Understanding the Capital Stack in an M&A Transaction

From: Crain’s Cleveland Business

By: Mike Makofsky and Josh Berggrun

In any M&A deal, it is imperative that both sellers and buyers understand the different layers of financing, or capital stack, that can go into funding an acquisition.

There are a number of ways to structure a deal, whether through equity financing, debt financing, cash or a combination of financing vehicles.
One strategy to consider is equity financing, which involves investors contributing cash to the buyer’s capital in exchange for percentage ownership of the target business. Although equity financing carries an expectation of higher rates of return, it provides flexibility that is not available with debt financing, such as no mandatory interest and principal repayments.

Rollover equity is a method of seller financing, in which a seller contributes, or rolls over, equity from the divested entity into the acquirer. This reduces the buyer’s up-front capital investment and results in certain post-transaction ownership by the seller. This strategy can be particularly attractive to buyers eager to retain a seller’s key management employees after the acquisition.

An alternative or supplement strategy to equity financing is debt financing, in which the buyer obtains a loan to fund an acquisition. Lenders often require a buyer to contribute a significant amount of its own capital before making any loan. However, buyers and target businesses that convey financial strength and sufficient collateralization could be in a position to take advantage of debt financing. This strategy involves a senior lender making certain secured loans to the buyer in the form of term loans or revolving lines of credit. There may also be mezzanine capital to bridge any shortfall in the capital stack. Buyers realize major benefits from debt financing, such as ownership retention and tax advantages from writing off interest payments.

As sellers and buyers evaluate potential deals, they must be mindful of the available financing strategies and the implications on post-transaction ownership.