Finance
Consideration / Price
The method of financing the purchase may depend on tax, financial and other factors relevant to the particular buyer. It some instances, the buyer may have a choice as to funding. In these instances, taxation and other considerations may make one form of finance preferable or more cost-efficient than another.
A company may be purchased in cash. That cash may be raised under a facility that is secured over the company’s assets, provided that the financial assistance approval procedure can be implemented.
If bank financing is required, the buyer will not be able to commit to the transaction until it knows that it is in a position to obtain the financing. Most commonly with share purchase agreements, the obligation to purchase becomes binding only on completion, contemporaneous with the drawdown of funds.
The terms of the consideration may provide for a deferred payment or for a variation in the amount of consideration based on the level of profitability that occurs in a set period after completion. This may be appropriate where it is difficult to ascertain the value of the company at the outset. Earnouts are also often appropriate where the seller or other key persons remain involved in the business. They provide a mechanism for incentivising them to maximise company value.
Considerations in relation to Finance
A relevant consideration is how the buyer wishes to integrate the target company into its existing group structure after completion. It may break up the company by distributing its assets and winding it up. It may wish to incorporate the target company into its group in a particular manner consistent with its existing structure.
Some buyers may be in a position to finance the purchase by using their own cash reserves. This may be facilitated by the relatively low level of corporation tax and relatively high rate of tax on distributions and personal dividends in Ireland. However, the fact that it is possible to purchase in cash does not necessarily mean that it is the best use of the resource for that company.
The company may find that the use of debt to finance the acquisition is less costly than cash, even where it is available. Using cash may lead to missed opportunities to use the funds otherwise, including to deal with unexpected future circumstances. It may be more efficient to use debt in the context of the overall structure of the buyer or its group.
Bank Finance
The buyer may obtain bank finance in order to raise the consideration for the purchase. There may be a facility for the acquisition in conjunction with facilities to refinance the company’s existing debt.
If the target has existing facilities, they may fall due by their terms, because of the acquisition. It may be desirable in any event to refinance them post-completion from an optimum funding /capital structure perspective.
Both the bank and the buyer will usually need to be satisfied in relation to the capacity of the business of the target company and the buyer to generate sufficient cash to make the required repayments. The issue may be of particular importance in the context of a management buyout where the repayments may be based almost entirely on the capacity of the target company and (thereafter) the buyers to generate funds.
Integration into Group
Commonly, companies are acquired by means of the formation of a new company, which acquires the shares in the target company. Companies and tax laws facilitate the grant of security over the assets of the new subsidiary/target company to be charged by way of security for the borrowings of the holding company.
An inter-group guarantee may be given. This may be supported by a charge over the assets of the acquired company and those other group companies.
The existing borrowings of the target company may need to be refinanced. Generally, finance agreements require consent to a change of control so that all monies can be thereby demanded on a sale.
Commonly, the buyer’ lenders will wish to secure all the group borrowings over all of the new group assets, in any event.
Secondary Finance
Sometimes mezzanine finance may be available. It ranks behind the senior debt and ahead of ordinary creditors and equity holders. It carries a greater risk and requires a greater return. This may be by way of interest or options /warrants to take shares in the company at a favourable pre-determined rate. It may be offered by venture capitalist or other investors.
The company’s constitution may provide for formal loan capital and debentures. A debt security may be constituted by a loan note or instrument. It is a structured debt, which may have some of the characteristics of a share. It invariably has priority over the repayment of equity shareholders in relation to dividends and in a winding up.
It generally does not have any further level of participation beyond the payment of interest and the repayment of capital. In some cases, it may carry rights of conversion into equity.
Financial Assistance
The Companies Act prohibits a company from giving financial assistance in connection with the acquisition of its own shares. The classic acquisition procedure involves the target company granting security over its assets and a guarantee for the holding company debt which has acquired its shares. This would breach the prohibition unless the summary approval / whitewash procedure is available.
The summary approval / whitewash procedure may be available if the relevant conditions can be satisfied. A private company can usually give financial assistance for the purchase of its shares where and to the extent that directors can personally confirm that it does not affect the company’s solvency.
The finance must be approved by resolution of the shareholders, the directors must make certain declarations (on which they may be personally liable), and certain filings must be made. See generally the chapters on the prohibition and in the summary approval procedure.
Finance by Buyer’s Equity I
Sometimes the buyer may be in a position to fund the purchase of the target company by the issue of shares in itself. Alternatively, it may issue shares for cash to the sellers or others in order to finance the purchase. This will dilute the shareholding of the existing shareholders.
In some cases, some shares may be issued directly in the target company to the shareholders of the buyer, which gives them certain direct participation rights.
Its existing shareholders may contribute equity to the buyer in order to finance the acquisition of the target company. The position may be governed by a share purchase agreement, which requires the shareholders to subscribe or provides that they have the option to subscribe proportionately.
The sellers may be granted equity in the buyer entity or a group company. Where the entire consideration comprises shares in the buyer entity or group, there is an effect a merger.
Finance by Buyer’s Equity II
If some shareholders do not take up their option to participate, their shareholding may be diluted under the terms of the relevant shareholding agreement. If some shareholders invest and others do not, there may be a renegotiation of the shareholders’ agreement in the buyer company in order to reflect the greater input by the investing shareholders.
Existing shareholding agreements may be modified so as to embrace the newly acquired subsidiary. Where there has been an investment, or there is a new investment to acquire the shares, there may be further provisions for the protection of minority investors and for the payment of a return (if possible) over a certain period in accordance with the shareholders’ agreement. Alternatively, this may be provided for in the terms and conditions applicable to the share capital issued.
