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Acquisition Funding
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Most founder-owned companies and independent sponsors are not backed by private equity funds, which makes it harder for them to mobilize acquisition financing when needed. They may have a few bank relationships, but acquisition financing needs are usually beyond a bank’s capability given their focus on risk ratings and regulatory scrutiny.
Despite the efforts of certain investment banking firms to highlight capital pathways for founder-owned companies, it is often a road less travelled due to unfamiliarity. There are a range of acquisition financing options out there that can be used. The most popular options include seller notes, earn-outs, rollover equity, mezzanine debt, and structured equity.
Seller notes and earn-outs defer purchase consideration to the seller and are used in a large percentage of middle market deals. Most lenders will count a seller note as equity if it is structured properly. Earn-outs are a little more complicated as they erode EBITDA on the income statement and lead to an increase in the leverage ratio.
A purchase price containing 10% to 20% seller note is a balanced and sound ratio, that most lenders will credit to your your equity contribution as long as you are investing a material amount of your own money in the deal. Too many cash strapped entrepreneurs suspend good judgement and cast about for a 100% financed deal where they contribute nothing but the seller note. This does not work as the acquisition financing lender will not take 100% of the risk for a 12% return.
Using Mezzanine Debt in Acquisition Financing
Rollover equity can fill the same role as a seller note, but it involves having a minority shareholder which can be problematic over the long term. Most acquirers want the prior owner to exit and having them in the capitalization table brings a level of scrutiny and involvement they wish to avoid.
Mezzanine debt capital is an equity alternative that can supplement a seller note and buyer’s equity. It will provide a loan up to 3.5 to 4.5 times adjusted EBITDA. It costs less than private equity and provides a balanced repayment structure that is 100% backend. This enables the company to close its acquisition financing and invest in growth, without having to worry about loan repayments over the immediate term.
