This was the very easiest way of acquisition and needs no complicated management work like other resources. The seller company can fund the deal with its capital, retained earning and profits. If the cash flow and the working capital position of the acquirer is very strong it is desirable to proceed with a cash component as a major chunk in the deal structure. It doesn’t have any risks except when the deal was with companies dealing with different currencies.
Pros
- It was the simplest way of finance and needs no complex assessments like with stocks and loans.
- Cash was very less volatile while compared to other available means.
Cons
- Cross-Border transaction and other transactions which involve companies dealing with different currencies suffers with risk of Exchange Rates which further complicates the transaction like hedging funds etc.
- Even Companies which have strong liquidity ratios won’t generally tend to disregard cash as an option for a payment as they may suffer liquidity risk and also Insolvency threat in the shorter term.
Earnout
Earnout refers to a transaction where the seller of the business will receive additional payments from the buyer based on the future performance of the business sold. For example in a hypothetical deal structured with Earnout Provisions – Buyers pays 40% of the value of the deal upfront and agrees to pay 30% of the revenue generated to the seller for the subsequent three years.
Pros
- Due to the Earnout Provision, the efforts of the seller to improve the financials of the entity continues even after the deal.
Cons
- As the consideration to the seller depends on the future performance of the business, the seller has to face Business Performance risk for some years even after successful completion of the transaction.
Leveraged Buyout
This was actually a strategy where the seller will be offering very less equity and asks him to invest more in debt capital. This will suit best to those start-up companies who are likely to have great growth in their beginning years. Once the company reaches its aspired growth point the company will pay off those debts. As a result of this strategy the seller holds great stake in the company.
Pros
- The Shareholders of the Seller company can protect their stake in the company.
Cons
- There are very high chances that the company can go to an insolvency position. Due to the Inverted Pyramid Capital Structure of the seller company it may face liquidity risks if it doesn’t have enough cash flow.
Bonds, Debt or Preference Share Financing
The Company can issue corporate bonds, debentures or preference shares as consideration to the seller company. They can even raise money through debt from the public for the purpose of funding the deal. Corporate Bonds usually have very less interest rates and long maturity periods. Preference Shares and Debentures issued to sellers were sometimes convertible into equity and sometimes non-convertible.
Pros
- This was one of the most preferred ways as the obligation to pay considerations breaks down into some future intervals.
- Issuing debt in place of equity to the seller company also helps the existing shareholders of the buyer company to protect their stake in the company.
Cons
- Issuing more debt may sometimes keep the buyer company into risk if they were not able to achieve the desired business result.
Taking over the Debt of the Seller
If the capital structure of the seller company is more leveraged. Then the buyer has the opportunity to acquire both the assets and liabilities of the entity. Commonly, creditors and banks who are lenders to the company tend to acquire it, if the entity is unable to repay them. This method best suits a situation where the seller company is highly leveraged and it is unable to generate enough cash flows to pay back the debt.
Pros
- This was an easiest way of acquisition as the acquirer entity is not required to contribute anything and is only obligated to pay the debts of the seller.
Cons
- The debt of a company can significantly reduce the sale value of the company because the objective of the seller company in the deal is to get a solution for its debts rather than making good money. This becomes an opportunity for the company’s creditors to acquire it in a cheaper means.
Loan
Taking Loans from banks and financial institutions for the purpose of acquisition was quite expensive while compared to other modes as it depends on the interest rates and they also come included with many hidden costs. However, depending on the country’s economic position and buyer’s credit profile they can workout best M&A deals through loans. It also depends on the business of the seller’s business as banks disregard giving loans to businesses which have great risks.
Another important kind of loan is Bridge Loan which means that the company will receive loan in line of its future receipts. It bridges the gap between time of deal and the company’s receipts which helps in maintaining a good liquidity position.
Pros
- It may be the desirable option for the buyer who is having a strong credit profile and great relations with the banks.
Cons
- Generally, structuring a deal with a great amount of loan amounts results in heavy cost.
Third-Party Funding
In recent years, there is a growing trend in funding of transactions by institutions like Investment Banks, Private Equity Firms and Venture Capitalists and various other Financial Institutions. Many Companies see these as a go to option because these firms were not risk aversive in nature and they prefer getting benefits in long term. Proper research about the funding entity and its objectives will make it simple for the buyer to get the deal financed.
Pros
- If you are able to show potential growth in the coming years, it is very likely that they will support your deal.
Cons
- These institutions except certain rights and reservations in the entity which may cause hurdles to effective decision making sometimes.
Conclusion
Even though there are many alternatives to finance an M&A deal, it is always completely specific to the deal and is affected by different parameters and situations in the transaction. Generally, to be able to create the perfect win-win situation for both seller and buyer they structure it with a hybrid and complex combination of different sources depending upon the purpose. The perfect deal structure will depend on the companies to the deal, their share situation, debt liabilities, and the total value of their assets. Each of these routes comes included with their own risks, hidden costs and commitments. Many other parameters like cost-effectiveness and speed of the transaction, impact of taxation also influences the finance part of the deal.
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