Financing Options: Borrowing Once a prospective target has been identified, the buyer may choose from a number of financing alternatives. For the risk-averse acquirer, the ideal mechanism may be to finance the transaction with cash held by the target in excess of normal working capital requirements—but such situations are rare. Venture capital or so-called angel investors also may be available to fund the transaction. However, this option may represent very expensive financing because the buyer may have to give up majority ownership of the acquired company.
Use of the buyer’s stock may be an appropriate way to minimize the initial cash outlay, but that option is rarely available in a management buyout or a buyout by privately held companies.
The seller may be willing t o accept debt issued by the buyer if an upfront cash payment is not important. Doing so may be highly disadvantageous to the buyer if the seller places substantial restrictions on how the business may be managed. The use of a public issue of long-term debt to finance the transaction may minimize the initial cash outlay, but it is also subject to restrictions placed on how the business may be operated by the investors buying the issue. Moreover, public issues are expensive in terms of administrative, marketing, and regulatory reporting costs. These reasons explain why asset- based lending h as emerged as an attractive alternative to using cash, stock, or public debt issues, if the target has sufficient tangible assets to serve as collateral.
Asset-Based or Secured Lending Under asset-based lending, the borrower pledges certain assets as collateral.
Asset-based lenders look at the borrower’s assets as their primary protection against the borrower’s failure to repay. These loans are often short term (i.e., less than one year in maturity) and secured by assets that can be liquidated easily, such as accounts receivable and inventory. Borrowers often seek revolving lines of credit that they draw upon on a daily basis to run their business. Under a revolving credit arrangement, the bank agrees to make loans up to a specified maximum for a specified period, usually a year or more. As the borrower repays a portion of the loan, an amount equal to the repayment can be borrowed again under the terms of the agreement. In addition to interest on the notes, the bank charges a fee for the commitment to hold the funds available. For a fee, the borrower may choose to convert the revolving credit line into a term loan.
A term loan usually has a maturity of 2 to 10 years and typically is secured by the asset that is being financed, such as new capital equipment.
Acquiring firms often prefer to borrow funds on an unsecured basis because the added administrative costs involved in pledging assets as security significantly raise the total cost of borrowing. Secured borrowing can be onerous because the security agreements can severely limit a company’s future borrowing and ability to pay dividends, make investments, and manage working capital aggressively. In many instances, though, borrowers may have little choice but to obtain secured lending for at least a portion of the purchase price. Asset- based lenders generally require personal guarantees from the buyer such as pledging a personal asset (e.g., the buyer’s primary residence).
This is especially true in small transactions if the buyer does not have a demonstrated t rack record of buying and operating businesses successfully.