Where the seller is given shares in the buyer or group, it is likely to be a minority shareholding so that a shareholder agreement may be required governing the future relationships. The considerations that usually arise in respect of shareholders agreements are considered separately.
Venture Capital I
Venture capitalists may provide finance in connection with the share purchase. This is commonly the case in a management buyout by which the existing management acquire the shares of the external shareholders.
The venture capitalist in effect provides risk finance which would not be available from a conventional bank. In return, they obtain a far greater stake in the target company, with the potential for a much higher return to compensate for the greater risk.
In the case of a management buyout, the members of management will usually (at least initially) hold a minority of the equity shares, with the venture capitalist having the majority together with a variety of other securities, reflecting the corporate finance “engineering” of risk, ownership and return.
Venture Capital II
The venture capitalists will usually require extensive and detailed warranties and indemnities from the promoter/managers as well as the sellers (in the latter case through the buyer entity).
The venture capitalist will usually have representation on the board and require detailed a prescriptive employment contracts with restrictive covenants which require the promoters/managers to optimise the business of the acquired company.
The venture capitalist may require a return by way of dividends on their shares and interest on their loan notes. The exit mechanism may be provided for over a timeframe. The venture capitalist will usually require the promoters to return the investment by way of a trade sale initial public offering or refinancing.
Management may have incentives to maximise the return for the venture capitalist. They may receive additional equity of or acquire it earlier by meeting defined targets. Many of the considerations that apply to earnouts, set out below, apply.
Earn-Out I
There may be a difference between the seller and buyer’s assessment of the value of the company. An earnout may give the seller an increased adjusted price on the basis of post-completion trading.
Earn-outs will commonly take place where the sellers remain in the management of the business for a period. The earn-out gives obvious incentives to maximise the value and profits et cetera.
From the buyer’s perspective, the earn-out reduces the requirement for an upfront cash payment. It may also bridge the gap between the buyer’s and seller’s expectations and understanding of the value of the company. The buyer is more likely to pay a price more closely linked with the value of the company than in a cash-only consideration.
Part or most of the consideration may be paid upfront, with the balance paid at defined intervals over a period of time-based on the trading performance of the company over the post-completion
The earn-out provisions may be part of the share purchase agreement or a separate agreement. The period is normally a number of financial years commonly two to five measured with reference to the profits of the company.
Earn Out II
The buyer may agree not to do anything, which might affect the amount of the earn-out. It might agree not to divert business. There may be a limit on certain types of fees and expenditure. They may be mutual obligations to use reasonable endeavours to maximise profits.
There are a significant number of permutations as to the precise terms of the earn-out clauses. They may be the subject of considerable negotiation. Accounting and financial input will be required.
The sellers /managers may have an incentive to focus exclusively on the targets defined in the agreement. This may encourage a short-term view and approach which is to the detriment of longer-term considerations and the development of the target company.
Measuring Post Completion Earnings I
Commonly, EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) is chosen as a finance neutral mechanism of determining performance. There can be scope for dispute, controversy and complexity over what constitutes the requisite performance. The position may be capable of manipulation. Precise definitions are required in relation to the measurement of the trading performance. There should be a mechanism for reference to an independent party in the event of a dispute.
The accounts of the company post-completion will need to be prepared in accordance with consistent accounting policies. Abnormal transactions will need to be screened out from the figures. The seller may require limits on the extent to which the buyer may make excessive payments to itself directly or through connected entities such as to adversely impact the profits on which the earn-out is reckoned.
Measuring Post Completion Earnings II
Some elements of increased profitability post-completion may be due to synergetic factors such as the sharing of overheads, reduced borrowing costs in a lower risk group, greater purchasing power, sharing of premises. The buyer will wish to screen out these factors.
Extraordinary items are usually excluded as they are not part of the regular trading of the company. They should be clearly defined. They may include, for example, the disposal of capital assets. In the case of some extraordinary items there may definitional and accounting problems and controversies in apportionment. It may be arguably what the effect of any particular transaction is or would have been.
Intercompany transactions between the buyer and the buyer’s group and the target company may have a distorting effect. It may be necessary to redefine the transaction as if they were at arm’s length.
Measuring Post Completion Earnings III
Where there is further earn-out consideration due, but a warranty claim arises in the meantime, the agreement may provide for the set off of one against the other. More generally, matters which might otherwise have been part of a warranty claim may impact on the post-completion profit so as to reduce the earn-out amount without the need for a claim or a claim to the same extent, as might otherwise have been so.
The calculation of the earn-out may itself be the subject of disagreement. There may be provision for the buyer and seller’s accountants or auditors to review the position and put-forward the resultant figures. The auditor may review the position and put forward a figure in the first instance. This may then be subject to review by the buyer and seller’s accountants. If the matter cannot be agreed, the matter may be referred for binding determination by an independent accountant.
The agreement may provide for security for the earn-out payment. A fixed sum may be placed in escrow in cash with the seller’s solicitor or another. Alternatively, a bank or other guarantee may be given. There may be a charge on the buyer’s shares for a period. A charge may not be possible if the funding bank requires security over the shares.
The placing of money on deposit may negate a significant advantage of the deferral of consideration namely not having to pay cash up front. Equally a bank guarantee itself would require a facility for the guaranteed amount and may be categorised in the same way as lending.