There are good reasons to expect that mergers and acquisitions activity for privately held businesses will increase in 2025 and the following years. Private equity firms are adjusting to the new normal of higher rates for longer. They need to deploy capital to achieve sufficient returns for their investors. Further, business owners belonging to the baby boomer generation will continue to retire. If the next generation in the family doesn’t want to take over the business, the retiring owners look to sell the company. All of this means banks who finance businesses are more likely to be involved in the purchases and sales of those businesses.

For the most part, the due diligence and loan documentation for financing a business being acquired is the same as financing a business with continuous ownership. The purchase and sale component, however, adds additional parties and complexity to the overall transaction. The aim of this article is to point out some of the extra layers and items to watch for when financing an acquisition. 

Types of Transactions

An owner looking to sell their company has two basic options: sell the equity or sell the assets. Buying equity means buying both the assets and the liabilities. Because a buyer doesn’t usually want to assume liabilities, asset purchases are more common. With an asset purchase, the buyer can take a more surgical approach in an attempt to acquire only the “good” assets, leave any risky and unnecessary assets behind, and avoid assuming existing liabilities. 

There are different types of buyers too. Some buyers are existing operating businesses acquiring another company as a means of growth. If you are already lending to the acquiring company, you will be concerned with how folding in the newly acquired business will affect the cashflow and profitability of your client. Will the increased size of the business require a larger credit facility? 

Private equity firms make it their business to acquire other businesses. If you are financing an acquisition by a private equity firm, ask them about their plans for the business. Is it a strategic acquisition to complement other companies in the firm’s portfolio? What is the plan to exit the investment? How long do they plan to hold the investment? You may want to match the term of the credit facility to their planned holding period. 

Another common buyer is someone already working with the company. The current owner may be ready to retire and one or more of the management team is ready to move into an ownership role. In these situations, dig in to see how active the retiring owner is in the business. Is the remaining management team ready to take on the roles that the retiring owner was still serving? In other words, are you comfortable the new owners can successfully run the business without the retiring owner’s presence? 

Similar to a management buyout is creating an employee stock ownership plan (ESOP). An ESOP transaction is essentially a sale of the company’s stock to a trust for the benefit of the employees, which enables the owner to sell without finding a third-party buyer. There can be tax advantages as well with an ESOP. Properly establishing an ESOP requires compliance with numerous complicated laws. Working with advisors and counsel experienced with ESOP transactions is critical.  

Dive into the Details

During the transaction, you, as the lender, are looking over the buyer’s shoulder as they conduct due diligence and negotiate with the seller. The buyer’s legal team will share drafts of the purchase agreement with you and your counsel. The goal is to learn as much as possible about the business being acquired, aka your new borrower. Remember, the seller is more familiar with the business. The seller knows what skeletons are in the closet. Watching how the seller negotiates the representations and warranties in the purchase agreement can give you clues as to where to dig deeper to ensure those skeletons don’t cause any problems. Similarly, review the seller’s disclosure schedules to the purchase agreement and ask questions about anything that looks unusual or potentially problematic. 

Despite thorough due diligence and solid representations and warranties in the purchase agreement, buyers (and their lenders) are still fearful the seller knows something negative about the business or its prospects that hasn’t been disclosed. To help allay this fear, deals are often structured so that a portion of the purchase price is held back and only paid out if no breaches of the representations and warranties arise after closing. Doing so motivates the seller to be as transparent as possible before the closing. One way to handle the holdback is to deposit part of the purchase price in an escrow account. If no claims are made by the buyer within a specified timeframe, usually six to 18 months, then the escrowed money is released to the seller. 

Another way to hold back part of the purchase price is through a seller carry-back note. The buyer signs a promissory note payable to the seller. As long as the business keeps performing, the seller receives payments on the note and eventually receives the full consideration for the sale. Seller carry-back financing keeps the seller invested in the business. Seller notes are typically unsecured and should be subordinated to the lender financing the acquisition. 

The purchase agreement may contain a mechanism for post-closing adjustments to the purchase price. A common adjustment is to account for any difference between the company’s actual working capital at closing and the working capital expected by the purchase agreement. A working capital adjustment discourages the seller from manipulating the company’s cash by accelerating the collection of receivables and delaying payments to vendors. For the seller’s benefit, the adjustment prevents the buyer from receiving a windfall if there is an unexpected increase in working capital prior to closing. 

Note that these approaches are not exclusive. Many deals use a combination of the approaches to structure a deal acceptable to both sides. Understanding the mechanisms in your deal will enable you to set expectations for potential cash outflows from your borrower after closing.

Considerations for Loan Documentation

A closing checklist for acquisition financing should include extra items beyond the usual loan document package. The buyer/borrower is entering into a purchase agreement and related agreements. As just discussed, those agreements may contain representations and warranties, indemnification rights, rights to escrow monies and other benefits in favor of the buyer. Although the lender is not a party to the purchase agreement, a collateral assignment of the purchase agreement and related documents gives you an interest in those benefits. Ensure the seller consents to the collateral assignment so you can enforce the rights directly against the seller.

If the deal includes a seller note, the lender will require a subordination agreement. This agreement creates a direct contractual relationship between the lender and the seller, establishing the priority of their respective claims against the buyer, the conditions under which the seller can receive payments, and what actions, if any, the seller can take to enforce its note prior to the lender being paid in full. Subordination agreements for seller notes are often heavily in the lender’s favor. 

When a private equity firm is involved, it will often include subordinated debt as part of the capital it provides for the acquisition. Unlike a seller note, the private equity firm usually takes a second lien and is more likely to negotiate the subordination agreement’s restrictions on payments, enforcement actions and bankruptcy implications. Experienced counsel plays an important role in protecting the lender’s position without driving away the investor. 

Loan agreements typically include a default for a change of control. This provision protects against unwanted changes in the ownership of the borrower. In an acquisition, the lender should tailor the change of control provision based on the post-closing capital structure. For example, the buyer may plan to issue a small amount of equity to key members of the management team for retention purposes. The change of control provision should include a carveout for that equity to avoid an unintended default. 

While lenders are used to conducting Uniform Commercial Code (UCC), lien and litigation searches on their borrowers, acquisition finance requires searches on the seller as well. For any liens discovered, satisfactory payoff letters or releases should be provided by the seller’s lenders to confirm you, as the new lender, will have a first-priority lien on the acquired assets.

After the Closing

Negotiating and closing an acquisition can be a long and stressful process. Once the closing occurs, the parties are ready to move on. Before moving on, however, schedule some key dates for follow-up. If the purchase agreement includes a working capital adjustment, calendar that date to check on the final calculation and ensure there is no dispute with the seller. Around a month after closing, conduct post-closing UCC searches to confirm the liens on the seller were properly released and that your filing is in the expected priority position. Finally, if part of the purchase price was put in an escrow, set a calendar reminder to confirm the escrow was closed and disbursed without issue.  

While acquisitions bring additional parties and complexity to a financing transaction, understanding the additional diligence to review and documentation to include can make for a smooth and successful transaction.