As an entrepreneur you are constantly focused on growing your business. Being an entrepreneur in everchanging environments is challenging. Entrepreneurs can take different routes when it comes to growing a business. Growing a company can roughly be divided into two different strategies: organically or via acquisitions. The end-goal in both cases is value creation for the shareholders.
Organic growth is a strategy in which a business grows by realizing year-over-year more revenues with or without help of a third party. Without any external financing a company can finance the growth from the cash flow made from their own activities. The alternative to fuel organic growth is to attract additional capital. In that way businesses receive extra capital with which they can accelerate their growth by investing more than what they make out of their own business activities (‘targeting growth’).
An alternative for organic growth is to grow by means of doing acquisitions. Growing via acquisitions is a challenging operation in which you should consider a lot of things, but if you do it well it can be an efficient and rewarding way of growing your company. The remainder of this article will handle which variables and best practices you should consider when doing acquisitions and how you can finance acquisitions.
A buy-and-build strategy is a strategy in which a business expands its operations in terms of size and scope by means of acquiring companies.
The advantages of doing acquisitions are multi-fold. First of all, you are growing the company in terms of revenues and (preferably) profitability. Next to that you can grow your business in terms of clients, geographic scope, product, talent and know-how. Additionally, buying the correct company can lead to cross-selling opportunities (selling new products to existing customers) and/or up-selling opportunities (selling more to existing clients due to extra resources). Furthermore, by acquiring a competitor, you might be able to increase your market share and reduce competition.
Growing by means of acquisitions is an intense process; you must really make it part of your strategy. Initially it takes a lot of prospecting and introductory talks. Later the correct analysis should be made on a target to estimate the fit and determine the correct price. After that there is the negotiation, the due diligence and the closing of the acquisition. Eventually the acquired company should be integrated. This requires strong people management and strong financial knowledge to structure it in the most optimal way.
When looking for acquisition targets, decision-makers should pay attention to certain things. A scalable business model is a major benefit. The recurring nature of revenues is a very strong element in pursuing acquisitions in the software/IT industry specifically. Next to that, synergies are very important. Cutting costs because you have certain resources double is a frequently used strategy. Additionally, it proves to be very efficient to roll out a buy-and-build-strategy in a fragmented market. Furthermore, cross-border acquisitions can give a company a direct presence in a new country.
Once you made the decision which company you are going to acquire, the financial options should be considered. Basically, there are two ways of financing acquisitions: debt and equity.
With debt you can finance the acquisitions by means of a bank loan and/or subordinated forms of debt (‘private debt’). Bank loans, traditionally the cheapest form of financing, can be attracted on the profit of your company combined with the profit from the acquisition target. On top of that you can attract an additional amount by means of subordinated debt, such as a mezzanine loan. This means that companies can finance a significant amount of the purchase price with debt, without giving away any shares compared to attracting an equity investor. This will most likely already cover the majority or the complete purchase price, depending on the market segment, the company and the setting.
Important to clarify is how such a construction of a bank loan together with a mezzanine loan goes hand in hand. The mezzanine loan is completely subordinated to the bank loan. Moreover, due to the grace period, the covenant light structure and the equity-like characteristics, banks see a mezzanine loan as a strengthening of the solvency. Additionally, you are first repaying the bank loan before you start repaying the mezzanine loan. In that way it fits perfectly together. In a hypothetical casus you would repay a bank loan in the first 5 years, whereafter you repay the mezzanine loan in year 6 and 7 (‘duration of a mezzanine loan’).
With equity you are going to attract an outside investor who is going to help in financing acquisitions. Equity investors can bring in sufficient capital to finance one or more acquisitions and contribute financial and strategic expertise. Traditionally, companies believe that equity investors are their only option to realize a buy-and-build strategy. However, specialized debt providers can support such strategies as well, both financially and strategically, without significant dilution for existing shareholders as a result.
In structuring acquisitions, three other special forms of financing can be considered. The first is a vendor loan, which is a loan given by the selling shareholders to spread part of the amount over time, making the total acquisition more financeable. The second is an earn-out, which is an arrangement in which the buyer must pay a part of the purchase price to the seller after certain results have been realized in the years after transaction. The third is payment in shares in the new company after transaction. This is an option when operational commitment of selling shareholders is preferred after acquisition took place.
Important to take into account regarding debt financing over time is that if you want to do new acquisitions after you have realized the first one(s), you are able to attract extra debt both on the cash flow of the new targets, but also on the organic growth of your own EBITDA realized in the period after the first transaction. In that way you can again obtain the most optimal financing structure. Important to consider by financing acquisitions with debt is that due to the leverage effect the return for shareholders increases. Additionally, the existing shareholders retain more control over the business.
As you can see there are a lot of different scenario’s how companies can structure the financing of one or more acquisitions. Important is always to find the structure that is most advantageous to you.
Pride Capital Partners is a provider of mezzanine loans for software and IT companies in the Benelux and DACH region. Speaking pro-actively with a lot of companies, we have established a big network in the market, which is constantly growing. In this way we can not only play a role on a financing perspective in a buy-and-build-strategy, but also on a strategic level.
Are you interested in how we can play a role in your acquisition strategy? If you want to know more about doing acquisitions and how to structure it financially in the most optimal way, please do not hesitate to contact us.
Anthony Van Praet
Pride Capital Partners