What Is Acquisition Financing? (With Types And Examples)

Updated 30 September 2022

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Companies may acquire other companies to expand their operations and increase their profit margins. Negotiating the right financing structure is a key component of a successful acquisition. Learning about acquisition financing can help you become more familiar with the various ways in which businesses raise capital to acquire other businesses. In this article, we discuss what acquisition financing is, learn about its various types, find out its benefits and review some examples to help you understand the concept better.

What Is Acquisition Financing?

Acquisition financing, also known as acquisition funding, is the capital that a company raises to buy another company. There are several reasons a company may acquire another company:

Improving market share
Gaining new technologies
Diversifying geographically
Eliminating competition
Increasing supply chain pricing power
Reducing taxes
Improving performance efficiency

A company may use various techniques to raise capital, such as cash transactions, stock swaps, debt financing, equity financing or earn-outs. Companies evaluate factors such as profitability, share price, earnings, integration costs, quality of assets and off-balance-sheet risks to choose the right financing technique to acquire another company.

Advantages Of Acquisition Funding

There are various benefits to acquisition funding:

Makes the process time-efficient: A company can save time by taking advantage of acquisition finance instead of trying to raise enough capital themselves. After the completion of the necessary steps, the funder releases funds for the acquisition transaction, enabling them to acquire capabilities or resources they might not otherwise possess.
Increases profitability: Acquiring another business provides access to various new technologies, resources and assets that a company can utilise to improve its products and services.
Provides competitive advantage: An acquisition helps a company increase its market share, which provides a competitive advantage in the marketplace.
Fosters career growth: Both companies' employees benefit from the acquisition, as they gain access to a larger pool of resources that can help them advance their careers, improve their skills and work on challenging projects.
Provides new career opportunities: Financing an acquisition allows companies to gain faster access to employees with enhanced skills and expertise. This enables them to meet their business needs and provide solutions for their unique challenges.
Improves collaboration: Upon the acquisition of a small company by a large company, different departments, including legal, human resources, finance, technology and management, collaborate to ensure a smooth transition and work towards meeting business objectives.

Types Of Acquisition Funding

Acquisition funding depends on various factors, such as the size and value of the companies involved. Financial experts aim to identify techniques that are both cost-effective and time-efficient. There are various techniques that these professionals can use:

Stock swap transaction

The technique involves exchanging one equity-based asset for another. During a stock swap, the target company's shareholders exchange their shares for those of the acquirer. Calculating a fair swap ratio requires an accurate valuation of each company's shares. By swapping shares of one company with shares of another, companies can cover their costs. Some parameters that financial experts use when evaluating the feasibility of a stock swap transaction include the current market value of the target firm, the current market value of the issuing firm and the pre-defined cut-off date.

Companies prefer this method because it helps reduce cash transactions which attract lower taxes, takes advantage of government policies and improves negotiating power with suppliers because of greater market share. Consider the following example:

A large pharma company ABC wishes to acquire another pharma company XYZ to expand its presence in small towns across the country. By acquiring XYZ, ABC can extend its operations, improve its logistics and expand its markets, while XYZ focuses on research and development. The management of ABC funds this acquisition through a stock swap transaction where shareholders of XYZ receive four shares of ABC for every five shares they have in XYZ.

Acquisition through equity

A company can raise capital to fund an acquisition by selling its shares for capital. This method of financing may be useful for a company that is acquiring a business in an industry that is volatile or does not have a steady cash flow. Since there are no deadlines or expectations, it is more flexible than other methods. Review the example:

A semiconductor company, ABC, wants to purchase a manufacturing company XYZ for ₹100 crores in ABC's shares. ABC's shares are trading at ₹100 per share in the market. XYZ's is trading at ₹180 per share and has five million shares. ABC hopes to raise ₹100 crores by issuing ten million shares. They give these shares directly to the stakeholders of XYZ in exchange for control over their stake in the company. Each stakeholder of XYZ receives two shares of ABC for every share of XYZ they own.

Cash acquisition

In this type of acquisition funding, a larger company acquires another company by completing the transaction entirely in cash. This is a risk-and-reward acquisition in which the risk is arranging for a lump sum of cash for the transaction and the reward is the complete ownership of the assets, liabilities, business operations and resources of the acquired company by the acquirer. Refer to this example:

An e-commerce company buys all of a logistics company XYZ's assets for cash. After this transaction, XYZ only has cash which it can liquidate or use to enter other areas of business.

Acquisition through debt

When compared with equity, debt can provide financing for acquisitions at a lower cost. Despite the ability to acquire another business with cash, very few companies do so because of budget constraints. Companies that seek less funding and wish to obtain it more quickly prefer debt financing over equity funding. The types of debts include:

Senior debt: Senior debts are debts that are highest in priority and carry lower risks. Because of their nature of risk, the interest rates are often lower and funded by banks.
Subordinated debt: Subordinated debt is any debt that has a lower priority than other types of debt. Since companies pay these debts only after they have paid other debts, it makes it a riskier form of debt for lenders.
Asset-backed debt: In this type of debt, a company offers its assets as collateral for a loan.

Obtaining debt financing requires a thorough evaluation of a company's finances. Lenders who provide funding evaluate a company's profit margins, cash flow and liabilities. For example, if a company wishes to acquire another company, it can consider borrowing from an asset-based lender by using its assets as collateral. If the company is unable to repay the debt, the lender can take ownership of the company's assets.

Acquisition through mezzanine-debt

Companies considering acquisitions may be interested in mezzanine financing if the target company has been profitable for a long time and has a strong balance sheet. The combined equity and debt aspects of this type of acquisition funding allow it to be converted into equity if desired. In this arrangement, investors and borrowers share risk and reward equally. Consider the example:

An IT company ABC is interested in acquiring a smart contracts development company XYZ. The net worth of XYZ is ₹195 crores. An investment firm offers ABC ₹100 crores at an interest rate of 9.9%. ABC convinces a mezzanine investor to pay another ₹50 crores. Now ABC only has to arrange ₹50 crores to finance the acquisition. Once the business is profitable and generates positive cash flow, ABC can maximise its return, while minimising its capital expenditure.

Leveraged buyout

Like mezzanine financing, a leveraged buyout (LBO) is an acquisition funding option that combines debt and equity. Here, both the target company and the acquiring company provide collateral. Many mature companies with steady cash flows can take advantage of LBOs.

It is important for acquiring companies to understand that LBO finance entails high risks and high rewards. Using leverage on the assets of the target company, an acquiring company may generate sufficient cash flow to cover the debt generated by the acquisition. Companies can avoid accumulating more debt than they can afford by taking proper precautions prior to obtaining financing. Consider the example:

Company ABC is an investment firm that wants to acquire a small tech start-up because of its advancements in quantum computing. The total value of the tech start-up is ₹450 crores. ABC uses ₹150 crores of its own money and borrows the remaining amount from a bank by using the tech startup's assets as collateral. They do this expecting a positive cash flow in the future, which they can use to pay their debts.