Whether it is a third-party sale, management buy-out, or transition of a business to family members, the purchase of a business is a complicated and challenging process. Not only do the buyer and seller need to agree on an acceptable price, but buyers often also need to secure the financing to complete the acquisition. This article provides considerations for acquiring financing to purchase or buy-out a business using a case study analysis.
A critical part of a successful acquisition is negotiating an optimal financing structure. An optimal financing mix is one that allows for a smooth ownership transition, ensures the continuity of the business, and positions the target company for future growth.
Enterprise value and deal structure
The first step in any successful transaction is establishing a view on value (i.e., establishing how much the target company is worth). This is often done using a multiple of profitability as measured by earnings before interest, taxes, depreciation, and amortization (“EBITDA”).1 A properly performed valuation will facilitate a smooth negotiation process. Once the final purchase price is determined between buyer and seller, a typical financing package is comprised of the following:
Equity investment
The buyer may provide a portion of the purchase price through an equity contribution from available cash or other personal sources of wealth (such as refinancing personal assets). The benefits of providing equity participation are twofold:
Vendor debt
When buyers lack sufficient capital to pay the full purchase price on closing, a vendor take-back (“VTB”) may be an option to consider. The debt owed by a buyer to the seller is subordinated to any debt issued by the primary lender; this can be at risk if the business fails. There are various forms of VTBs that are specific to each transaction.
Senior debt
The senior debt in an acquisition, typically makes up the majority of the financial package and is secured by the assets or cash flows of the company. Senior lenders will have a first charge against assets of the borrowing company, meaning in the case of financial distress, they would be repaid before any other debtors. The lender typically decides how many multiples of EBITDA it is willing to lend to finance an acquisition. More importantly, lenders also look to pertinent ratios to determine a sensible level of debt for the business and hold the business to certain performance targets. More details on these are provided in the case study.
Case study
Buyer A has agreed with Seller B to purchase all outstanding shares of Company C for $10,000,0002 , which represents a multiple of 5.00x normalized EBITDA. The table below illustrates the sources and uses of funds in this transaction:
The terms and conditions of the senior loan customarily include financial covenants such as Fixed Charge Coverage Ratio, Debt Servicing Ratio, Total Debt to Equity Ratio, Total Funded Debt-toEBITDA, and Maximum Total Funded Debt-to-Capitalization which will have to be met during the useful life of the loan. The details of the VTB and the sources of equity investment funds (i.e., cash received from refinancing a personal property) may impact the covenants of the senior loan and ultimately the borrowed amount.
Other forms of financing can be included in this example as well. It’s not uncommon to see refinancing of, or charges taken against the commercial property owned by the subject company (i.e., Company C). The key to each in the financing package is to successfully integrate the acquisition and support future growth.
Seek tax and legal advice
In the event where the purchaser of shares of a private corporation incorporates a holding company (“HOLDCO”) and purchases such shares through the holding company, the following select benefits are available and should be discussed with the purchaser’s external tax advisors:
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Tax-efficient debt financing: To the extent debt financing can be held inside the purchaser’s holding company, the debt can be serviced using lower, after-tax corporate funds versus higher, after-tax personal funds. That is, the net after-tax operating company profits may be paid via a dividend to the HOLDCO with no additional income tax cost to the HOLDCO and dividend funds used to service the debt.
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Interest deductibility on borrowed funds: Interest costs are deductible when funds are used for the purposes of earning income. Funds used to purchase shares which can generate dividend income are an eligible use to claim interest deductions. However, inter-corporate dividends to the HOLDCO do not typically trigger any taxable income and the interest costs may not provide any tax benefit within the HOLDCO if there is no taxable income. It is critical to assess income sources to ensure efficient borrowing.
Finally, as a result of pressure from business owners and business associations, the Federal government has recently made amendments to the Income Tax Act to ease some of the tax planning in a family business transition. Previously, it was perceived to be more tax onerous when transitioning a business within a family as compared to a third-party sale, but this is in the process of being remedied with Bill C-208.
Seek advice
The complexity of planning for an acquisition is multifaceted. Your BMO financial professional can refer you to a Business Advisory and Transition Planning specialist for a more detailed discussion on this topic.
For more information, please speak with your BMO financial professional.
1 Commonly, EBITDA is normalized by removing non-recurring expenses and/or revenues.
2 Assuming the company is sold for cash and is debt free.
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