Mergers And Acquisitions Financing: External Vs. Internal Options - Proactive small-business owners implementing a mergers and acquisitions strategy to grow enterprise value need to consider all financing options to fund their aspirations. Depending on your industry, internal and external financing options can differ vastly, yet several key considerations are common to all.

External Vs. Internal Nuances 

External and internal financing are delineated in one crucial aspect: If you bring a third party into your ownership structure to complete any transaction, you are employing an external financing mechanism; when you are financing without a new partner with seller financing, bank financing, etc., you are internally financing the transaction. One important distinction is internal financing may entail including a third-party bank loan to complete the transaction; however, you are not relying on another entity or individual’s balance sheet to secure the financing.

Internal Financing Options

If you do not desire another equity partner to pursue your M&A goals, there are two commonly utilized internal financing options: seller financing and bank financing. Each type has its benefits and drawbacks.

Seller financing is similar to a contract for deed where the seller provides the financing, holds the note and can expedite time to close the sale of the business. Rates, terms and conditions of seller financing can vary greatly; ensure you are constructing a loan agreement commensurate with the market. Buyers and sellers oftentimes seek to avoid seller financing. For sellers, they retain the repayment risk and do not receive full liquidity at close. For buyers, seller financing is commonly structured over much shorter time horizons resulting in higher monthly payments that can cause cash flow stress on the firm.

The other option is to utilize a small-business loan, commonly structured as a conventional loan or Small Business Administration loan. Borrowers who qualify for conventional bank financing typically receive a less costly and much more time-efficient application process than borrowers who do not. In some cases, lenders seek additional assurance that their loan will be repaid and use an SBA loan structure. The SBA guarantees that a significant portion of the loan will be paid back to the lender in the event the borrower defaults.

Regardless of the internal financing option employed by a small-business owner, one factor is consistent: The ownership structure of their firm does not change in conjunction with receiving financing to acquire another firm.

External Financing Options

External financing entails adding a “capital partner” as an equity participant partner in your business. New partners can offer the benefit of expertise and guidance, but may seek control in your business that may be less desirable. External financing for small businesses is commonly obtained from three sources: venture capital, private equity or “angel” investors.

Newly formed small businesses may find it difficult to obtain VC or PE financing due to limited operating history and less attractive financials. As a result, angel investors may be the only external route. Angel investors are commonly individuals who have had a business relationship with the borrower or other personal relationship. Angel investor terms vary greatly depending on the relationship to the business owner and the size of the opportunity.

Venture capital firms manage a pool of privately held small businesses. VC firms are run by sophisticated investors who have experience in M&A and negotiating equity partnerships with small-business owners. VC investors can offer expertise, but will require differing levels of operational control over their investments.

Private equity firms commonly invest in businesses that are more established and may have already had a round or two of angel and/or VC funding. Similar to their VC peers, PE investors are extremely savvy investors — they will require equity participation and some control in your business.

Independence Vs. Guidance And Control

When considering which financing mechanism to utilize to grow your small business via mergers and acquisitions, there are several factors to consider. At the onset, small-business owners need to determine how important maintaining control is compared to receiving expertise. External and internal financing both come at a price, but always ensure your choice does not come at the price of losing too much control of the business you have built.

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