Growth-stage technology companies are increasingly using debt to help finance strategic M&A. Ed Bryant of M&A Advisory Firm Sampford Advisors and Will Hutchins of Espresso Capital, a leading venture debt provider, discuss why.

Well-executed acquisitions can be an important complement to organic growth for growth-stage technology companies, enabling them to achieve critical scale faster and helping accelerate product development, speed market entry, and strengthen competitive position.  But for companies that aren’t yet generating meaningful cash flow, finding the right acquisition financing––and enough financing––can be a challenge. Compounding that challenge is the fact that in M&A, speed matters. The ability to quickly secure financing is often a critical factor in ensuring a successful acquisition.  With a variety of debt financing solutions now available, we review how the effective use of debt can complement other sources of funding and help technology companies raise needed capital within the tight time frames required by M&A processes.

Funding the Acquisition:

Private market M&A transactions are often financed using one or a combination of the following:

  • Cash. It’s important to consider how much cash the combined company will need, for ongoing working capital as well as for any one time transaction and integration costs, to determine how much (if any) cash to use towards the acquisition. Typically, excess cash will provide only a small portion of the total required funding.
  • Equity Financing. Acquirers may seek additional equity investment from existing investors or seek new equity investors to help finance an acquisition. Equity is the most costly form of capital, particularly for high-growth technology companies, so careful consideration should be given to how much equity to use.  Perhaps equally important, raising equity can be a lengthy process, made more complex in a M&A context as investors need to evaluate the combined company and associated integration risks. The inability to raise equity within the tight time frame of a potential transaction is a common reason deals fail.
  • Vendor Take-Back. In some cases acquirers may satisfy a portion of the purchase price by issuing the vendor a note (e.g., vendor financing) or shares in the combined company.  While vendor take-backs help ensure vendors are motivated to support the integration, vendors will generally seek to significantly limit non-cash consideration and maximize cash received on closing.
  • Earn-Out. Common in transactions involving smaller private companies, earn-outs make payment of a portion of the purchase price conditional on the target meeting certain operational or financial targets post closing. Similar to vendor take-back financing, an earn-out will generally make up only a small portion of the total purchase price.

Using Debt to Help Finance An Acquisition

Growth-stage technology companies now 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 have several benefits, including:

  • Speed of Funding. The ability to move quickly can be the difference between a successful and failed acquisition, particularly in competitive bid situations. Venture debt can generally be secured much faster than equity allowing an acquirer to react quickly to acquisition opportunities.
  • Reduced Complexity. Using debt financing can help avoid (or at least minimize) complex valuation discussions with equity investors, reducing transaction complexity and allowing management to focus on the evaluation and execution of the transaction.
  • Non-Dilutive. Debt financing is generally non-dilutive and therefore less expensive than using equity to fund a transaction. This allows existing investors to retain control and enjoy a greater share in the acquisition’s upside.
  • Extending Runway to Subsequent Equity Round. In some situations debt can be used to finance some or all of the purchase to provide the acquirer time to realize the full benefits of an acquisition, setting the foundation for a subsequent equity financing on more attractive terms.
  • Maximize Funding. When used in conjunction with equity financing, debt can serve to maximize total available funding, enabling companies to pursue larger deals.
  • Governance. Leenders will not require board seats or other governance rights commonly required by large equity investors.

There are several factors to consider in determining whether, and how much, debt is appropriate to use in financing an acquisition:

  • Debt Service. Careful consideration should be given to the combined company’s forecast cash flow profile, including any one-time costs, to ensure it has ample ability to service the interest on the debt. If debt service costs are too high, it may hamper the company’s ability to realize on the original strategic and operational objectives underlying the acquisition.
  • Term and Repayment. Ensuring the term (e.g., maturity) of the loan coincides with the company’s projected ability to repay or refinance the debt is vital to ensuring a successful transaction. While it’s difficult to forecast with total accuracy what the company will look like in the future, it’s important that management consider the potential refinancing options on maturity (e.g., refinancing with a new debt facility or equity raise).
  • Amortization. Acquirers should work closely with their lenders to structure an amortization schedule (if any) that ensures they have access to the capital they require over the term of the loan. An overly-aggressive amortization schedule can put undue pressure on the combined company’s liquidity and negatively impact its ability to invest for growth.
  • Financial Covenants. While venture debt facilities will often be structured as ‘covenant-lite’ deals, ensure any financial covenants are compatible with the company’s forecast and that you understand their potential impact on the go-forward operation of the combined company.

A well-executed acquisition can be a powerful tool to drive growth and enhance shareholder value for technology companies. Taking the time to determine the optimal financing strategy will help ensure your acquisition is a success.

About the Authors

Will Hutchinsis Managing Director with Espresso Capital.

Ed Bryantis President and CEO of Sampford Advisors, an M&A advisory firm for Canadian technology companies.