One of the most frequently asked questions by aspiring entrepreneurs is: “How do I actually finance a business acquisition?” Many managers who want to become entrepreneurs through a Management Buy-In (MBI) mistakenly assume that they must finance the entire purchase price themselves. Fortunately, that is rarely the case in practice.
At the same time, it’s important to note that a good company doesn’t automatically mean that financing will fall into place. A successful business acquisition starts with a realistic valuation, a well-thought-out financing structure, and a compelling financing memorandum.
What does a typical financing structure look like?
In an MBI transaction, the purchase price is often structured using multiple sources of financing. Each financier assesses the risk allocation and expects the buyer to demonstrate a commitment as well.
A commonly used rule of thumb is that the buyer must contribute at least 25% of the total purchase price. This does not have to consist solely of personal savings. Funds from investors can also be part of this personal contribution.
The remaining portion of the financing is often covered by a combination of bank financing and a “vendor loan” (i.e., financing provided by the seller).
What does a bank finance?
Banks primarily look at the business’s future cash flows. The key question is simple: Can the business meet its interest and principal payment obligations?
As a rule of thumb, we see that banks are willing to finance up to three times the historical “EBITDA” (a measure of profit that excludes depreciation, interest, and taxes) for healthy companies. Of course, factors such as industry, the stability of results, dependencies, and growth prospects play an important role in this.
That is why it is crucial to thoroughly assess in advance whether the desired purchase price can actually be financed. After all, a high valuation is of little value if no financier is willing to back it.
The Role of a Vendor Loan
In many MBI transactions, the seller also plays a role in the financing. This is done through a vendor loan.
In this arrangement, the seller does not immediately receive the full purchase price, but leaves a portion of it in the company as a loan. This loan is usually subordinated to bank financing and is subject to agreements regarding interest and repayment.
For financiers and MBI buyers, a vendor loan is often a positive sign. It demonstrates the seller’s confidence in the company’s continuity and indicates that the seller is sharing part of the risk of the transaction.
What is a business actually worth?
Before financiers look at the structure, they want to understand how the valuation was arrived at. In practice, two methods are often used for this:
The multiples method
This method involves examining the business’s EBITDA or EBIT. A market-based multiple is then applied that is appropriate for the business’s industry, size, and other risk characteristics.
Although this method is relatively simple, it remains important to examine the underlying quality of the results. Are the historical figures representative? Are there any extraordinary costs or revenues that need to be normalized? Is there any deferred maintenance?
A discounted cash flow (DCF) analysis examines the business’s future free cash flows. These cash flows are then discounted to present value using a discount rate that reflects the business’s risk profile.
A DCF analysis forces the buyer and the financier to look beyond historical performance alone. Future investments, growth expectations, and risks are also factored into the assessment.
What else do financiers look for?
In addition to the financials, financiers primarily assess the risks associated with the company and the acquisition.
That is why a thorough SWOT analysis is often a key component of the financing application. Interestingly, it is not the opportunities that receive the most attention, but rather the weaknesses and threats. Financiers want to understand what risks exist and how they are managed.
A proven track record also plays an important role. Historical results give financiers confidence that future projections are realistic.
You often only get one chance
A financing application is very similar to a business plan, but places much greater emphasis on the financial rationale behind the transaction.
The financing memorandum must clearly answer questions such as:
- What does the overall financing structure look like?
- Where does the money come from?
- How are the funds used?
- Can the company still manage the financing even if its results are temporarily disappointing?
Precisely because financiers often get only one first impression, a carefully drafted memorandum is essential. Good preparation not only increases the likelihood of securing financing but also often results in better terms.
Financing is more than just raising money
Many MBI candidates view financing as the final step in the acquisition process. In reality, it begins much earlier.
A business’s financeability has a direct impact on both its value and the feasibility of a transaction. That is why it is wise to take a critical look at the final financing structure as early as the valuation and bidding phase.
Ultimately, a successful MBI isn’t about raising as much money as possible, but about striking a healthy balance between the purchase price, risk, and future growth opportunities.
Would you like to know which financing options are right for your acquisition plans? A thorough analysis up front prevents surprises later on and increases the likelihood of a successful business acquisition.
