4 ways of custom financing an acquisition

Acquiring a business often requires multiple sources of financing. This can be a complex undertaking, especially in cases when more than $500,000 is needed. In most cases, there are four types of lenders and investors willing to finance an acquisition.

Lenders interested in fixed assetsAcquiring a business often involves the purchase of buildings or equipment. Your tax advisor might suggest you take out a separate bank loan for this part of the project, either from your bank or jointly with other financial institutions.

The Canada Small Business Financing Program makes it easier for small businesses to obtain financing from banks up to a maximum value of $500,000, of which $350,000 can be used to finance the purchase or improvement of equipment and the purchase of leasehold improvements.

Lenders interested in the whole package BDC often supports expansion projects with term financing. Unlike conventional bank loans, this formula allows flexible repayment terms. Another advantage is that a BDC loan will not be called without a valid reason.

Companies that have a competitive advantage in a fast-growing industry should consider subordinate financing. Under this formula, financial institutions lend higher amounts than they would under other circumstances and accept subordinate security in return. But such arrangements will always require a higher return for the lender, who may also ask for royalties on future sales or stock options.

Equity investorsDepending on your situation and the amount you need to raise, you can seek out venture capital from investment banks, institutional investors and mutual or labour-sponsored funds. Your new financier will become a major financial partner, taking an ownership stake in your company and the right to name some members of your board in exchange for a significant injection of capital. Industry Canada's web site has more information on this subject.

Venture capital firms invest across all sectors of the economy but target only businesses with excellent growth potential. Sometimes technology-oriented venture capital companies also consider outright acquisitions. For example, they will look favourably on buying a leading-edge business with products almost ready to put to market that would complement a more mature company's product line.

Strategic investors
These investors focus on certain types of businesses and are often faster than others to grasp developments within a particular industry. These are often groups of professionals from the same industry who keep close tabs on their market and are therefore quicker to recognize risks and opportunities. Major corporations also sometimes acquire equity in companies whose growth they believe it is in their interest to support. The goal can be to exploit a promising niche in their industry, for example, or to improve their firms' technological know-how. Regardless of the type of financing you have in mind, management consulting companies and accounting firms specializing in acquisitions can provide invaluable outside advice. Their contacts with investors and financial institutions often help them quickly identify people who are interested playing a role in an acquisition. Getting specialists involved at the outset also greatly simplifies tax reporting.

How to evaluate a proposed business acquisition

There's nothing simple about estimating the value of a business you want to acquire. Valuating a business is not a simple exercise, nor is it an exact science. It simply provides a theoretical value that will give you an idea of the fair price to pay for a business.
You mustn't rely only on the judgement of your accountant or of the seller. It is recommended that you have an expert, who specializes in business valuations, produce an independent report. While this is an unregulated field, the Canadian Institute of Chartered Business Valuators (CICBV) does provide guidelines and a code of ethics.

In general, you will rarely be able to compare your potential acquisition with a similar transaction. There is little information available on such transactions and they may not even apply to your specific conditions. Also, the terms may be too closely related to a particular sector to be useful.

3 degrees of assurance
According to the CICBV, there are three types of reports, they vary from the most general to the most detailed:

• Calculation report: provides an approximate valuation for initial planning
• Estimate report: ideal for preliminary negotiations, succession planning, and situations involving important issues that are subject to budgetary constraints
• Comprehensive report: appropriate in situations that involve high risks, important issues, or when there are legal proceedings
• To prepare their reports, evaluators look at the facts and financial data, formulate a conclusion, and the possible impacts on the estimated value. They will also add a disclaimer regarding the scope of the mandate, which varies with the quality of the report provided.

Work required
To produce a calculation report, the valuator reviews and analyzes the financial information and may meet with management.

The estimate report takes the same approach but is more exhaustive.

In the comprehensive report, the valuator provides an opinion. It is a more in depth analysis of the business and it reviews:

• Patents, bylaws, and shareholder agreements
• Business' economic situation and sector
• Market conditions and the competition
• Clientele and any contracts, backlog of orders
• Suppliers contracts and commitments
• Visit to the business
• Financial and forecast data
• Rationale for the choice of discount and capitalization rates using accepted financial models

Basic valuation principles

The first step in the process of establishing a price consists of determining the fair market value of the business. The three main valuation principles are:

• Value is dependent on expectations
• Value is dependent on future cash flows
• Value is dependent on tangible capital assets

Valuation methods and techniques
There are two basic ways of determining the value of a business:
 Asset-based

• Book value: company's net worth, which is equal to assets minus liabilities. What is shown in the financial statements
• Liquidation value: assumes that the business sells all its assets, pays off all its debts, including taxes, and distributes the surplus to its shareholders

Earnings and Cash flow

• Discounted cash flow: value is based on the future cash flows of a business
• Going concern value: assumes that the business will continue operating and compares the current cash flows with future inflows to make projections

Some of the most common techniques used to calculate a business value include:

Capitalization of typical net earnings
A value can be attributed to future earnings resulting from the acquisition. To obtain the going concern value, a capitalization multiple is applied to these earnings and non-operating assets are added.

Capitalization of typical cash flows
The same as above with the exception that cash flows, rather than earnings, are capitalized.

Discounting of expected future cash flows
Consists of determining the most likely future cash flows and discounting them at the valuation date.

Determination of adjusted net assets
Liabilities are subtracted from the determined fair-market value of the assets. It is used for businesses, such as those in the real estate sector, whose value is asset-related rather than operations-related

For more information, consult the Steps to Capital Growth guide included on Canada Business website.

Other rules
In some sectors of the service industry the value of a business is based on a multiple of revenues. For example, an insurance brokerage firm can be worth 1 to 1.5 times the commissions received over a period determined by negotiation.  In the final analysis, purchase conditions and the final price paid will be determined in your negotiations with the vendor