An important aspect of most business acquisitions is financing the new enterprise, including providing adequate money for both the purchase and working capital needed to make the new business succeed. The starting point for any useful analysis of how to finance a business, as well as a very good guide to what the business is really worth, is therefore a comprehensive business plan and projection for the proposed business.
If the business plan and projections are consistent with the objectives of the buyer and seller, and if they justify a price that is acceptable to both the buyer and the seller, then the structure of a deal and a basis for negotiation of financing become feasible. The buyer can think of the financing as being an inverted pyramid:
- At the bottom, sometimes the smallest portion of the total financing, there is equity, usually provided by the buyer or a group of investors working with the buyer.
- Above that base, there is frequently (although not always) a layer of intermediate subordinated debt, which may have some equity-type features.
- Finally, the bulk of the financing for many acquisitions, particularly working capital for future operations, may be in the form of conventional debt from a bank or other institutional lender.
Through this post, we discuss the principal characteristics of these three layers of financing. Read On…
Allocation of Risk
The equity represents ownership of the entire enterprise and is totally at risk if the enterprise fails. The equity holders typically receive no return until all of the debt has either been repaid or so fully secured that the lenders are willing to permit distributions to the equity holders. The subordinated debt represents debt that is to be repaid prior to any distributions to the equity holders, but it is junior to the rights of the senior lenders, including being secured by liens on assets that are junior to the security rights of senior debt. Because the subordinated debt is less secure than senior debt, it typically receives a higher-interest return and often has quasi-equity features, such as warrants or a right to convert into equity at some point in the future. Finally, the senior debt is conventional debt of the type any operating business might have. It is secured by a first lien on tangible assets or current assets, such as accounts receivable and inventory, and bears a market rate of interest [perhaps a point or two over prime, depending on the degree of risk the lender incurs].
The distinctions among the various types of financing are not as clear as the lines on the pyramid might suggest.
There may be several categories of financing within each of the three principal types, and the most senior portions of one layer may overlap with the most junior portions of the next layer up. For example: some equity owners may hold preferred stock or other rights to preferential distributions and preferential rights upon liquidation, giving them seniority over more junior equity holders. In contrast, some of the subordinated debt holders may be subordinated to all of the debt above them (including other classes of subordinated debt), and may have rights very much like those of equity holders to participate in the future profits of the business or to convert their debt into a conventional form of equity. Even the most senior debt for a new business may have some mezzanine or quasi-equity features, such as the right to bonus interest payable out of future profits or increases in the fair market value of the enterprise.
However, despite some blurring of the lines, the categories are of considerable conceptual value and are often important for tax and other legal purposes. For example, if debt is true debt, the interest is probably deductible for tax purposes, whereas dividends or other profit distributions on equity are not deductible. If a particular right is truly equity, it is almost certainly junior to the rights of any unsecured general creditor in the event of bankruptcy or other insolvency of the enterprise.
Importance of Equity
Obviously, the willingness of lenders to provide financing to the buyer is almost always contingent on the buyer proving that there is a satisfactory commitment of equity available. Thus, in practice, a buyer who is shopping for loan financing must be prepared to demonstrate that it already has or can readily obtain commitments for equity investments. In reality, however, what the investors can reasonably expect to receive from the business depends on what first must be given to the lenders to satisfy their needs. Thus, any analysis of the relative rights and benefits available in any particular transaction will probably start with an analysis of what collateral, interest, and other characteristics will attach to the debt. Thus, the most useful way to analyze the total structure and effect of the three-tiered financial structure is probably to start with the rights of the senior debt.
Incidentally, although there often are multiple layers of financing, it is also possible for an acquisition to be accomplished with only one or two layers.
A buyer can make the entire purchase with its existing funds or by issuing stock, thus making it a 100% equity deal. More likely, if the purchaser is reasonably well financed, it will provide all the equity necessary for the transaction and will obtain operating capital with a conventional secured loan, thus resulting in a combination of equity and senior debt but with no intermediate subordinated debt in the transaction. However, for purposes of this discussion, we will continue to assume the use of at least three levels of financing, with the likelihood that there will be some subcategories within each of the three major components.
