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For companies seeking acquisitions, there are a number of financing options, such as cash, debt, sellers notes, stock or any combination of those items. According to Glen Mastey, vice president of Commercial Banking of Capital One Bank in Dallas, the ultimate financing structure is dependent on many factors, including the objectives of the buyer and seller, the state of the credit and capital markets, operating and cash flow characteristics, industry dynamics and purchase price. However, much of the capital required to make an acquisition along with required working capital comes from senior debt provided by a commercial bank.
An acquisition is often a litmus test for the relationship between the bank and client. Smart Business spoke to Mastey about what a business needs to know to figure out its ideal acquisition financing structure. How important is it for a business and its commercial banker to know each other well? For example, many commercial banks require clients to be fully secured, some require clients to be partially secured, and some are comfortable relying on cash flows.
Understanding this will allow company management to more effectively structure the overall transactions and allow its commercial bank to respond to its financing request more quickly. An acquisition should have the appropriate balance of risk and return for both the bank and borrower. For example, a bank generally operates with a gross profit margin of less than 3 percent, providing a thin margin for error. However, if a bank is smart, it will look for the risks and rewards for it and its client.
Since the post-acquisition combined entity will likely have higher leverage than either of the participants had prior to the acquisition, company management should be sure of the following:. A well-thought-out and documented financial package consisting of historical and projected financials on a stand-alone and combined basis should be assembled. The package should include projected cost savings and required spending assumptions.
It should also highlight profit margins and cash visibility to service its interest and principal debt payments. Additionally, balance sheet flexibility, asset valuation and break-up value should be reflected. Loan covenants should allow for growth and flexibility but protect the bank in the event of a significant misstep. Acquisitions often require specialized covenants as opposed to other senior bank debt financing transactions.
Although these covenants vary from acquisition to acquisition, they focus on servicing debt and maintaining a strong balance sheet, and they may include an adverse contract and cost-reduction covenants, inventory and accounts receivable turns. Can companies expect banks to build the same financial structures for all? No, because there is no one structure that fits all. Management needs to understand that several factors including the inherent profitability level of the company and industry, cash flow and earning visibility, and stability will generally impact the financing structure.
Companies in industries that are highly cyclical or subject to rapid technological obsolescence may experience unpredictable external forces that have a substantial negative impact on cash flows. Such companies are a poor risk for high leverage. Competitive position is important, too. Dominant market participants are likely to have control over margins and revenues, putting pressure on smaller competitors.
Higher equity with less leverage should result in less liquidity risk and less stringent terms, but the dilution of stock reduces shareholders rewards. A higher proportion of equity and subordinated debt should result in less stringent bank loan covenants and leave additional borrowing capacity for unforeseen needs.
A higher portion of long-term debt versus short revolving debt is generally a better financing match, improving working capital and thus liquidity. Since the post-acquisition combined entity will likely have higher leverage than either of the participants had prior to the acquisition, company management should be sure of the following: The acquisition size should be small enough not to trip up the acquiring company in the event of poor integration. What should management be aware of when considering a financial structure?