While basic in form, this question is complex in answer. Many purchasers of businesses feel they know all there is to know about how to finance an acquisition. The reality is that most business acquirers would benefit greatly from researching the different forms of capital and risk profiles of each acquisition financing path. Many revert to basic financing methods of bank loans, SBA loans, or private placements without really thinking about what they are doing.
To finance an acquisition, one must go beyond plain vanilla thinking and first analyze risk in two different ways: financial risk and business risk. Financial risk involves looking at the impact that the form of financing will have on solvency of the business. An acquisition is a long-term investment and it should be financed with long-term capital. Often, in the finance of an acquisition, a short-term yet cheap interest rate loan is used, rather than a more expensive, yet long-term loan.
This creates a high performance hurdle on the business requiring the acquisition to perform exactly according to plan in order to pay back the loan. When the acquisition performance deviates from plan due to conventional business risk, the lender cannot be satisfied in such a short term. This creates stress and can lead to massive financial risk for the solvency of the business. Savvy operators understand that to finance an acquisition means to have an insurance policy embedded in your capital structure.
Planning for inevitable business plan deviations is prudent so long as term loans should always be considered. Long-term lenders are purveyors of patient capital and are better equipped to tolerate the usual budget under performance. Savvy operators understand that prudence should prevail in the finance of an acquisition. Loans should have long-term structures. Principal repayments should not occur for the first several years after an acquisition to allow for some breathing room.
Principal payments should be back ended. Extra cash should be put on the balance sheet to allow the company to weather the inevitable rough patch in its performance. Covenants should be set at reasonable levels to allow the business latitude. Longer-term loans such as unitranche, one stop, cash flow, and mezzanine loans are great ways to finance an acquisition. Beneath the surface, where real risk lies, these forms of capital are superior in value when seeking to finance an acquisition.