1. Define your objectives.

Even the soundest financing strategy cannot save an ill-conceived acquisition. It is of utmost importance to have a solid understanding of why you are undertaking the acquisition in the first place. For example, you may wish to penetrate new markets, vertically integrate, eliminate a significant competitor, acquire key staff, offset cyclicality in your existing business lines, avoiding the risk and the cost of starting your own business, etc. Next, you need to be certain that you have the resources required to execute the acquisition, which includes financing, and finally clear metrics around the integration and on-going performance post-acquisition.

2. Know the alternatives.

Most people are familiar with conventional senior financing – the standard form of financing (operating credits, term loans, mortgages) provided by banks and credit unions which requires proven cash flow, a pledge of collateral sufficient to cover the full loan amount and usually personal guarantees. Most times it takes more than senior debt to effectively finance an acquisition and you should be familiar with and understand the use of the following financing tools:

A. Subordinated debt. Essentially a cash-flow based form of term financing. Requires a track record of profitability sufficient to service the loan amount being considered, but does not require any collateral coverage and only partial guarantees (usually 0-25 percent of the loan amount). As such, this is an ideal tool for financing the ‘goodwill’ portion of an acquisition – i.e. the portion of the purchase price that is not supported by asset value. Ranging in cost from 12 percent to 18 percent, sub-debt is more expensive than senior debt, but cheaper than equity and an important piece of a leveraged buy-out strategy.

B. Vendor financing. The amount of the total purchase that the seller is willing to receive over time. To a purchaser, vendor financing is a beautiful thing – make sure you use it to the fullest extent possible. Why? Because vendor notes are typically last in line in terms of their claim on both cash flow and assets (equity like risk). The level and terms and conditions of vendor financing are largely a function of negotiating power – which will increasingly favour purchasers as the demographic wave kicks in and more and more sellers materialize.

C. Equity. The piece of the capital structure that is not debt and thus does not require payments of principal and interest. Consists of the equity you contribute towards the acquisition and may also include private equity and/or angel financing. Equity is typically the most expensive piece of the capital structure and so minimizing the equity component through the use of higher leverage helps amplify the return on investment.

3. Understand that leveraged returns are higher

Adding leverage (debt) to your acquisition capital structure helps amplify your return on equity. For example, if you bought a business for $1 million using only equity and sold it four years later for $1.5 million, your compounded annual return on equity would be around 11 percent. If you had only put in $200,000 in equity and borrowed $800,000 (which you paid back over the four years) then your return on equity would spike up to over 65 percent – much as the mortgage on your home increases your equity return.

4. Know and limit your downside

Before you enter into any acquisition you should have a clear understanding of what the situation looks like if the acquisition is a failure. Particularly if you are pursuing a more leveraged acquisition strategy you need to know to what extent the aftermath washes up on your personal balance sheet. Minimizing the amount of equity you need to contribute and the levels of personal guarantees you are required to pledge help keep your personal downside hedged.

5. Leave some margin for error

Experienced acquirers know that no acquisition goes as planned. It may seem attractive to fully utilize available senior facilities for funding an acquisition due to the lower cost of this form of debt. However, if you max out your senior facilities at the outset, then the slightest hiccup, such as the unexpected loss of a key client or staff member, can put you out of covenant and into a difficult position early on.

6. Do your due diligence

Any financing partners you choose are going to do their due diligence on you, so you should make sure that you do similar on them. The big banks and credit unions provide a relatively similar mix of commercial financing products and services. You will, however, want to ensure that the account manager you deal with has experience with structuring more leveraged acquisition transactions. Sub-debt, private equity and angel financing sources are considerably more diverse with unique investing philosophies, deal structures, security requirements and monitoring styles. Understand the differences and ask for references.

7. Provide an acquisition plan

It doesn’t have to be voluminous nor does it need to be glossy with lots of graphs and pie charts. However, your acquisition plan should make it evident to lenders and investors that you know why you are undertaking the acquisition, you have the resources and the right people to execute it successfully, and you have identified and mitigated the key risk factors.

8. Shop…but not too much

Clearly you want to get a competitive rate for every form of financing you secure. Finance professionals realize that they are likely not the only group you are talking to. Having initial discussions and getting pricing indications from two to three providers is completely appropriate – but nobody wants to be part of an auction process. If you shop your financing requirements too widely you may well find lenders and investors have a greatly diminished interest in looking at your transaction.

9. Use a corporate finance adviser

There are a lot of moving parts involved in the financing of an acquisition – and financing is just one piece of the acquisition puzzle. The process also often requires valuation specialists, tax advisors and lawyers. A good corporate finance adviser will help with strategy, identify targets, structure the deal, negotiate the terms and conditions, determine the optimal capital structure, source the requisite financing pieces, manage the process, coordinate the other advisors, and assist with closing and post-closing matters. Adviser fees can add up in acquisition transactions but the high quality expertise and experience in this context can be invaluable. This is not an area to cut costs – get the best advisers you can.

Axel Christiansen is an Investment Manager with Vancity Capital, where he specializes in subordinated debt financing for successful small to mid-market BC-based companies. He has over 15 years of sub-debt investing experience and is a founding member of Vancity Capital. A CFA charterholder, Axel is also a member of The Succession Network – an organization focused on educating buyers and sellers on business acquisition and divestiture.