Financing: the subordinated vendor loan
Once a shareholder has decided to sell to an Employee Ownership Trust (EOT), how to finance the transaction is the next important question:
In this discussion, we will assume a business is being sold for 5.0x EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation, or operating cash flow). We will also assume a bank is willing to lend 2.5x EBITDA on a senior basis, with the remainder of the purchase price financed by a vendor loan. The vendor loan is subordinated to the senior lender both legally and structurally. From a legal perspective, the bank is granted superior positions with respect to both assets and cash flow through the loan documentation. The bank will take a first charge on all company assets and will be positioned to drive any potential restructuring with a long-term, if not permanent, standstill provision in the inter-creditor agreement that governs the relationship between the senior (bank) and junior (vendor) lenders. Structurally, the loan payments on the senior debt are made prior to any payments whatsoever on the subordinated vendor loans. Payments of interest on the subordinated vendor loan would be made on a periodic basis following principal and interest payments made on the senior debt. In effect, vendor loan payments are often made only from excess cash flow, and then only with respect to interest. It would be rare for a senior lender to allow for principal repayments on the vendor loans.
A fundamental issue that needs to be dealt with from a credit underwriting perspective is how the vendor loans will be viewed by bank credit approvers. On a practical level, are they debt or equity? From a technical perspective, they are clearly debt. How they are viewed by the lender in the credit underwriting process, however, is the key consideration. To the extent there are no structured payments required, the bank may view the vendor loans as quasi-equity in the transaction. The greater the formalised payment requirements on the vendor loan, the greater the likelihood it will be viewed as debt by the lender. If they are viewed as debt that is not properly subordinated, it will be very difficult, if not impossible for a bank lender to finance a 100% sale to an EOT. Properly structured, there is no reason to believe that the vendor loans will not be viewed as quasi-equity in the deal, based on our extensive experience in this area.
We recommend structuring vendor loans to mirror terms that would be provided by commercial subordinated debt or mezzanine finance lenders. This means they would carry an interest rate between 8-10% (potentially divided between cash pay and accrual interest) and also have an equity warrant position to provide equity upside in return for taking longer term subordinated debt risk. From an all-in return perspective, this tranche would provide the seller with a return in the range of 10-15%.
Structuring the vendor loans on commercial terms has another significant benefit. It provides the potential to realistically refinance the debt with third party lenders if that was something desired down the road. If the vendor loans carry below market terms, it would be difficult for the EOT trustee as a fiduciary looking out for the best interests of the employee beneficiaries to consent to a potential third party refinancing if it was on more expensive or on otherwise less attractive terms. By increasing the cost of debt when refinancing low cost, non-market rate vendor loans with higher cost senior debt, there is the possibility that the EOT trustee would be seen as violating its fiduciary duty to the employees. Similarly, shortening the repayment schedule could be seen in the same light. Getting the structure right is a tricky proposition and it is important to get it right at the beginning rather than be left scrambling at some point in the future.