Reasons to be Cheerful, Part 3 – a deal structure for every occasion

“The juice of the carrot,

The smile of the parrot,

A little drop of claret,

Anything that rocks.

Reasons to be Cheerful, Part 3”

Ian Dury was a unique artist and performer. His musical style was fused from diverse influences and his lyrics were a combination of poetry, word play, observation of British everyday life, character sketches and (very) edgy humour.

One of Ian Dury’s early songs, and one that he played throughout his entire career, was “Sweet Gene Vincent”, written for his own great musical hero who died in 1971. Ian Dury was a man who paid incredible attention to detail and to planning. He wrote the lyrics to this personally important song after spending 6 weeks of research on Gene Vincent, which included reading two biographies!

The third and final instalment of Reasons to be Cheerful, highlights the wide array of deal structures that are available to private companies and their shareholders, providing considerable flexibility to tailor and optimise deal terms even in uncertain times, as well as the importance of research, evaluation, negotiation and attention to detail if the best outcome is to be achieved.

So, subtitled to some of Ian Dury’s greatest songs (and no offence intended):

There Ain’t Half Been Some Clever B@$#@*ds...

Our second reason to be cheerful was based on the plentiful debt and equity capital available to businesses. Beyond the cheque, however, is the double-edged sword of complexity and structural flexibility when it comes to buy-outs and growth capital deals.

The majority of these transaction structures have an element of value being rolled over, not just those that are growth capital deals but because in a buy-out there is often a degree of vendor dependency and/or existing management shareholdings (or share options being exercised). Also, the management team which the investor is backing will receive equity in the buy-out entity as long term incentivisation.

Private equity deal structures can be a thing of incredible beauty and the beginning of a great partnership: competition and weight of money get vendors a great price, risk and return are in balance, contractual and equity returns are mixed appropriately, overall cost of capital is “on-market”, use of leverage is sensible, business growth goals are aligned (and funded), and management teams can expect to be richly rewarded (tax efficiently) for delivering their business plan. A glorious win-win scenario.

But these are highly complex structures with many moving - and negotiable - parts.

Let’s be frank, venture capitalists and private equity investors are trying to make as good an investment return as they can. Competition with other investors, a need for vendors to get a fair deal and management to be properly incentivised, does keep the playing field reasonably level.

Vendor shareholders often fixate on the headline valuation on the business. Not that this isn’t important, but the “Newco” terms in a private equity deal can be more so where a shareholder is rolling over material value and/or a management team is signing up to receive equity for the first time (for which they will generally have to invest “hurt money”).

So what’s in the investor’s toolkit?

Secured debt may or not be deployed in the structure from a bank or alternative lender which influences financial risk and overall cost of capital. The equity investment is often into loan notes carrying preferential return rights and an interest coupon – both paid and accrued. There can be redemption premia too, sometimes fixed amounts regardless of early repayment. Plus “make whole” provisions to compensate for too early repayment. The accompanying equity holding in Newco might be a majority or a minority interest but regardless, there will be detailed consent provisions to major business decisions and equity covenants (possibly linked to swamping rights), together with preferential dividends and drag rights to encourage facilitation of an exit. Arrangement fees and monitoring fees also play a part in an investor’s overall “blended” return and money multiple expectations.

For management shareholders, a fundamental question is whether any rollover is into loan notes (to underpin current value), and equity, or just the latter. There is also the relevance of an equity ratchet to consider, which would skew more outperformance value to management once certain return hurdles for investors are met.

A competitive process does provide some reassurance that overall terms are fair, but also funding terms and deal structures from several investors can be “apples and pears”. Evaluating a private equity offer requires not just a view on the headline price at completion but also the eventual outcome for each faction of Newco shareholders after the exit event some 5 years out together with the derived real cost of funds.

To compose a thing of such complex beauty, get best terms and the optimal capital structure needs time, care, planning and attention to detail, as well as good corporate finance and legal advice.

Hit Me With Your Rhythm Stick…

Trade sale processes come in all shapes and sizes, from off-market pre-emptive approaches to limited and wide auctions and accelerated marketing for distressed businesses.

So too do deal terms, with a majority of private company sales having some element of deferred or contingent consideration. Occasionally, some have minority equity retained by the vendor or share consideration from the buyer (generally if it is listed or a private equity backed consolidator).

A challenge in trade sale processes is to maintain the momentum, or rhythm, in the timetable – ideally to the seller’s tempo and not the buyers’. Large corporate acquirors can have complex decision-making processes and proprietary approaches to due diligence. Multiple parties need to be corralled over an extended period and visibility into the buy-side process can vary.

The key is in the planning and preparation, ensuring that the data room can be presented with “no surprises” and the marketing phases timed carefully, launched from a position of strength. Unsolicited approaches can tempt sellers into premature exclusivity, based on an indicative offer that has little foundation and the business ill-prepared, resulting in a scramble to get information presented for due diligence.

