One way you can grow and scale your business is via an acquisition, where your company buys another company, or the material trade and assets of another company. There are many reasons to acquire another company – you may want to purchase a competitor’s assets or customer base for example, or perhaps you’d like to take over a competitor and achieve an advantage in your sector.
If you’re thinking of an acquisition, the first issue on your mind will be how to fund it. Most companies don’t have sufficient cash reserves to complete a buy-out, and so need additional finance to complete the purchase.
Merger and acquisition funding is different from normal corporate finance such as venture capital, and the investor pool also varies. Acquisition funders can include private equity companies and traditional banks, for example. The two most common types of acquisition finance are debt finance and equity finance. Debt finance involves borrowing money to fund the acquisition while equity finance involves issuing new shares.
There are several considerations as to whether to purchase an entire company’s shares, or just its material trade and assets, not least that in a share purchase the existing entity will remain in its current form – and subject to all existing liabilities – as a subsidiary. For this reason and others an asset purchase may instead be considered.
In this article, we'll cover:
- Buying a company with cash
- Buying a company by offering the seller equity in Newco
- Buying a company by issuing a promissory note to the seller
- Using borrowing to fund an acquisition
- Using equity to fund an acquisition
- Debt financing vs equity financing: a comparison
- Factors influencing fundraising structures
Buying a company with cash
If your company is cash-rich, you may have enough reserves on hand to buy a company outright, without recourse to outside capital. Since companies for sale tend to be valued at multiple times their annual earnings, you may need a significant amount to complete the sale, so outright purchases with cash are relatively rare.
Buying a company by offering the seller equity in Newco
Another way to finance an acquisition is to use equity, offering the seller shares in the newly created company (a 'Newco') that results from a merger between your company and the target company. Your shareholders will end up owning a stake in Newco, alongside the shareholders of the acquired company. This can be a helpful means of making an acquisition, especially if you would benefit from the expertise of the seller to make a success of the merged business.
Buying a company by issuing a promissory note to the seller
If your seller agrees, one way to fund an acquisition is to part-pay for the target in cash, and partly by way of a promissory note. If the vendor is keen to sell and confident in your ability to operate its business, this might be a viable option to defer payment of the purchase price.
Using borrowing to fund an acquisition
While a bank may be the obvious choice to fund a purchase, bank finance isn’t always straightforward. You’ll need to show sufficient cash flow to fund the borrowing, and Newco will need to have a robust financial position so that it can meet ongoing financial covenants. If you’re considering bank finance, you’ll need to bear this in mind when qualifying targets, and the fact that your bank financing will be senior to other investors and note holders, including any promissory notes issued. You may also need to issue personal guarantees, or be willing to procure that other companies in your company group give such guarantees, as part of the transaction.
The key methods of debt acquisition finance are loans and debt securities.
Loans
If you choose to borrow, your loans may be secured by your, or Newco’s, assets, provided they do not breach the rules on financial assistance in the Companies Act 2006.
If the target is a publicly listed company, then the buyer (the bidder) will need to make sure they can complete the offer once it’s accepted by the selling shareholders. This means having enough money to complete the purchase. You’ll need to have a signed loan agreement in place and be able to draw down funds without conditions before making a public takeover offer.
We would recommend in this case to take specific advice in respect of listing requirements and restrictions.
Debt securities
If you fund an acquisition through issuing debt securities, your company will issue notes or bonds to investors in return for funding. Debt securities represent a debt from the entity issuing it to a lender. They contain a promise for the issuer (the company) to repay a defined amount to an investor (the holder of the debt security). The obligation is usually to pay on or by a specified date.
Most debt securities are transferable, meaning that they can be bought or sold by an investor on a debt capital market.
For more information, read our guide to raising debt finance.
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Using equity to fund an acquisition
There are a variety of different ways to use equity to fund an acquisition:
Rights issues
A rights issue is where you offer new shares to your existing shareholders in proportion to their existing holdings. If you don’t have cash on hand to finance the acquisition, this can be a viable option.
