Acquisition Finance Sources: Equity and Seller Financing

By: Linda Curtis and Andrew Cheng, Gibson, Dunn & Crutcher LLP.

Equity

Equity financing for a business acquisition can take many forms and is highly dependent on the structure of the acquisition. For example, a public or private company may purchase all or a portion of the stock of another company by issuing its own stock to the seller(s). A merger, similarly, may be funded all or in part by equity issued by the purchaser. Even a corporate acquisition in the form of an asset sale may be consummated by providing the seller with all or part of the consideration in the form of equity securities.

The number and type of equity securities issued to the seller(s) depend both on the valuation of the acquired company and the value of the securities themselves. Because the value of a buyer’s stock may fluctuate, the purchase price becomes less certain than a pure cash or debt deal. Also, for acquisition deals including equity in the buyer as part of the consideration, shareholders of the acquired company will gain a stake in the buyer and become entitled to any participation or voting rights embedded in the shares received. This may impact the buyer’s capital structure and the entities controlling the buyer. On the flip side, equity financing encourages the selling shareholder to remain involved despite a change in ownership.

In private equity acquisitions, it is quite common for a portion of the financing to be provided in the form of an equity contribution from the applicable private equity fund(s). The lenders for the acquisition, in fact, may require that the private equity buyer provide at least a specified percentage of the total purchase price in the form of an equity contribution. This percentage will vary based upon the risk profile of the target company, but in recent transactions, ranges from 20% to 35% of total consideration. The lenders view the equity contribution as a cushion of value that reduces their risk of non-payment. Note that all other factors being equal, the larger the proportion of total financing for the acquisition that is provided by equity, the lower the fraudulent transfer risks relating to the acquisition. See Fraudulent Transfers and Related Doctrines.

Equity financing is also highly dependent upon the type of equity being issued as consideration for the acquisition. Public companies often use their publicly traded common stock as currency for making acquisitions. One advantage of using publicly traded common stock is the easily ascertainable market value of the stock. Private company securities may also be used. Limited liability companies or limited partnerships may use limited liability company or limited partnership equity interests as consideration for an acquisition. Whenever the buyer issues equity securities as part of the acquisition consideration, it should carefully consult counsel regarding issues relating to compliance with applicable federal and state securities laws—including registration of the securities to be issued, to the extent applicable, and securities disclosure issues. Both public and private companies may also consider using preferred stock or other preferred equity securities as acquisition consideration. Preferred stock by definition has a liquidation and/or dividend preference relative to common stock, and as such, may be more attractive consideration than common stock to a potential seller. Many private equity acquisitions are consummated with all or a portion of the private equity fund’s contribution being in the form of preferred stock. As with common equity, federal and state securities issues should be carefully considered in such an issuance.

Note that the senior secured lenders in an acquisition financing may view preferred equity similarly to mezzanine debt. At the margin, mezzanine debt and preferred equity have a very similar role in a company’s capital structure. Typically, subordinated loan capital is treated by senior secured acquisition lenders as similar to equity, as there is little or no anticipated return of capital to the subordinated lenders/equity holders until the senior secured acquisition facility is repaid. Accordingly, senior secured lenders may be reluctant to approve cash pay dividends on the preferred securities and/or any maturity date that occurs before the maturity of the acquisition debt. Lenders are always concerned when funds may be distributed to equity holders in preference to the prior payment of their debt. Even contingent put rights for the preferred (such as upon a change of control) may be of concern to senior lenders to the extent the preferred equity holders would have rights to payment in situations where the debt is not similarly accelerated.

Seller Financing

Seller financing allows the buyer to defer part of the purchase price for a pre-negotiated period of time. Often, seller financing will be combined with some other sort of consideration to bridge the gap in purchase price. By having sellers finance part of the purchase price, a buyer may gain confidence that seller shareholders believe the business can thrive without them. One way that a seller can help bridge the gap is by accepting notes from the buyer to be paid over a specified period of time at a pre-negotiated interest rate. These instruments are commonly referred to as seller notes. Payments on seller notes are often subordinate to the senior lender in an acquisition and may be suspended for a period of time if the acquired company’s cash flow falls below a pre-determined level. Buyers are therefore afforded extra protection against unexpected drops in a company’s performance. Typically, seller notes are unsecured debt instruments and carry a higher level of risk than any senior secured debt of the acquired company. Sellers may, however, ask for personal guarantees, stock pledges or specific collateral to support the seller notes, especially if they anticipate a particularly high risk of nonpayment. Any such credit enhancements for seller notes will need to be permitted under, and integrated with, any third-party acquisition debt financing.

As noted above, the issuance of public or private equity may be part of the consideration issued by the seller as part of an acquisition. This is a form of seller financing. Particularly if the recipients of the seller’s equity are members of the target’s management, seller equity financing may be referred to as rollover equity. The term rollover in rollover equity describes the concept that certain equity holders in the acquisition target are rolling over their prior equity into the equity of the buying entity (rather than having that prior equity cashed out as part of the acquisition). The issuance of seller equity, even more than seller debt, aligns the interests of buyer and seller as to the future financial performance of the acquiring entity.

A seller may also be willing to defer some part of the purchase price by agreeing to earn-outs to be paid by a buyer based on performance of the acquired company. Earn-outs are typically tied to some future measurement of the target’s financial performance (e.g., revenues, EBITDA, sales increases, etc.) and are an excellent way to bridge the gap in a negotiation of purchase price where buyer and seller have different perceived valuations of the target business based upon uncertainty in future financial results. Earn-outs are similar to seller equity in aligning incentives between buyer and seller but differ in that the seller’s future contingent compensation in an earn-out is usually based on the financial performance of the purchased business (rather than the acquirer as a whole).

One tricky practical point for an acquisition financing with an earn-out component is working through the treatment of the earn-out under the senior debt documents. The senior lender will not want the earn-out paid in the case of a default under the senior debt documents, while the seller receiving the earn-out will want to be paid regardless of whether there is a default. The seller will not want to assume any risk relating to the buyer’s financing terms. One way to resolve the issue is, effectively, to subordinate the earn-out payment to the payment of the senior debt. However, the extent and terms of the subordination may be an issue of detailed discussion. In addition, even outside of a default situation, the accounting for earn-outs under applicable accounting principles has evolved in recent years, and one point of dispute may be whether the expected value of the earn-out counts as debt for purposes of the financial and negative covenants in the senior financing.

In general, the better the performance of the acquired business, the more likely that the earn-out will need to be accrued as a balance sheet liability under applicable accounting principles. However, the negotiated definition of debt for purposes of the financial and negative covenants may not necessarily track the accounting treatment. The treatment of earn-outs for this purpose is usually specifically negotiated. In any event, the buyer may be called upon to help resolve the issues that may arise between the senior lender and the seller as to priority and other treatment of the earn-out. For further information regarding earn-out arrangements, see Understanding, Negotiating, and Drafting Purchase Price Provisions — Earn-Outs

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