By: Robert C. Hackney
This blog post is focused on exploring all of the possible categories of debt financing in the context of a merger or acquisition transaction.
In connection with financed buyouts, there are seven frequently referenced categories.
• First is senior revolving debt and senior term debt. Both senior revolving debt and senior term debt are typically provided by institutional lenders such as banks and sometimes insurance companies.
• The second most common category is subordinated debt. In the industry it is frequently called mezzanine debt.
• The third category, or layer of financing, is the sale/lease back category.
• The fourth layer of financing is Seller financing, and it can take the form of either the seller’s subordinated debt or alternatively seller’s preferred stock.
• The fifth layer of financing is the sale of preferred or common stock to a third party. The third parties that buy this stock are either financed buyout investment funds or one of the senior lenders as part of their lending package.
• The sixth layer of financing is the common stock that is sold to the buyer or principals of the buyer and sometimes even management of the target if they are going to stay on and be part of the new ownership. This is the equity or down payment portion of the transaction.
• The seventh and last commonly referred to category is that of warrants or options to acquire stock. These are granted to all or some of the participants in the financing and even sometimes to the seller. These are usually referred to as inducements or kickers and later through their exercise they may provide additional funding to the company.
Now let’s delve more into each of these categories.
I. Senior Lending
Senior debt can frequently take the form of part revolving loan, which is used to provide the working capital, and part term loan, which is used to pay for the purchase price of the asset or the stock.
Senior term debt is used for the acquisition of the assets or stock and is secured by a first lien on all of the target’s fixed assets – that’s the equipment that the target owns as well as any property. It is also secured by either a first or second lien on inventory and accounts receivable. It may also be secured by liens on intangibles, including intellectual property.
Senior revolving debt, which is used for acquisition financing and working capital is always secured by a first lien on inventory and accounts receivable. It can also be secured by a first or second lien on the target’s fixed assets and possibly by a lien on intangibles and fairly frequently a pledge of stock of the acquired company.
The most important thing to remember about senior debt is that your senior lender should be involved in your transaction from the earliest possible point in time because you can’t do a financed buyout without leverage and you cannot get leverage without a lender. If you can’t get senior debt, then you can’t get any other type of debt, and consequently your deal cannot be done. You need to know very early on about the basic financiablity of the deal.
Bank Involvement in Your Business
Senior debt lenders are also getting more astute and getting more involved in the operational end of a borrower’s business. In the old days of banking, senior debt had a fixed term. There were specific non-intrusive type covenants and the reliance of the banker was not only on the business, but on the personal guarantee of the borrower, who in many cases was a known person or group of people of long standing with the bank. In today’s marketplace, there is more demand lending. By that I mean the term of the loan may not be fixed and the bank may have the right to call the loan at any time.
Senior revolving loans typically now have discretionary clauses which permit the bank to only make advances at its discretion, similarly the covenants contained in these agreements have become more protective and set forth requirements for the bank to consent to numerous actions which may not be in the ordinary course of business, but which under old banking standards would not have required the consent of the lender. In essence, the banks have become more involved in their client’s business. The biggest problem that this seems to create is among fairly unsophisticated bankers who take some of these provisions at face value and may not be aware of the fact that there is a commercial reasonableness standard that is imposed upon the bank which does not permit them to act arbitrarily, therefore, if a bank takes some action which a court at some time in the future determines to be unreasonable, and the business suffers damage, or even goes out of business, the bank could be held liable for the resulting losses.
The Commitment and Related Fees
As far as senior lending is concerned, let me mention some of the basics that are usually contained in the commitment that you will receive from a senior lender. First, you will probably think most importantly to the bank, the commitment letter will set forth the fees that will be paid to the bank and these are generally about as many as the bank can think of and sometimes as high as they can get you to accept. You can expect to pay a commitment fee when the letter is signed by the bank and sometimes even a second commitment fee is due upon the execution of the commitment letter by the borrower. I have also never seen one of those fees that was refundable.
Another fee that is typically charged is some kind of a syndication fee which can be called a management fee or possibly an agency fee, and this is a fee that is charged when the bank has put together other lenders as part of the senior lending group, (if there is to be a group). Sometimes you can get credit for these commitment fees at closing and they would be credited to what is known as a closing fee that the borrower pays. So, for instance, if your closing fee were $50,000 and you had paid $20,000 in commitment fees you would only have to pay $30,000 at closing. This closing fee and commitment fee can range generally from one percent to three percent. Another fee that you will see will be referred to as a facility fee and this is a fee on the amount that is available and not yet drawn upon under the revolving credit line. This fee can be as low as a quarter of a point but more typically a half or three quarters of a point.
