What Is Acquisition Financing? (With Types and Benefits)

By Indeed Editorial Team

Published October 6, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

It's common for companies to acquire other businesses before they have the full amount of cash on hand to do so. To pay for the acquisition, they often use a process called acquisition financing. There are several types of acquisition financing, all with different terms and requirements. If the organization you work for is planning to acquire another company in the future, it's helpful to understand more about acquisition financing.

In this article, we define acquisition financing, review how it works and explore the different types of acquisition financing available.

Related: Mergers and Acquisitions: Definition, Types and How They Work

What is acquisition financing?

Acquisition financing is the funding a company uses for acquiring or taking ownership of another company. There are multiple ways a business can obtain the capital needed to purchase another company, but it typically occurs through lines of credit or large loans from a bank or credit union.

When one organization acquires another, the acquiring organization automatically grows and holds a bigger place in the market. As such, the business then has more capital and a higher chance of generating the money needed to pay back the loan.

Related: Acquisition vs. Merger: What's the Difference?

How does acquisition financing work?

There are many different ways a business may choose to finance an acquisition. In all cases, the party giving the loan or line of credit does so under a set contract outlining the terms. Typically, these are detailed contracts and include information regarding how long it should take to pay back the loan, the interest rate and any specific terms or conditions under which the loan or line of credit exists.

Related: 8 Steps To Take if Your Company Is Being Acquired

Types of acquisition financing

There are many ways to engage in acquisition financing, including taking on debt or purchasing some level of equity in an organization. Here are a few common types of acquisition financing:

Bank or credit union loan

Receiving a loan from a bank or credit union to pay for an acquisition is a common form of financing. With this type of financing, an organization receives a loan that pays in full for the acquired one, and then it has a certain amount of time to pay the loan off. Typically, the acquiring organization also uses the acquired company's assets as collateral to secure the loan.

Related: A Guide to the M&A Process

Debt

Debt financing is generally the least expensive financing option. A company may choose this when it's unable to pay for a company in cash, so it sells bonds to raise the funds. Typically, companies choose debt acquisition through asset-backed financing, which is fairly inexpensive and may have eventual tax benefits.

Related: Liabilities vs. Debt: Definitions and Examples

Equity

Another way to engage in acquisition financing is through purchasing equity in an establishment. The acquired establishment sells company shares to investors. Companies can decide to do this if the acquired company is in a particularly unstable industry that may not guarantee high profits or profit maximization. It's also a more flexible type of acquisition financing due to equity financing's lack of deadlines and expectations. This is typically the most expensive type of acquisition financing.

Related: What Is Strategic Acquisition? (Definition, Benefits and Tips)

Earnout

An earnout process is a more flexible, creative way to engage in acquisition financing. The business participates in a deferred purchase price, which means that the original company owner can receive additional compensation if the company meets certain, specified financial goals in the future. With earnout acquisition financing, the business is most likely going to flourish after the acquisition.

Leveraged buyout

Leveraged buyouts are another popular type of acquisition financing. Both the acquiring company and the acquired gather their own assets as collateral in addition to taking on debt through a bank loan or credit union loan. This type of acquisition financing is considered risky but also rewarding due to the uncertainty but chances of profit maximization associated with it.

Related: What Is a Merger? A Guide to Combining Companies

Mezzanine debt

Also called "subordinated debt," this is a hybrid form of financing that involves a combination of equity funding and debt. This type of financing lets the acquiring company secure most of the control. Mezzanine debt is customizable and flexible to be as relevant as possible for each transaction.

Typically, companies that have a steady, high cash flow and solid plans to expand in the future choose to use mezzanine debt. Companies may also choose to use this type of acquisition financing when they don't want to or can't use bank or credit union loans.

Related: 5 Types of Funding for Businesses

Benefits of acquisition financing

There are various benefits to using acquisition financing when acquiring a new business, including:

Quickens the acquisition process

Acquisition financing often makes the process of acquiring an organization quicker. Since you don't have to wait to have all the funds needed to make the acquisition, the process is typically less complicated. The faster an organization is able to buy another one, the faster it's able to generate revenue and garner results. Acquisition financing can also shorten the time it takes for the company to experience a return.

Related: How To Use Acquisition Marketing and Customer Retention To Grow Your Business

Increases presence in the market

Acquisition financing facilitates your ability to become a more pronounced establishment. The larger your establishment becomes through acquisitions, the higher likelihood of it having a larger presence in its respective market. Having the funds to expand your company can help you become a market dominator and possibly expand even more in the future, which can result in more revenue and profit maximization opportunities.

Related: 21 Growth Hacking Strategies for Fast Business Growth

Builds business credit

If you pay off acquisition loans in a timely manner, your credit score can increase. This can help you receive even larger loans in the future if you plan to acquire new companies or organizations. Building business credit also can help you build rapport with banks, loan officers and credit unions.

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