Preparation for a sale cannot start too early. Advisers can be lined up, strategic options can be properly evaluated, data rooms built and processes properly planned. If shareholders are minded to sell at some point, being ready to respond to unsolicited approaches can be greatly advantageous, both in terms of articulating and negotiation value, but also to get into the due diligence and execution phase without loss of momentum and a significant risk of the buyer deviating from terms.

Once again, the range of deal structures available to private companies is broad, creating the ability to optimise terms where there is a need to address a difference of view on value or certainty of trading outlook (eg through an earn-out), demonstrate the vendor’s commitment to remain involved in for some time (eg through a retained equity interest with a put/call option mechanism), align acquiror and target business in a merger scenario (eg with shares in the buyer) or “assist” a buyer with its financing (eg with deferred consideration or even vendor loan notes).

Private companies have the ability to determine the form of sale process that works best for the business and its shareholders. Good planning and preparation helps maintain the rhythm.

They are also able to deploy a range of structural elements to the deal to optimise terms with a particular buyer, align commercial interests such as management transition or address market dynamics (both uncertainties and opportunities).

Clever Trevors and Blockheads…

A word of warning. There are a lot of people out there masquerading as “buyers”. Many are individuals without cash and are not corporate buyers, investment funds or groups of seasoned industry teams bringing management expertise and succession to the table.

Generally, the dialogue starts with a letter, the same one that goes to many other businesses in a variety of unrelated sectors. When challenged on what the valuation and deal structure would be and how consideration would be funded, the answer goes something like:

“Valuation would be based on a derisory multiple of profit. Cash consideration would be any free cash on the balance sheet plus what the business itself can borrow, secured on its own assets. The balance would be paid out of a proportion of post-tax profits over 5 or 6 years. I won’t be putting any cash in but will take all the shares and a director’s fee. Oh, and the vendor will need to keep running the business for a couple of years at least, until I can recruit a replacement.”

The flaws in such a “self-funded”, high risk, low return deal really don’t need spelling out?

Sex & Drugs & Rock & Roll…

Of course, not all businesses want the rush of a trade sale or have the head spinning growth trajectory for a private equity transaction. Some have an aspiration for long term family ownership or management-controlled autonomy. There are structures to accommodate and enhance these positions.

Debt-led buyouts, or VIMBOs, or FAMBOs, can enable a tax-efficient cash-out for vendors alongside a transition of ownership to management or younger family members. The debt market is diverse, and liquid, with the suitability of ABL, amortising, bullet, junior and hybrid facilities to evaluate. Vendor rollovers can combine secured loan note underpinning and the related contractual returns with minority equity. These deal structures suit relatively mature, cash generative business with management succession and are much sexier than selling to management for deferred consideration only.

Employee Ownership Trusts (“EOTs”) involve a sale of a majority, up to the entirety, of the business to a trust, which holds the shares for the benefit of all the employees. EOTs suit people-centric businesses with relatively flat team structures where all employees feel incentivised by such a long-term benefit, eg veterinary practices, recruitment firms, architects. Whilst highly tax efficient for the vendors, they are very much less so for employees and often this and the dynamics of a senior management team wanting to lead a buy-out make the latter more compelling.

More benign options include EMI schemes and growth shares to incentivise and help retain senior employees. A group diversifying into a new market or technology and wanting to really motivate a team could consider setting up a subsidiary, allocating shares to management at nominal value and funding launch through an intercompany loan.

So structures a-plenty beyond paying dividends.

What A Waste…

Corporate transactions take time. Time to evaluate, plan, launch and execute. Tax planning and HMRC clearances reside in many. This can add up to a year from start to finish.

The current UK tax regime remains favourable to entrepreneurs and private companies undertaking capital transactions. Capital Gains Tax remains much lower than that for income and dividends.

A General Election is coming, and change will follow. It is better to control the timetable and achieve an optimal outcome than negotiate with a buyer or funder from a point of urgency and disadvantage. It’s better to have a HMRC clearance than take a punt and be caught out by anti-avoidance measures.

Tax avoidance is no reason to do a deal. But if there is merit in undertaking a transaction for reasons of business and shareholder strategy, the time required to do a good deal should not be underestimated, or hard-earned value risks being wasted.

The third of three Reasons To Be Cheerful…

With (Part 1) a climate of economic improvement and reenergised business confidence going into 2024, (Part 2) a diverse, liquid debt and equity funding market and (Part 3) the availability of a wide array of tax-efficient deal structures to accommodate every business and shareholder value scenario, we have our three reasons to be cheerful.

Economic and geopolitical uncertainties are undoubtedly high. But corporate transactions should derive from long-term planning and a long-term outlook and be not knee-jerk responses to events.

More creative deal structures can address change and transition as well as specific business, market ?and shareholder dynamics. Many private businesses greatly underestimate the range of options available to them or that the vast majority of deals have some of the complex elements discussed above.

But with complexity and flexibility comes opportunity.