Acquisition Financing and Payment Structures
Winning Strategies for Both Sellers and Buyers

Standard valuation formulas are rarely the final yardstick in determining the price of a company. Both sellers and buyers must consider and negotiate many other elements, not least of which is how the acquisition will be financed and how payments will be structured. Here are some common payment and financing structures you should know about so you can select the best for your situation.

Payment Structures

When deciding what payment structure will best fit their needs, sellers need to consider the following:

• Innovative payment structures. Deferred payments such as consulting agreements can significantly affect the final price of the company. For instance, the seller might agree to a lower price if the buyer offers an earnout that promises appropriate rewards in the future. On the other hand, the buyer might be willing to pay a premium through a consulting agreement if the seller stays on with the company. The buyer can thus benefit from the seller’s guidance, expertise and continuity of management. An added advantage is often low employee turnover that can be essential to a company's continued success.

  Sellers should also consider the benefits of deferred payments in the form of installment payments or royalties for unique technical skills. A seller who can wait to accept payments until a time when his or her income is relatively lower can realize substantial tax savings.

• Size of down payment. Instead of deferring payments, the seller may want as much cash up front as possible. He or she might be willing to reduce the asking price if a sufficient cash amount is offered.
  
  

• Terms of the loan or note. A seller can use great creativity in working out these terms to the advantage of both parties. If a buyer needs strong cash flow immediately, for instance, the seller might be able to ask a slightly higher price for the company while lowering the interest rate on a note offered to the buyer. Or the seller might extend the length of the repayment period. The buyer gains lower monthly payments while the seller enjoys more money in the future.

Using Debt as a Financing Option

Buyers often find it tempting to carry a large amount of debt to finance acquisitions and mergers. In leveraged buyouts, in particular, a buyer may be able to limit his or her cash investment to a small percentage of the purchase price.

One of the main appeals of using debt instead of equity to buy a business is, of course, the tax benefits – interest payments are deductible while dividend payments are not.

The fact is, however, that when the economy weakens or an unexpected crisis arises, an over-leveraged position can be deadly. So, the question business buyers must ask when assuming debt to finance a deal is, "How much is too much?"

Here are some guidelines buyers can use to make sure they don’t take on more debt than they can handle comfortably. We’ve included some tips to help buyers avoid trouble.

Use ratios to check your debt coverage. Lenders use several ratios and formulas to measure the ability of a company or individual to handle debt. Buyers need to become familiar with these measures. One of the most widely used is the interest coverage (IC) ratio. The formula for calculating it is:

EBIT = IC
   I

EBIT: Earnings before interest
depreciation and taxes

I: Interest charges

The number of times interest is covered or protected by earnings gives an indication of the business’s ability to handle interest-bearing liabilities. This ratio also serves as an indicator of a firm’s capacity to take on additional debt. Because interest is an allowable income tax deduction, an earnings figure before income taxes is used in the numerator. EBIT should be several times larger than interest charges, lenders say. Some bond indentures and loan agreements require that a specific interest coverage ratio be maintained.

Make sure long-term cash flow is plentiful. On term loans, free cash flow is usually used as the measure of a company’s ability to handle debt, as in the debt coverage (DC) ratio:

FCF  = DC
P + I

FCF: Free cash flow

I: Interest

P: Principal

Free cash flow can be defined as the company’s net operating profit (before interest expense and after taxes) plus depreciation and amortization and less capital expenditures and working capital requirements.

In leveraged buyouts in particular, a large and reliable cash flow is mandatory to cover payments on acquisition debt. Because cash flow is the main source of debt retirement, the debt coverage ratio measures a firm’s ability to repay principal. It is also an indicator of the firm's ability to take on additional debt.

The assumption that all cash flow is available for debt service is misleading. However, this ratio is considered a valid measure of the ability to service long-term debt. Lenders say an ideal cash flow ratio is 2-to-1, but most businesses have found this margin deteriorating over recent years.

