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M&A deals: how to bridge the funding gap

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Conditionality: This is without doubt the least popular method of addressing the problem. Sellers will now routinely request evidence of how any purchase will be funded at an early stage in negotiations. Asking for the heads of terms to include a condition that the deal is subject to the buyer getting funding on terms acceptable to it does not go down well with sellers. However, if the buyer is in a strong negotiating position, it may be able to get a seller to agree this if the buyer agrees to use reasonable endeavours to obtain funding and not decline any funding offered if it is on reasonable commercial terms.

Another way to deal with this issue is to make the deal conditional on the business meeting certain financial criteria such as minimum EBITDA (earnings before interest, taxes, depreciation and amortization), cash levels or borrowing restrictions at a fixed date. The rationale for this type of condition is that the buyer should be in a position to establish relatively quickly what criteria funders require to be satisfied before they will fund a deal on reasonable terms.

Rollover: Very frequently the only way to get a deal done is to have the seller rollover some of his shares in the target for shares in the acquiring company or its ultimate parent, thus reducing the cash sum payable on day one. Clearly the seller having a continuing interest raises a number of issues: how and when the seller will achieve an exit; what rights the seller will have to exercise control over the company (positive and negative covenants, a seat on the board, veto over certain issues, for example); and the seller’s obligations to the business (such as ongoing funding, restrictive covenants and so on).

The agreement reached on these issues will depend, to a great extent, on the percentage of the buyer owned by the seller post deal and on how long it is intended that stake should continue to be held.

There is no “standard” deal here. Every situation is different. For example, sometimes there is an agreed price and timescale for the seller’s exit. On other occasions the seller may remain a long-term investor in the buyer.

Obtaining the correct tax treatment for any rollover will be crucial for the seller. The sale and purchase agreement must be properly drafted to ensure no CGT is payable in relation to the rolled over portion of the consideration.

Earn-outs: Earn-outs allow sellers and buyers to close the gap between what they each believe to be the true value of the business. If the business performs as well as the seller predicts, the buyer pays more. If not, then no additional payments will be made. In effect, they allow a buyer to defer some of the purchase price until the business has generated sufficient cash to fund it.

While the concept of an earn-out is simple, the devil is always in the detail. It is difficult to cover every eventuality in the drafting of the earn-out provisions and it is vital that the seller understands that cash payable under the earn-out may never be paid, either due to underperformance of the business or because the buyer attempts to rely on a loophole in the contract that delays or reduces payments.

In a situation where the buyer’s plan is to integrate the purchased business with its own or to make significant changes to the business post completion, it can be very difficult to agree earn-out terms. The seller will want the price to be based on the terms of the business he is selling, not on a different entity over which he has no control. It is this “grey area” over control of the business on an ongoing basis that causes most difficulty and results in most disputes. 

Although earn-outs are difficult, they can provide a useful solution that allows a deal to go ahead – so long as both parties take a practical approach.

Seller finance: A common solution to the lack of available debt finance is now for the seller immediately to loan back some of the consideration it receives on specified terms. While agreeing terms between the seller and buyer can be done relatively easily, integrating the seller finance into the overall financing package is considerably more difficult. The banks will not want the seller’s debt repaid prior to bank debt, and will not want the seller to have security or any rights that allow him to call up his debt save in very specific circumstances.

 

A consequence of the lack of debt finance has been more innovative and flexible deal structures and greater co-operation between buyers and sellers. The current economic situation has not only changed the political landscape, but also how we do business – co-operation is now the name of the game!

Catherine Feechan is a partner in the corporate department of Brodies LLP.

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