Financing Your Business Purchase
In the world of private M&A, financing the deal can come in three predominant forms: (a) Institutional funding from a financial institution (b) capital contributions or (c) vendor financing.
Institutional Funding
Institutional financing is the most common forms of funding a business acquisition. The terms of the loan, such as the repayment schedule and collateral requirements are negotiated between the purchaser and the bank as part of the acquisition process; and transaction remains conditional upon the bank’s commitment letter to fund the deal. The loans will always be secured against the assets of the target business in the form of a first-ranking secured registration or lien under the Personal Property and Security Act (PPSA) and will most often take priority ahead of any vendor take back financing the purchaser may seek with the vendor.
Collateral can include both tangible assets (ex inventory, equipment, real estate, securities) and intangible assets (ex intellectual property, accounts receivable, contractual rights). The specific assets used as collateral depend on the nature of the borrower’s assets and the terms negotiated between the lender and borrower.
Secured loans typically have favorable terms for borrowers as compared with unsecured loans, including lower interest rates, longer repayment periods, and higher loan amounts. These favorable terms are a result of the reduced risk to lenders due to the presence of collateral. In the event of default, the lender has the right to seize and sell the collateral to recover the outstanding balance of the loan. This provides lenders with a level of protection against losses and reduces the risk of non-payment.
Secured lending transactions require legal documentation, including loan agreements, security agreements, promissory notes, and PPSA registrations in Canada (or UCC filings in the United States). These documents outline the terms and conditions of the loan, the rights and obligations of the parties involved, and the details of the collateral securing the loan.
As part of the funding process, the bank will often want to review key agreements and ancillary documents relating to the purchase such as the underlying purchase agreement, as well as the lease agreement, non-competition covenant or transition services agreement. The target company’s leasehold improvements to its premises, and the very location of that premises due to its notoriety within the public, are critical items of value to the lender for which the lender will require a firm lease with a significant term and right of renewal. There are a host of other funding conditions that the lender will require to be completed or provided in order to release funds, ranging from adequate identification to insurance requirements (both commercial liability and key person) and other legal documents.
Capital Contribution/Private Equity Raise
In this form of funding, the group of purchasers or acquirers inject capital into the purchase vehicle in exchange for ownership equity. Equity can be raised from the founders or shareholders themselves in an initial capital contribution. This is most common for a small company that is looking to bootstrap a business without capital from third parties.
Private equity firms often invest in privately held companies by purchasing ownership stakes in exchange for capital infusion. Private equity firms provide not only capital but also strategic guidance and operational expertise to enhance the value of their investments.
Private placements involve offering shares or ownership interests in the company to a select group of accredited investors. These offerings are typically exempt from public registration requirements and can be an efficient way to raise capital from private investors. Private placements can be used to finance acquisitions or provide capital for expansion.
Vendor Financing
With vendor financing, the seller of the business extends credit to the purchaser to facilitate the sale. The purchaser makes payments to the seller over a specified period, often with interest. This approach can be particularly beneficial when traditional financing sources are limited, and it can provide an opportunity for a smooth transition of ownership. Seller financing is common in small business acquisitions and is typically secured by a second-ranking security registration behind the primary lender, which is often the bank. Vendor financing also provides for an additional opportunity to share in the risk of the acquisition post closing. To the extent a post-closing purchase price adjustment is baked into the purchase agreement with a right of set off, the vendor may share in the risk of the business’s failure to reach certain revenue metrics or targets post closing.
An earn-out agreement is a type of vendor financing arrangement where a portion of the purchase price is contingent on the future performance of the business. The buyer pays an initial amount at closing and agrees to make additional payments based on predefined performance milestones or financial targets. This allows the buyer to mitigate risk while aligning the seller’s interests with the business’s future success.
In some cases, the buyer negotiates with the seller to defer a portion of the purchase price to a later date. This can be structured as a balloon payment or as a series of installment payments over time. Deferred payments provide flexibility to the buyer in managing cash flow after the acquisition.
How to Choose
The choice of financing a private M&A transaction method depends on factors such as the business’s financial situation, the transaction’s size, the buyer’s and seller’s preferences, and the specific goals of the acquisition. Each method has its advantages and considerations, and a well-thought-out financing strategy is essential for a successful business deal. At Kalfa Law Firm, we are here to walk you through these various options and assist with the legal components of securing financing to close the deal.
