M&A transactions sometimes require financing and buyers must carefully weigh their financing options to ensure a successful acquisition, i.e., one that will not jeopardize their financial condition. It’s also helpful for sellers to understand why buyers offer equity versus cash or sometimes ask the seller to finance part of the purchase.
Two of the most common forms of financing for acquisitions are the use of debt or the issuance of equity to fund the acquisition. Given that there are advantages and disadvantages to each form, many buyers use a combination of the two.
Financing an M&A transaction through the use of debt can be appealing since it is typically cheaper for the company to issue compared to equity, which usually carries a much higher rate of return expectation from investors. Issuing debt has tax benefits because the interest payments are tax deductible and the increased leverage can also boost a company’s return on equity. Another benefit of issuing debt is that no additional shares are issued and so there is no dilution of ownership. On the other hand, there are many notable downfalls to financing through debt. The issuance of too much debt will hurt the company’s credit rating which would hinder its ability to borrow money in the future and would lead to an increase in the company’s cost of debt. Debt issuance may also be limited by existing lender covenants that set a restriction on the amount of debt the firm can assume. This might make it impossible for some companies to borrow enough money to make a large acquisition.
When equity financing is utilized, a buyer can either offer its stock to the target firm’s shareholders or offer cash, which would be generated by the proceeds from an equity offering. Despite the higher cost of equity, it is still very common in M&A transactions because of the flexibility it provides the issuers. Some of the benefits of equity include (i) no mandatory interest payments, (ii) no principal that must be repaid, and (iii) no restrictive covenants related to its issuance. Financing an M&A transaction with equity has no impact on a company’s credit rating therefore allowing them to issue debt in the future if needed. Equity offerings can however have negative side effects. Issuing stock can hurt a firm’s earnings per share and return on equity as it becomes less leveraged. Furthermore, the volatility of a company’s share price can cause uncertainty about the exact acquisition valuation, which in turn can increase the amount of time needed to reach a closing or even destroy the planned transaction.
Frequently, public companies use equity financing as their preferred form of payment in M&A transactions. Nevertheless, debt still plays an important role because of its cost effectiveness and the advantages of leverage.
An experienced M&A advisor can help buyers and sellers figure out the best combination of debt and equity for any particular transaction.