Shareholders pay for their new shares in cash, and normally at a discount to the current market price. A key element of a rights issue is that the right to subscribe for shares has value and a shareholder can sell this right without buying the shares. These factors compensate shareholders for the dilution that results from the new share issue. This method is known as selling the rights ‘nil paid’.
Even if a shareholder does nothing, they’ll have the right to receive any value over and above the subscription price if the shares are sold at a premium to the subscription price plus costs. Brokers are normally employed by the issuing company to sell any unwanted shares (known as ‘the rump’).
Placings
A placing is where you offer shares in return for cash to selected investors. This offer is not proportional to existing shareholdings and may include new investors.
In a placing, the recipients of the shares are usually institutional shareholders who are likely to hold the shares as a long-term investment.
By law, if you want to offer new shares, you must first offer them to existing shareholders before you offer them to external investors. If a company is listed, then you’ll typically get a waiver from shareholder pre-emption rights to make a placing at their AGM.
It’s common for listed companies to obtain waivers to make cash placings of up to:
- 5% existing issued ordinary share capital in a year
- An additional 5% of existing ordinary share capital for an acquisition or capital investment
- 7.5% of existing ordinary share capital on a cumulative basis in any three years
A cash box placing is a special kind of placing where the deal is structured as a share-for-share exchange to avoid statutory pre-emption rights. Cash box placings tend to involve Jersey-incorporated companies with multiple types of share capital.
The sole asset of the cash box company is cash, normally provided on a subscription of shares by an investment bank. The issuer will agree to issue new ordinary shares in exchange for taking ownership of the cash box company (and its money).
A ‘bought deal’ is a type of placing where one investor takes a block of shares so it can sell those shares on for a profit. Bought deals are normally conducted by large securities houses.
An open offer is an offer of new shares to existing shareholders also on a pro-rata basis. However, open rights do not use provisional allotment letters and can’t be sold by a shareholder nil paid. Further, under an open offer, no arrangements are made for the sale of any shares not taken up by shareholders.
A vendor placing involves a buyer allotting shares to a seller in exchange for shares in a target company. The seller then agrees with an investment bank to place its shares in the market for a cash sum.
Debt financing vs equity financing: a comparison
The key difference between funding an acquisition via debt versus equity is one of ownership.
In equity financing, the business owners surrender part of their ownership in a company. By contrast, in debt financing, the owners of a business don’t change but the company becomes indebted to investors.
Despite the difference between equity finance and debt finance, both may involve securities. In equity finance, securities normally take the form of shares whereas bonds and notes are common forms of securities in debt finance.
Investors who acquire shares in a company will be entitled to the usual shareholder rights, including the right to receive dividends and vote at shareholder meetings.
By contrast, debt investors are not entitled to vote in shareholder meetings or a share in a company’s dividends. Debt securities are commonly time limited and only entitle investors to receive payments so long as the debt remains outstanding. Shareholders on the other hand remain entitled to vote and dividends for as long as they hold shares.
Debt securities will primarily only be subject to the contract of investment between the company and the investor. In a share issue situation, the investor will also become a shareholder and will be subject to the company’s articles of association.
Factors influencing fundraising structures
If you’re considering how to fund an acquisition, you’ll need to factor in borrowing costs, and in particular weigh the fees, interest etc against the cost of diluting share capital.
As we’ve seen, issuing new shares means diluting existing shareholdings and increasing the number of investors entitled to dividends and share buybacks. Depending on the type of equity issued, a company may also incur additional costs in preparing a prospectus and marketing new shares to investors.
If your company has already borrowed heavily, you may only be able to finance an acquisition through the issue of new shares. Your existing loan agreements may also limit the amount you can borrow without the lenders’ consent.
Finally, there may be tax implications. For example, a company is allowed to deduct all expenses incurred in connection with its loans. However, there is no tax relief available on dividend payments. This usually means that debt is more tax efficient than equity funding.
For more answers to commonly asked questions and advice on company acquisitions, consult our M&A solicitors. Get in touch on 0800 689 1700, email us at enquiries@harperjames.co.uk, or fill out the short form below with your enquiry.
