Structuring an Acquisition

June 2002

With banks turning away from pure cash flow lending to asset-based lending, they are financing a smaller portion of merger and acquisition deals. As a result, structuring an acquisition has become a greater challenge. This fundamental change in the credit market has resulted in the greater use of mezzanine financing, a higher equity contribution from the buyer and often an equity participation on the part of the seller.

For a great majority of transactions a multiple of EBITDA is used as a means to determine the price. EBITDA means earnings before interest, income taxes, depreciation and amortization, adjusted for owner’s discretionary spending and non-recurring income and expenses not necessary for the operation of the business.

For purposes of explanation, let’s assume a manufacturing company with $12mm in annual revenue and an EBITDA of $1.5mm. The company is sold for $6.75mm. Dividing the selling price by the EBITDA determines a sale multiple of 4.5X EBITDA. ($6.75mm ÷ $1.5mm = 4.5.)

The amount of equity as a percent of the total purchase price has increased from approximately 13% in 1989 to roughly 40% today. It is also becoming more common for the seller to buy back into the deal for 5% - 25% of the total equity position.

Assuming 40% equity is required to do the deal, equity would be roughly $2.7mm, leaving a balance of $4mm or 2.66X EBITDA.

In the event the fixed assets, accounts receivable and inventory of the company being acquired were not of sufficient value to secure bank financing (Senior debt), mezzanine financing (unsecured) would be necessary. Mezzanine lenders charge a higher interest rate and usually require warrants for up to 10% of the company’s ownership. This, of course, will dilute the ownership positions of the other owners.

In chart form, the source of funds for the acquisition example we have been discussing could look like this:

Next month’s newsletter will address questions we’re often asked concerning Goodwill.