If there is a standby or commercial letter of credit involved in the transaction, the bank will of course charge a letter of credit fee. There you will have to pay one percent to a point and half per annum.
One thing you are going to have to look out for in your senior lending is that there will be some sort of a penalty fee usually on the term loan if it is paid back prior to maturity. The reason for this is that if you find a less expensive lender a year or two after the transaction has been completed and the company is operating within your projections and you refinance your loan, the original senior lender is going to lose money because of the early termination of the loan. Consequently, the senior lender will try to impose some kind of a penalty which is an amount that usually decreases on an annual basis as the loan heads towards maturity.
Since the bank doesn’t want to lose that anticipated profit on your loan, they figure they are going to get it out of you one way or another. Most lenders are not going to be willing to drop those fees, but they may be willing to limit them to one or two years instead of having them run out the full term of the loan which could be five years, seven years or more. The lenders have taken the risk, and consequently, they want that anticipated profit locked in for a certain period of time.
Next you are going to see more information about your prepayment rights and what the prepayment penalties may be that are proposed by the bank. Third, the bank will outline the collateral that is going to be required. Fourth, the bank will specify in its commitment letter how you are supposed to use the money that it is lending to you. Fifth, the bank may outline a required amount of equity and some limitations upon the subordinated debt that is contemplated in the transaction as a condition of making the loan.
Last, but not least, the bank will outline for you the fact that you will have to pay all of its expenses in connection with the loan. This expense provision I have found to be almost never negotiable. You should carefully review your commitment letter because the fees accessed against the borrower will generally be for all of the lender’s expenses which include its fees to the bank’s attorneys. The commitment letter may provide that if the loan doesn’t close, that you as the borrower may be never the less liable for these out of pocket fees and expenses.
Recapping the Commitment, it will contain the following:
1. Commitment Fees
2. Prepayment Rights
3. Required collateral
4. Use of Funds
5. Equity Requirements
6. Bank’s Loan Expenses
II. Subordinated Lending
Subordinated debt always carries a higher interest rate than senior debt. It may be completely unsecured or it could be secured by liens that are secondary to the senior financing.
The subordinated debt category, which is referred to in the industry as mezzanine debt, includes what is commonly referred to as high yield bond financing. High yield bonds became popular during the buyout activity during the 1980s, and were referred to as “junk bonds” because they were unrated and viewed as speculative. The typical high yield bonds are gap fillers, and by that I mean that the high yield bond debt is layered in between the senior debt that we have just discussed and sometimes the layer of debt following the high yield bonds that is usually the seller financing. You will even see layers of high yield bonds and those will be referred to as senior subordinated debt and junior subordinated debt.
High Yield Bonds
High yield bonds generally have the following attributes. First of all they are usually not short term obligations. Their term usually runs in the range of ten to fifteen years, although, of course, there are certain circumstances where they could be for a seven year period or for twenty years or more. They are always subordinated to the senior debt. They carry interest rates that are substantially higher than the interest rates related to senior debt. The high rate, along with equity kickers, may produce a return in the range of twenty to twenty five percent.
With high yield bonds, there is usually a provision that does not permit prepayment, certainly for the first two years and sometimes for as long as five years. If they are prepaid after that initial two to five years, then there is usually some form of prepayment penalty which is assessed. Normally junk bonds are unsecured.
Warrants attached to Bonds
You will also frequently see warrants attached to high yield bonds. As you know, warrants are nothing more than a right to buy the stock from a company at a specific price during a specified time period. For example, you might have a warrant to purchase a hundred shares of common stock of a target at a price of ten dollars a share and the warrant may be good for a period of two years from the date that it is issued. After that time period has passed, the warrant has expired. If you want to purchase the stock from the company at the given price, you must exercise the warrant, pay the purchase price and do so before the expiration of the warrant. This is another inducement to a high yield bond purchaser which is also commonly referred to as an equity kicker. In the past, buyers of large blocks of high yield bonds have sold the warrants that they have received with the high yield bonds to other investors or back to the underwriter of the bonds. The effect of the sale of the warrants is to put the bonds in the hands of the buyer at a discount.
