Editor’s note: This post originally appeared in Bostinno.
Tech sector M&A activity mounted a strong, V-shaped recovery late last year, with a record 815 deals. That impressive rebound represents an 81 percent increase between Q2 and Q3, when buyers retrenched due to the economic uncertainty caused by the global pandemic. Such a rapid rebound is a testament to the fact that acquisitions can provide companies with an effective way to scale faster, accelerate product development, speed entry into new markets, and strengthen their competitive position. Growth-stage companies are no exception.
Of course, a key element to any successful acquisition is financing. For fast-growing, cash-flow-negative technology companies, that traditionally meant raising equity capital. Yet, with a growing number of debt financing options available, technology companies and their boards should consider how they can incorporate debt into their M&A financing strategies to minimize funding costs and reduce execution risk.
Below are some of the key advantages of using debt to finance either all or a part of an acquisition as well as some of the structural considerations you should bear in mind should you choose to do so.
Using debt to help finance an acquisition
Today’s growth-stage technology companies have more options when it comes to debt financing, ranging from traditional bank loans to venture debt facilities. Using debt to help finance an acquisition can offer several benefits, including:
- Reduced cost. Debt provides a lower cost of capital than equity, particularly for high-growth companies. By striking the right mix of equity and debt funding, you can significantly lower your overall cost of capital and thus maximize the acquisition’s long-term value creation for you and your investors.
- Lower complexity. Using debt financing can help you avoid — or at least minimize — complex valuation discussions with equity investors. In doing so, you’re reducing transaction complexity and helping free up your management team’s time to focus on evaluating and executing the transaction.
- Greater speed. Reduced complexity can also mean greater speed. Being able to move quickly can make the difference between a successful and failed acquisition, particularly in competitive bid situations. That’s where venture debt can be particularly advantageous. It can generally be secured much faster than equity (often in as little as 30 days), allowing companies to react quickly to acquisition opportunities.
- Deferring equity financing until synergies are realized. A major challenge with raising equity capital to fund an acquisition is convincing prospective equity investors of the company’s ability to successfully integrate the new asset and realize key benefits, such as revenue and cost synergies. In some cases, it can be advantageous to use debt to finance some or all of the acquisition, and then refinance the debt with equity on more attractive terms once you’ve had the time to demonstrate synergies and other benefits of the acquisition.
- Enhanced acquisition capacity. Used in conjunction with equity financing, debt can serve to maximize the total available funding, allowing you to pursue larger acquisitions than might be possible using equity alone.
In addition to the benefits cited above, in some instances, as an acquirer, you may wish to issue your own shares to the seller rather than raise equity from new investors. While this can be an effective means of aligning the seller with the continued success of the combined business, particularly if the principal selling shareholder will be joining your management team, the seller may wish to take at least a portion of the sale proceeds off the table. Using debt can allow you to offer a cash component alongside equity in the combined business.
Structuring considerations when using debt
There are several factors to consider in determining whether, and how much, debt is appropriate to use to finance an acquisition. Depending on how much leverage you’re looking to secure, for example, you might opt to work with traditional banks or a specialized venture debt lender.
Beyond considerations around who the right partner is, it’s also important to think about your combined company’s forecast cash flow profile, including any one-time acquisition-related costs, to ensure you’re able to service the interest on the debt. If debt service costs are too high, it may hamper your ability to fully realize the original strategic and operational objectives underlying the acquisition.
Next, ensuring the term and amortization of the loan match your projected ability to repay or refinance the debt is vital for a successful transaction. While it’s difficult to forecast with total accuracy what your company will look like in the future, it’s important for management to consider the potential refinancing options on maturity (e.g., refinancing with a new debt facility or equity raise). Likewise, an overly aggressive amortization schedule can put undue pressure on the combined company’s liquidity and negatively impact its ability to invest for growth. As an alternative, consider obtaining a loan with a longer term, bullet repayment at maturity instead of amortization.
Finally, while venture debt facilities in particular will often be structured as covenant-lite deals, ensure any financial covenants are compatible with your company’s forecast and that you understand their potential impact on the combined business’s go-forward operations.
Setting your next acquisition up for success
While the long-term impact of the pandemic remains to be seen, the fact is that a well-executed acquisition can be a powerful tool to drive growth and enhance shareholder value for technology companies. With more SaaS companies engaged in M&A activity in late 2020 than ever before, it’s important to remember that there are an array of financing options at your disposal, many of which are designed to meet your specific needs. Taking the time to determine the optimal financing strategy will go a long way toward helping ensure the success of your next acquisition.