The Funding Gap: Seller Protection in an MBO
In our article on deferred consideration we discussed the funding gap in the context of management buy out’s (MBO’s). In this article, we discuss priority of payment and protection for sellers who have helped fill the funding gap.
Sources of Credit
In addition to the support the sellers are willing to make available to the MBO team, the sellers and MBO team can consider other sources of credit from:
- Banks or secondary lenders willing to make available new lending;
- A single investor or group of investors willing to put their own money and/or time in and to work with the management team.
- Private equity funds with either loan or equity funding which they are willing to make available to the management team and/or to package up with an investor or group of investors
Each of these types of investor will change the relationship between the sellers and the MBO team after completion of the buy out.
Types of Security
However, before we look at that, let us consider the type of security that the target company can offer its credit providers. These include:
- Loan creditors – mortgage security over land and/or debenture security over other assets of the target company;
- Asset lenders – the most common of these are the book debt lenders which are secured by sale of the book debts (through a confidential discounting or factoring arrangement).
In each case the assets of the target company are charged, almost always, under a first priority charge to secure new loan funding which is then used to fund the purchase price as follows:
The loan may have to be supported by personal guarantees from the MBO team members and they in turn may have to be supported by a charge (typically a second ranking charge) over a home or other personal assets.
Second Ranking Priority over Assets
The greater the compass of the security required by the external credit providers the fewer assets are available to the sellers. If there are valuable second ranking security over assets in the target company the sellers’ exposure may be covered, at least on a paper valuation, but the senior creditors are likely to require a deed of priority also known as an intercreditor deed (or ICD) from the sellers (and MBO team) under which they agree not to enforce their security without the permission of the senior creditor. This can mean that the sellers are simply unable to take any enforcement action and, until permission is obtained, the security is effectively worthless.
Protection for the Seller
The sellers may therefore need to look to other ways to protect their position including the following:
Charge over Shares: shares in the newco buyout vehicle are often (but not always) left uncharged by credit providers and can be charged by the MBO team to support newco’s commitment to pay deferred consideration. The share charge gives the sellers the right to sell the shares in newco (and with it, the shares in the target company) and to use the proceeds to pay off the amount outstanding and remit the balance to the MBO team (who will have given the charge).
This may be useful leverage but is not ideal, in that it does not immediately give control over newco. This can be addressed by supplementing the terms of the share charge with an automatic right of the sellers to be appointed to the board, to be registered as the owner of the shares and to have all dividends paid to them.
However, the sellers can only ever have a security interest (not an outright interest) in the shares of the company.
Option to Buy Back: An alternative that avoids these concerns is an option under which for an agreed sum, the sellers have the right to buy back the shares in newco if a deferred consideration payment is missed.
Whilst this may suit a sellers who is willing to contemplate getting back in the management saddle, it can have significant down -side for the MBO team who may have paid almost all the deferred consideration at the point at which the option is exercised and the shares transferred back to the sellers. In those circumstances the sellers will become an outright owner of the company and can run it for their own benefit and, if they sell it, can do so and keep the sale proceeds without an obligation to account to the MBO team. The MBO team will be left with the burden of personal debt or guarantees that they entered into to fund the purchase without control of the company that it was raised to buy and the arguments around the option exercise price can be heated. It is only in exceptional cases that an option-based arrangement which is acceptable to both sides can be agreed.
Management and Financial Covenants: management and financial covenants include any or all of the following
- The right to receive financial information such as management accounts so that issues can be spotted early;
- The creation of a separate bank account into which funding for deferred payments are placed and control over which is exercised by the sellers as well as the MBO team;
- The right for the sellers to appoint an observer at board meetings or to be re-appointed to the board
- The right for the sellers to veto certain decisions. These need to be carefully drafted but the overall aim is to preserve the value of the target company or newco or its ability to pay the deferred consideration.
- The right to be paid early in certain circumstances (as discussed in my earlier article).
- Any other special arrangement that the sellers and MBO team agree and that suits the circumstances.
These can be combined with a Charge over Shares or Option to Buy Back but can also be stand alone measures.
The sellers in an MBO buy out where there are external creditors funding the initial payment of the purchase price can expect to rank behind the security interests of the external creditors as regards the payment of deferred consideration. Some creative thinking will be required to identity assets that are available and measures that the sellers can take by way of security for the debt owed to them.
Specialist legal advice
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