A company’s cash flow may look good today, but acquirers must assess how solid it will be over time. Weaknesses of over-leveraged debt service may be apparent during an industry downturn that would not be visible in a stronger economy. Use of worst-case and best-case scenarios can help a buyer get a better picture of a business’s long-term cash flow. Here are some ways to make sure that the business can handle the debt used to finance the deal:

• Use the financing debt to create higher profits. Even if cash flow appears to run deep, the buyer must be able to use the debt assumed in the deal effectively to create after-tax profits larger than the after-tax cost of the debt.

• Insist that assets earn their keep. All assets should generate income. Unproductive equipment, obsolete or excess inventory, and unnecessary real estate can generate cash and should be sold to reduce leverage.

• Match debt with terms and maturity. Poor timing of debt service can be a killer. Will the buyer have to make a large repayment of principal when expenses are high because he or she expanded operations? Without a crystal ball, it’s tough to see future crises or opportunities, but matching debt terms to projected cash flow as closely as possible is wise.

• Anticipate higher interest costs. If the buyer’s financing is through a variable rate loan, he or she should determine the breakeven interest rate and worst-case scenario. The key here is projections.

• Allow a cash cushion for taking evasive action. Finding alternative financing will be easier if the buyer isn’t desperate. If the buyer sees that the projection of interest rates or other aspects of the financing were disastrously wrong, he or she could try to restructure the loan with the same lender or, if necessary, obtain financing elsewhere.

Other Financing Options

The diversity of economic and business conditions requires business buyers to discard one-size-fits-all financing.

Buyers can use various financing strategies and options individually or in combination to tailor payment methods and terms, or to minimize interest, commitment fees or other debt-related encumbrances.

Some of the most innovative financing approaches are being provided by sources other than commercial banks. These lenders include finance companies, insurance companies, pension funds, mortgage bankers and venture capitalists. Here are some of the more interesting financing options available:

• Asset-based or secured lending. This type of lending uses the value of business assets (accounts receivables and inventory, primarily) as collateral. The lending source – commercial finance companies and some commercial banks – establishes a line of credit (as high as 80%) based on eligible collateral. A maximum amount is established that cannot be exceeded without renegotiating the loan agreement.

• Venture capital. A pool of professionally managed funds that invest in smaller, high-growth, privately held companies, this type of financing focuses on quality of management and established tract record as financing criteria. Investors require equity position in the company.

• Employee stock ownership plan (ESOP). Sometimes used to leverage a management buyout of a company, an ESOP is set up to allow employees to purchase the stock of a business. Both the principal and the interest are deductible. The lender, such as a commercial bank, provides funds adequate to purchase the stock of the targeted business. The acquiring company guarantees the loan and makes annual contributions to the ESOP until the loan is amortized. Complex regulatory aspects usually require professional administration.

• Seller financing. This type of financing usually involves business acquisition or preferred stock purchases and is typically asset-secured. Sellers may be willing to "take back" part of the purchase price in the form of a note to assist a sale. A seller can even finance the sale through a vehicle not designed explicitly for that purpose. For example, consulting agreements can be used to help finance a sale. The seller thus increases the attractiveness of the package for the buyer, who can deduct the full cost of that agreement. Other forms of this vehicle include royalties, sales commissions and even research and development in technology companies.

Avoid Buyer or Seller Euphoria

Both buyer and seller should avoid putting rose-colored glasses on a transaction that should be examined through a magnifying glass. An acquisition made without rational and thorough due diligence beforehand is asking for trouble. Bringing in an objective advisor is important. Please give us a call. We can help weigh the risk of a potential transaction and determine the type of financing and payment structure most likely to lead to long-term success.

Both buyer and seller should avoid putting rose-colored glasses on a transaction that should be examined through a magnifying glass. An acquisition made without rational and thorough due diligence beforehand is asking for trouble. Bringing in an objective advisor is important. Please give us a call. We can help weigh the risk of a potential transaction and determine the type of financing and payment structure most likely to lead to long-term success.

March 1998