In any M&A transaction, your goal as the seller is to maximize cash proceeds and minimize risk. One consideration that you should pay close attention to when evaluating acquisition offers is how a prospective buyer plans to finance the transaction. There are many options, and they all have their pros and cons. The financing structure of a transaction impacts the certainty of closing, upfront cash received, and risk associated with potential future cash proceeds.
Here are some common methods of financing an M&A transaction and issues to consider for each one.
Upfront Cash
If you are selling 100% of your company in an all-cash deal, you obviously will receive all the cash at closing. However, even in a deal where you are selling less than 100%, you still want to maximize the upfront cash you’ll receive at closing. Ideally, this cash consideration is coming directly from the buyer’s balance sheet or a committed pool of capital and is not contingent on the buyer securing debt or equity financing. From your perspective, receiving as much non-contingent cash as possible upon closing reduces risk, and provides value certainty.
Contingent Cash
Contingent cash consideration typically takes the form of an “earn-out,” meaning that payments to you after the sale will be based on specific performance metrics. There are many ways to structure earn-outs. Examples include payments made upon the business achieving certain revenue or EBITDA targets over specified timeframes post-close. When evaluating contingent cash as part of an offer, you need to be comfortable that the performance metrics are attainable and within your control to achieve. To that end, any earn-out timeframe should match the amount of time you plan on staying with the business post-close. Ultimately, you should consider contingent consideration as an “upside” in the overall offer, i.e., you should be satisfied with the amount of upfront cash received and view any earn-out as an additional source of value that may not be realized.
Seller Financing
If you’re providing seller financing for a buyer, you’re essentially taking on the role of a lender and providing some portion of debt financing for the transaction. You’ll receive a note for a fixed amount that entitles you to interest and principal payments paid periodically over a defined term. Some important considerations in evaluating seller financing include the interest rate associated with the note, the term of the note (how long before you receive your principal in full), what rights you have as a lender, and how much additional debt the buyer is taking on that is senior to your note. This last point is critical, as it directly impacts the likelihood of payback in scenarios where the post-acquisition company is underperforming and ends up restructuring its balance sheet.
Rollover Equity
In certain scenarios, a buyer will ask that you “roll” a portion of your equity into the post-acquisition company. An example would be a buyer purchasing 80% of the stock of the company and asking you to roll over the remaining 20%, i.e., you become a 20% minority owner. If equity is being rolled into the transaction, you -need to confirm through due diligence that the buyer has solid experience acquiring and operating businesses, and sound strategic and operational plans for the company post-close. Even if you plan on staying with the company in an operational role, the new buyer will ultimately be in control of the business. Alignment on the go-forward plan is critical to feeling confident that any rolled equity will be worth something in the future. While rolled equity could ultimately be worthless, there is also the potential for it to become extremely valuable if the post-acquisition company significantly grows revenue and EBITDA.
Debt Financing
Debt financing is a common source of funds for many M&A transactions and can take on multiple forms. At a high level, a debt financing package for a middle-market transaction will include senior-secured debt, which is typically a loan provided by a bank or a private, non-bank lender, and mezzanine debt, which is higher-cost debt more likely to be provided by a non-bank lender.
Senior debt is secured by the assets of the company and has a priority claim on the cash flows it generates, which results in it being the lowest-cost debt available. Mezzanine debt can enable borrowings of additional capital beyond the senior-secured debt and can be unsecured (meaning it has no claims on the assets of the company) or subordinate (meaning it has a second priority claim on the assets of the company, behind the senior-secured debt). This results in it being more expensive than senior-secured debt.
There are several important considerations when evaluating the debt financing portion of a potential buyer’s offer. Debt financing can typically be 50-80% of the source of proceeds for a transaction. In scenarios where the closing of a transaction is contingent on securing debt financing, the more debt a buyer plans on utilizing, the more risk there is to close a transaction. It’s critical that you understand the current state of the financing market, the buyer’s process for securing debt financing, and whether any of the proposed financing is committed, i.e., a lender has already committed to providing the financing prior to your executing a Letter-of-Intent to sell the company.
Additionally, if you have any rollover equity or seller financing in place at the close, increased debt and interest expense incurred by the buyer can jeopardize the future value of these forms of consideration, especially if the business doesn’t perform well post-close.
It’s crucial that you understand the different methods for financing an M&A transaction when evaluating offers for your business. Hiring the right advisor to help you make the best decisions will maximize your upfront and overall cash proceeds if you decide to sell.
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