Shopping for Debt
For most senior debt, financing will be competitive and fairly generic. A buyer may wish to shop two or three banks or other institutional lenders but is likely to find that each of them will make substantially similar offers, although relatively minor differences between two loan proposals are usually worth looking for. If a lender is interested in providing the financing, it will usually provide a commitment letter outlining the interest rate, total facility availability, required collateral, and other principal terms and conditions. A commitment letter is by no means a real “commitment”. It is a letter of intent indicating the interest of the lender in making the deal on the terms specified; it can almost always be withdrawn or modified without penalty to the lender.
In practice, however, most lenders will not issue a commitment letter unless they are confident they can proceed on the terms proposed.
If the buyer accepts the commitment letter, it is usually required to pay a fee to the lender at that point to cover the lender’s time and expense in proceeding with due diligence and formal documentation of the loan. There may be an additional fee in the form of interest points on the total amount of the facility at the time the formal loan documents are executed.
Typical terms of a bank loan agreement are complex, onerous, and to a very large extent nonnegotiable. The buyer will be required to make numerous representations and warranties about both itself and the target business. The original advance of loaned funds, and any subsequent advances, will be tied to the satisfaction of various continuing conditions, and the loan agreement will contain detailed provisions about collateral and other security rights, probably including personal guarantees by the buyer’s principals for smaller transactions.
Of particular interest to any accountant working on a loan transaction will be a series of negative and affirmative covenants in the loan document. These covenants will cover a variety of topics, but the most important ones address financial issues. A negative covenant might, for example, be the absence of any litigation or other contingency in excess of a specified dollar amount. An affirmative covenant might be a requirement to maintain a certain level of net book value in the acquired business or a specified level of cash flow sufficient to service the debt and provide for other necessary items, such as projected capital expenditures. Minimum net earnings and net book value affirmative covenants are likely to be set forth either by month or by quarter, perhaps taking into account seasonality and other variations, but generally requiring a steady improvement in the financial condition of the borrower.
The unwary buyer may well be trapped here by its own business plan projections. If the lender approves the loan, the approval is probably based on acceptance of the projections that the buyer previously provided to the lender, and the lender’s covenants are likely to be based on these book value, earnings, and cash flow projections. Although a lender will typically allow some deviations from projected numbers, a material failure to meet goals may trigger a default, with a right on the part of the lender to call the loan. Thus, the buyer’s confidence in the business plan on which it has based the request for financing will be tested. Many business plans include several different projections, typically an expected case, a downside case, and an optimistic case. Usually the borrower will want to make sure that the financial covenants in the loan documents relate to the lowest case, not one of the higher ones.
Another area of concern for the buyer’s accounting personnel is bank loan requirements for periodic reports to the lender. These may simply ask for annual audited and monthly internal financial statements, but they also often require more difficult and frequent reports, such as weekly or even daily accounts receivable reports. The accountant often must certify the accuracy of this information, and an error may expose the certifying officer to personal liability.
Another area of individual concern in smaller transactions is that a senior secured lender may require personal guarantees from the buyer’s principals. These are frequently joint and several guarantees of the entire principal amount of the debt, although many lenders are willing to accept limited guarantees subject to a cap for each of the individual guarantors. The lender’s theory in this regard is that none of the guarantors has sufficient net worth to pay the entire amount of the debt, but each of them should have a guarantee exposure large enough to severely threaten their personal net worth as a means of keeping them focused and devoted to the success of the new business.
Subordinated debt is available from a variety of sources. Many banks and other conventional lenders have a division or an affiliate that specializes in mezzanine financing. Another common source of subordinated debt is the parties themselves. Some of the investors may feel that at least some of their investment ought to be secured (even if junior to the bank conventional financing) to give them an advantage over other investors and over general unsecured creditors in the event of insolvency. The senior lender may—although it will not necessarily—be relatively indifferent to the company’s mix of equity and subordinated debt. From a senior lender’s point of view, all other financing is subordinate to the senior lender, and therefore, in theory at least, equity and subordinated debt are equal.
In practice, most banks and other senior lenders have a strong preference for a balance sheet that reflects equity rather than subordinated debt, and therefore this distinction may be more important to lenders than it seems it should be.
Another source of subordinated debt is the seller. Particularly if the seller is receiving a premium price or a price that is to some degree a contingent or earnout amount, it would be normal for the seller to take some of the consideration in the form of a long-term note. The senior lender will almost certainly require that any indebtedness to the seller be subordinate to the rights of the senior lender; therefore, if the seller wants to see the deal completed, it will probably have to agree that its debt will be subordinated.
