Corporate transactions categorized as Mergers & Acquisitions (“M&A”) generally include asset purchase agreements, mergers, reverse mergers, stock purchase agreements, share exchange agreements, consolidations, tender offers, and other transactions involving the combination of two or more companies. A transaction can fail to meet expectations when too much time is spent determining how much to pay for an acquisition and not enough thought given to how the deal will be financed. In this section, we’ll review various ways capital can be used to fund an acquisition and some of the most common business ownership structures.
Ownership Structures
The structure and formation of either company involved in a transaction is important as it has key implications in the company’s and its owners’ liability, tax treatment, management style, ability to raise or borrow money and governance issues. Working together with an attorney at formation to strategize your needs, anticipated capitalization and fundraising needs, and ultimate exit strategy will save significant struggles later.
Here are some of the most common ownership structures for non-professional entities:
- Sole Proprietorship – This is the easiest to form, as it does not require any filings with the state and is often the first choice for some as it provides complete control of your business. You don’t have any partners to negotiate with, you keep all the profits and have the ultimate say in the business decisions. However, the biggest disadvantage is unlimited personal liability-meaning your personal assets and liabilities are not separate from your business assets and liabilities. You can be held personally liable for the debts and obligations of your business.
- Limited Partnership – In a Limited Partnership, there are two types of partners; 1) the General Partner and 2) the Limited Partner. The General Partner manages the day-to-day aspects of the business and makes the decisions on behalf of the business. As such, the General Partner has unlimited personal liability for the debts, liabilities and obligations of the entity itself (similar to a sole proprietorship above). Limited Partners do not and cannot make management decisions for the partnership and as such, have limited liability- meaning a Limited Partner is not liable for the debts and liabilities of the partnership itself; their personal assets are protected. Generally, a Limited Partnership enjoys pass-through taxation.
- Limited liability company (LLC) – An LLC is arguably the most popular choice because all the owners (known as members) have limited liability and are protected from the company’s debts and liabilities. LLC can be managed either by the members themselves, where they all have a say in the decision making; or the members can appoint either one of the members or a third party to act as the Manager. In a Manager-managed LLC, the day-to-day operations and decision-making is delegated to this one person or entity. The Manager can also be a group of people much like a Board of Directors for a corporation. The only obligation is that the management style be adequately outlined in the Operating Agreement; the members have the freedom to agree to what they want. One of the many advantages of an LLC is pass-through taxation, however it enjoys the flexibility to elect to be taxed as a corporation. In sum, LLCs are popular as they provide limited liability for its members, like a corporation, but are much more flexible in their management.
- Corporation – The main advantage in forming a corporation is that it’s considered a legal business entity separate from its owners, officers or directors. While you may think of a large business as soon as you think of a corporation, the truth is that many small businesses are formed as a corporation due to the law being well-litigated and decided. It also allows for a more formal method of management through the use of a Board of Directors and executive officers (CEO, President, etc.). The owners, the shareholders, can take a much more passive role. Often times it is easier for a corporation to raise money through the sale of shares, and only a corporation can be publicly traded.
Transaction Financing
When it comes to funding an acquisition (despite the entity type), buyers must consider options that offer the best future operating cash flow for the company. Financing structures differ widely by pricing, term, and risk tolerance.
A best practice in choosing the right structure for your specific needs is to create financial projections over multi-year periods. Jacko Law Group, PC, specializes in assisting individuals and companies in the preparation of 3, 5, and 7-year plans, their projected financial statements, capitalization tables, and related needs.
Here are a few of the many financing options for M&A acquisitions:
- Cash on hand – It’s possible to pay 100% cash with no outside capital, depending on the amount of cash available. Opting for some form of hybrid financing that includes cash on hand may lower business risk by not having to utilize your company’s liquidity.
- Equity – Cash doesn’t have to be used. Some parties choose to use securities (shares of stock, membership interests, etc.) as part or all of the consideration for the purchase price. This works well when the target firm wants to maintain some control in the new firm or when cash is needed to fund operations.
- Institutional Financing – With interest rates still historically low, local or national banks can be a good choice, depending on your company’s annual cash flow, years of being in business and other requirements. Reviewing the business loan options at the bank you already have a relationship may be easiest, as you need to be able to establish a credit history and likelihood of repayment, but shopping around for the best interest rates is always smart.
- SBA loan – The Small Business Association (“SBA”) works with banks that will lend up to 90% of a transaction. One of the challenges with an SBA loan, however, is that it comes with mandatory personal guarantees in the event you default on the note.
- Third-party financing – Private equity firms often are interested in acquisitions if afforded the opportunity to participate in management decisions. This is a way to grow your industry network of influencers.
- Mezzanine financing – These are customized, long-term loans that allow an acquirer to defer the principal repayment of the loan until the cash flow of the business has materially increased.
Next Steps
Financing a business and choosing the best ownership structure are complicated decisions in the M&A process. And peace of mind can be more valuable than the cost of any acquisition. Schedule a consultation with Jacko Law Group today so we can help determine the best way forward for you and your business. Contact us today by calling (619) 298-2880 or visit us online at jackolg.com.