At the outset of most transactions, all parties involved are invariably optimistic that the structure to the deal, the financing behind it and the documentation can be kept simple.
Unfortunately the real world tends to kick in and the level of complexity increases as the transaction progresses, more parties become involved and issues need to be catered for in the transaction. These often require more creative and complicated solutions.
Complications in a deal’s financing structure generally emerge as the result of meeting price expectations, business specific problems or uncertainties which arise, financing issues or other shareholder concerns.
In any advisor’s kit-bag are a range of tools that can be adapted to overcome price gaps and transaction issues.
In the majority of cases one would hope not to have to employ too many tools as it complicates the transaction process, the documentation and may have unforeseen consequences after the transaction.
Structuring the deal
In some situations, where a purchaser and/or a financier is unwilling to meet or unable to afford a price level, it may be necessary to provide structuring options to reach an agreement on a deal and bridge a gap in price expectations. Examples include:
- realisation of surplus assets or sale of non-core entities;
- property removal by the vendor and leaseback to the business;
- deferred consolidation such as loan notes or consultancy agreements;
- contingent consideration – i.e. additional payments dependent upon future events (such as contract renewals) or financial performance;
- working capital adjustments – realising excess assets.
There are other structuring options available – such as residual equity interest for a vendor and future surplus asset realisations – but they are normally a sign that the deal is being pushed to the limit. Such options should act as a fallback only, so keeping the deal simple works best.
For both the seller and the buyer, there can be advantages in considering different financing options. The best approach is to use the cheapest source of funds first and then create a pyramid of more expensive borrowing.
External equity investment should be seen as a last element, but in between are a number of options available such as mezzanine debt and vendor finance.
In the majority of deals it is rare, unless the business is asset rich or has significant unused borrowing potential, that cash flow lending and asset lending will be sufficient to self fund the transaction. Banks and finance houses will only provide facilities up to their normal lending multiples and will rarely wish to “overlend”.
Assuming the business is of sufficient size and profitability, the next option is mezzanine funding. Mezzanine funding is usually provided by specialist financial institutions and is neither pure equity nor pure debt.
It can take many different forms and be secured or unsecured, usually earning a higher rate of return than pure debt. Conversely, it carries a higher risk than pure debt, although less risk than equity.
This type of funding has a significant premium cost of higher interest charges and occasionally equity participation, but is cheaper than raising external equity investment.
It’s now common in deals to see vendors accept some form of deferred consideration, perhaps in the form of loan notes that can be settled over a period of, say, two to three years. These may be unsecured, insured or occasionally have some asset security for the vendor to feel that he is not overly exposed to the actions of the purchaser.
Vendor finance can often meet the requirements of both the seller and the buyer. For the seller it enables the purchaser to meet the price expectations and payment timescales, whilst it is cheaper and more flexible for the buyer than introducing stretched debt or external equity. It also means that an additional party is not added to the negotiations.
In any deal structure there is usually an optimum that generates the maximum amount of sensible fundraising from appropriate sources without pushing the seller or purchaser to the limit.
Ideally, keep each financier just inside their comfort zone. Balance is key – if one or more elements have gone too far it makes it harder to restructure the deal and allow room for change as the transaction process unfolds pre-deal or afterwards if circumstances change or unexpected problems arise.