Debt vs Equity in Acquisition Financing: Striking the Perfect Balance

In life as in acquisition financing, balance is the gift that keeps on giving. Much as portfolio diversification is the only free lunch in stock investing, so too does the right mix of debt and equity bring risk diversification to your transaction. Too often buyers tilt their allocation to debt and leave too little equity in the acquisition financing equation.

Balancing Debt and Equity: Key Considerations for Structuring Acquisition Financing

This happens in bull markets when lenders relax credit standards and are eager to lend. The supply side driven availability of acquisition financing impinges on the theoretical underpinnings for equity leaving companies with too thin an equity layer and vulnerable to the risk of unexpected events. The decision of how much debt should be arrived at through asking a few fundamental questions when determining the right mix of debt and equity for your acquisition financing structure.

1. What is the inherent risk of acquisition – can the target be easily integrated in year 1 and will it add significant cash flow to the acquirer by the end of year 2. If the cash flow growth is not realized by year 2, the EBITDA required for loan repayment may not materialize over the life of the loan. If you deem the acquisition a risky one, you need more equity and less debt in your acquisition financing structure.
2. Is there a need for Growth Capital – will the acquisition create more need for investment and working capital. This may absorb more of the combined company’s cash flow, diverting cash available for principal repayment. If this is possible in your deal, you need less debt and more equity.
3. Do you have an acquisition track record – acquisitions are some of the most difficult growth projects for a company. They are subject to long and indeterminable lags and significant projection errors. When there is a big mistake, having too much debt in the structure puts the company at illiquidity risk.
4. How important is financial flexibility to your organic growth – too much debt in the mix can lead to never having enough cash on hand which limits your ability to spend when you need it the most. If having cash to invest opportunistically is important, you need more equity.