The concept of subordination runs through any discussion on financing. Some subordination rights exist as a matter of law. Equity is almost always subordinate to debt; unsecured debt is subordinate to secured debt. There are, however, exceptions to these general rules. For example, in a bankruptcy proceeding, recent collateral rights granted to owners or other insiders are likely to be classified as preferences that may be set aside and disregarded by the bankruptcy court. Subject to these qualifications, the general proposition is that the law and the recorded security rights of the parties determine subordination to a substantial degree.
Aside from the question of priorities that exist by law, parties can enter into contractual subordination agreements. Most lending banks have a standard subordination agreement that they will try to require the borrower and all of the borrower’s other lenders to sign. The basic concept of subordination certainly implies that the subordinated lender can be paid, in the event of liquidation, only if and to the extent that there is anything left after payment of the senior creditor. However, a bank subordination agreement is likely to go much further than this.
It typically requires that no payments be made to any subordinated lender so long as any amount is still due to the senior lender. It may also contain other restrictions, such as a waiver by the subordinated lender of any rights it might otherwise have as a matter of law to foreclose on assets, commence legal proceedings to enforce its rights, and so on. These types of subordination agreement provisions are generally subject to modification through negotiations. A reasonable accommodation on priority of payments, for example, is an agreement by the senior lender that junior lenders may be paid periodic installments of interest as long as all payments are current to the senior lender and there are no defaults under the senior loan agreement. Arrangements permitting repayment of the principal amount of any subordinated debt are likely to require greater concessions to the senior lender. For example, a significant increase in the book value of the borrower might be a condition to repay any principal due on subordinated debt. The issues surrounding subordination agreements are often a principal subject of negotiation in the course of the financing.
Forms and Types of Equity
Like debt, equity comes in many forms and types. The first equity in most deals comes from the buyer, which we tend to refer to as a single individual, but which is likely to be a company or group of individuals. These are the people whose money is at highest risk. They may in turn obtain additional equity subscriptions from friends and colleagues or from professional venture capital sources.
Although venture capitalists can usually take care of themselves, a buyer who is in the business of raising money should emphatically be aware of the severe limitations placed on money raising by federal and state securities laws. Violations of these laws can be a criminal offense and, at a minimum, are likely to provide the investors with a civil right of rescission, meaning that if they become dissatisfied with the transaction they can, for an extended period after they make their initial investment, demand that the promoter of the deal rescind the transaction and personally refund to them the full amount of their investment. Thus, compliance with all applicable securities laws, although time-consuming and burdensome, is absolutely necessary for a buyer who is going outside its own resources to find risk capital support.
The ultimate source of equity financing is the general public. Financing through a public stock offering, often referred to as an initial public offering (IPO), is not usually used for funding an initial purchase price. It is, however, a way of raising additional operating capital as well as providing an exit strategy for the initial investors in the project (i.e., a means for them to liquidate their investment after the new company has become successful). Public stock offerings are a complex topic, and only a few issues need to be mentioned here. If a public offering is intended at some point in the foreseeable future, strict compliance with applicable legal and accounting standards is essential.
When the company goes public, it must file a registration statement including historical audited financial statements and full disclosure of any significant legal issues. A clean accounting and legal history is therefore very important.
Another issue to understand when using a public offering as an exit strategy is that registration of stock does not usually provide immediate liquidity to the existing investors. Registrations apply to stock, not to companies. The stock that is likely to be registered in an IPO is previously unissued stock belonging to the corporation.
Most underwriters are reluctant to allow existing investors to register any of their stock as part of the IPO, because this has the appearance of a bailout by the owners, which is detrimental to the perception of the company in the public market. Therefore, the stock owned by the existing investors is usually not registered; in any event, it is probably what is considered to be affiliate stock under the securities laws. Both because it is unregistered and because it is owned by affiliates, the insiders’ stock can be sold only in accordance with Rule 144, which requires an extended holding period and limits the volume of shares that can be sold in any particular period.
In addition, the underwriters will probably not only forbid the registration of existing outstanding stock but will also require that such stock be held in escrow or otherwise be made subject to restrictions on transfer so that it cannot be sold for a period of a year or two after the public offering. Therefore, although a public registration offers the potential for long-term liquidity, it does not usually provide an immediate exit event to the original investors.