There are a number of different funding arrangements to suit any transaction.

Seller funding is an important element in many owner managed business sales. They are used to help to bridge a funding gap, typically with an MBO or MBI deal and to 'keep sellers honest' so that the business has to prove its future value.

Benefits of this structure for the buyer include that he will have a useful pool of retained consideration, into which he can dip if there is a warranty or indemnity claim, and that sellers assume a portion of the risk, which provides a greater level of confidence and assurance to banks, investors and acquirers in the transaction proposal.

In this article we look at the forms of seller funding that are used in transactions today and whether there is a downside for buyers. We also discuss the degree of risk to the seller in various types of funding.

By this we mean the risk inherent in that form of funding that the sellers will not be paid unless the company they have sold or the larger buyer group performs. The forms of funding and degree of risk to the sellers can be shown on a sliding scale as follows:

Looking at each of these in more detail:

Cash: Cash paid on completion is at no risk to the seller except where there is a subsequent warranty or indemnity claim to recovery. The Seller may be asked to agree to use the company’s own cash resources to help fund the cash on completion payment.

Loan Funding: A typical example of loan funding is a straight deferred consideration, payable as a fixed amount on a specified date or dates.  The extent of the seller’s risk will be affected by the security supporting the payment obligation. A bank guarantee can be cast iron (if properly worded) but requires the buyer to find the money to deposit with the guarantor bank, so is rare.

Insurance is now available to cover the insolvency of the buyer or default in payment. It is often prohibitively expensive to cover default, although a policy just covering insolvency can provide useful comfort and is more reasonably priced. Other security includes specific assets of the buyer or a charge over the shares in the company itself although this latter option is more like quasi equity. Priority of security with the buyer’s bank and other investors will often be an issue that needs careful consideration. Buyer directors’ guarantees may be an alternative.

Quasi-equity: This is an arrangement where the prospect of payment is dependent to some degree on the continuing success of the company.  Earn outs are an obvious example of quasi-equity funding. The seller agrees post-completion targets and a deferred consideration, maintaining a stake in the business in order to ensure those performance targets are reached to qualify for the earn-out. Less obvious examples are straight forward deferred payments where for instance there is a priority agreement that does not allow the buyer to make payment unless the bank is satisfied that there are sufficient profits. We look at earn outs further below.

Equity Funding: This is where the seller agrees to leave some of their stake in the company behind. Typically it takes the form of new shares in the buyer. A key issue will be whether a seller will reduce its stake but stay in for the next exit as a fully participating ordinary shareholder in the buyer (perhaps as part of an 'equity release') or whether the equity holding is to be purchased at a fixed or pre-determined price at a given time in the future. This can be as part of the rights attaching to the shares, such as redeemable preference shares, or an option arrangement with shareholders.

Seller support: Other forms of seller support can include leaving loans in the company, continuing to provide guarantees and sureties or reduced rate services under a post sale consultancy or employment arrangement.

Seller funding will normally involve a cost to the buyer whether in extra interest charges, reduced equity share or reduced gross margin but as is apparent from the above many forms of seller funding are self funding – they are only be payable out of profits if they are made.  

Forms of seller funding can be 'mixed and matched' and we are finding that to complete deals today, these mechanisms are often introduced to bridge the funding gap after bank credit committees have determined the extent of bank funding available. They are useful tools to keep deals alive where the parties are committed to the deal.

However, there can be potential downsides for buyers.  

As part of the package, a seller will often require some ongoing controls over the company that they have sold and/or the buyer company itself and may even require a continuing place on the board. During this period the opportunities to integrate or to invest or make changes may be restricted. 

In particular, during an earn-out period, the seller may require the company’s business to be maintained 'as is', whilst it is established whether the targets set for it are met. In addition, a key component of the earn-out is that it should be 'earned' by the seller or the management team. For buyers using it as an incentive, it is imperative that the upfront payment is not so large that the seller becomes indifferent to achievement of the target and that the target is a genuine and achievable measure of performance.

Buyers will want to ensure that, during the transition period, the key relationships and contracts are successfully transferred, so that the business continues to maintain its performance once the period has completed, and does not immediately drop off.

Corporate newsletter - Winter 2009