III. Sale or Lease Back Financing
The sale of the target’s real estate can be placed with either an independent third party or a group related to the buyer, usually in the form of an investment partnership, which then leases the real estate back to the target. Sale/lease backs also often come into play in short term financing of office equipment to long term leases of substantial computer equipment and other machinery used by the target company.
IV. Seller Financing
If the seller takes back debt, this debt will be subordinated to senior and mezzanine debt and can either be secured or unsecured and depending on your negotiation, can be convertible to stock of the target. In the alternative, the seller may accept preferred stock and that stock may either be convertible or exchangeable for debt.
Debt or Equity?
Sellers are generally not crazy about taking debt or equity financing back in connection with the sale of their business. As we have discussed, this form of seller financing is usually subordinated to senior debt as well as mezzanine debt and consequently the seller realizes that being at least third in line, he won’t get paid unless the company does very well after the acquisition. The use of seller financing also solves that basic psychological problem that we talked about early on in this course and that is that if the seller has over estimated the value of his business the way that sellers sometimes do, he can save face by having a purchase price that may be close to his original estimate with a substantial portion of that purchase price being seller financing.
Seller financing also a big plus to the seller if the company is very successful and does very well because he will end up sharing in that success by actually realizing payment of the debt that he took back as part of the seller financing. The question usually boils down to whether or not the seller will take a note in connection with his financing or preferred stock. The most advantageous position to the buyer is to get the seller to accept preferred stock. The reason for this is that preferred stock appears as equity on the target’s balance sheet and in a highly leveraged deal, he can substantially decrease the possibility of a technical insolvency.
A seller taking back preferred stock also gives the senior debt lenders and the mezzanine debt lenders more comfort and more incentive to participate in the transaction. This can also be very important in connection to what is commonly referred to as a fraudulent conveyance problem, which we will cover below.
Preferred Stock to the Seller?
The disadvantage to the buyer of preferred stock is that it will produce dividends to the seller and those dividends are not deductible by the buyer. If the buyer had given a promissory note, the interest payments under the note would be deductible. One other disadvantage to a buyer in connection with preferred stock is that you can’t have more than one class of stock in an S corporation, so it is going to prevent the buyer from electing S corporation status. There also are some other tax consequences which can be adverse and which are beyond the scope of this blog post.
Debt in the form of a Promissory Note to the Seller?
From a seller’s standpoint, generally debt in the form of a promissory note is more advantageous because, generally speaking, the interest payments will be due no matter what occurs with regard to corporate earnings. Under various state laws, dividends which would be payable under preferred stock are not permitted to be paid unless the company has earnings. There is no such restriction upon interest, however.
There are two other considerations that benefit the seller if he takes a promissory note. The first is that he may be planning to sell the note and it will be much easier for him to sell a note than to sell preferred stock. The other is a perception situation and by that I mean that the seller may want to totally divest himself from the situation and if he continues on in some form as a stockholder, he may not feel that he has accomplished that goal, whereas being a lender is a little different category and the seller may feel that he wants that complete divestiture of ownership.
Even if the seller does take a note, an added incentive to him might be to give him some form of an equity kicker, and that again would become stock or preferred stock and in recent times the use of warrants to purchase common stock has become very popular. If after the acquisition, the target wants to be eligible for S corporation status, then the use of warrants can facilitate that eligibility, and do not preclude S corporation eligibility as is the case when preferred stock is used.
Use of Warrants in an S Corporation?
One area that you need to be careful about in the use of warrants in connection with an S corporation is the exercisablity of the warrants. Generally, the warrants cannot be immediately exercisable since their exercise would probably trigger the loss of S corporation status. Usually warrants used under these situations would be exercisable or exercise would be triggered by sale of all of the target’s stock or assets or secondly a public offering or third, a change of control of the target. Those situations will usually cause the loss of S corporation status anyway, and you might as well go ahead and let the warrant holders obtain that benefit of equity ownership that would be derived upon the sale of the company stock or assets or public issuance of its stock.
The other benefit of the use of warrants is that the seller may not want to be a common stockholder and as a warrant holder, he only has the right to acquire common stock and therefore is not a common stockholder and may be able to maintain that sense of detachment that he is looking for. The benefit to the buyer is that since he is not a common stockholder under most the states’ laws, he probably would not be entitled to receive the kind of corporate information that a common stockholder is granted under the various state corporate laws.
V. Preferred or Common Stock
Next let’s move to the category or layer of debt that has been described as preferred or common stock sold to an independent third party. These independent third parties are frequently acquisition buyout investment funds. These investment funds are usually limited partnerships or limited liability companies which frequently have raised funds or obtained commitments, not through a public offering, but through some form of a private placement by selling the interest in the fund to institutional investors, pension funds and well-heeled private investors. These funds are usually structured as blind pool investments.
Since transactions of this type need to be done quickly, it is beneficial to have either the funds or a commitment for the funds readily available because the best deals are snapped up very quickly. Consequently, the limited partners in these partnership investments have no idea when they make their commitment as to what companies the fund will choose for investment. The investment decision is made by the general partner and the limited partners will have no say in how the funds are invested. One of the reasons that these funds raise their money through private placements involves various exemptions from the Investment Company Act of 1940, as well as the Securities Act of 1933. If you are raising money from the public and you are investing that money in the stock or other securities of various other companies, you are going to need to be in compliance with the Investment Company Act. The Act contains various registration requirements as well as public reporting requirements and prohibitions against interrelated financing. Some of these finance buyout investment funds will also provide bridge financing which is short term funding that is used during an interim period before permanent financing can be arranged. The short term bridge financing is usually for a period of six to nine months and it is only in place until such time as all of the work can be done to put the permanent financing in place. Bridge loans also typically involve equity kickers.
VI. Equity Investment
As referenced above, this is the equity portion of the acquisition, which is provided by the buyer, and sometimes by management of the target if they are part of the acquisition group acquiring the company from its owners.
VII. Warrants or Options
Warrants or options to acquire stock are granted to all or some of the participants in the financing and even sometimes to the seller. These are usually referred to as inducements or kickers and later through their exercise they may provide additional funding to the company.
Areas of Concern in Financed Buyout Transactions
Fraudulent Conveyances
Let’s go back and discuss one issue I raised earlier, and that is the issue of fraudulent conveyances and why the fraudulent conveyance issue is important in financed buyouts. In the unfortunate event that your deal doesn’t make it and the target files for protection under the bankruptcy laws, the senior lenders obviously want to be assured that their lien on the assets and the note that they have received will be enforceable. Federal bankruptcy law and the comparable state laws contain the concept of a fraudulent conveyance or transfer. A promissory note may be worthless and the lien may be void if the pledge of the assets and the granting of the promissory note by the target are deemed to be fraudulent conveyances or transfers. The underlying purpose of this doctrine is to protect general creditors of targets where the acquisition transactions have the resulting effect of depriving the acquired company of the means to pay its debt to its general creditors. It usually has nothing to do with whether or not there was an attempt to defraud anyone, although in some cases there has been held to be such an intent.
The problems specifically related to financed buyout loans is that a lien on the assets or the promissory note will be held to be fraudulent if the company receives less than reasonably equivalent value in exchange for the pledge and the note and any one of the following three situations exist.
• First, that the company was insolvent at the time of the transfer or became insolvent as a result of the transfer.
• Second, that the company was left with unreasonably small capital as a result of the transfer.
• Or third, the company incurred or intended to incur debt beyond its ability to pay.
The issue of whether or not the company received reasonably equivalent value in the transaction is frequently raised in bankruptcy situations because when you look at the transaction, usually what has occurred is that the selling stockholders got all the money and the resulting target ended up with heavily encumbered assets. Of the three situations that are problematic, the insolvency issue is the most difficult because the loans were based partially on projections. The target should be able to demonstrate that it has neither unreasonable small capital or the inability to pay its debts.
Insolvency Question
Let’s address the insolvency question and why it is a problem. The main problem is that the definition of solvency as used under bankruptcy law is different from the definition used under generally accepted accounting principles or GAAP. Under GAAP, if a company has assets that are greater than liabilities, then it is solvent. Also under GAAP, if the company has assets that are sufficient to pay its debts as those debts mature, it will also be considered to be solvent. Usually one or more of the GAAP solvency definitions can be met in any financed buyout situation, but that doesn’t solve your problem, because under the bankruptcy laws, the company is solvent only if the fair salable value of its assets is greater than its probable liabilities. Under this definition, assets are valued at their worth upon disposal and in many situations, that means their liquidation value, and not their book value.