Embarking on the journey to sell your business is a monumental decision, especially for small to lower-middle market business owners. It’s not just a transaction; it’s a pivotal moment that can shape the future of what you’ve built. However, amidst the excitement and potential for growth, there lurks a critical challenge that could derail your plans: counterparty risk, particularly the risk stemming from financing contingencies.

Understanding and addressing this risk early on, specifically at the Letter of Intent (LOI) stage, is crucial. This stage is your best opportunity to gauge the likelihood of a successful transaction before becoming too invested. For businesses in the small to lower-middle market sector—those with total sales under $150 million—engaging in a sale process is not only a significant financial commitment, involving advisors such as attorneys, financial analysts, and accountants, but also a substantial investment of your time.

Counterparty risk in M&A transactions can arise from various sources, but one of the most common and challenging to navigate is the buyer’s inability to secure adequate financing. This issue can affect deals across all market segments and involves both financial buyers (like private equity firms) and strategic buyers (larger companies within your industry).

At the LOI stage, it’s essential to critically assess the risk associated with the buyer’s ability to obtain appropriate financing for your transaction. Some LOIs will explicitly state that the deal’s closing is contingent upon the buyer obtaining suitable financing. However, even without a specific financing contingency, a buyer’s limited access to necessary funds—whether through equity or debt—poses a significant risk to closing the deal.

This financing risk can manifest in various ways:

• • The buyer may have access to financing, but it comes with stringent conditions;
  • The buyer’s ability to deploy cash to purchase your business may be subject to loan covenants restricting investments made to purchase other businesses (like yours) under the buyer’s existing credit arrangements, or otherwise require the approval of the buyer’s existing lenders ; or
  • Alternatively, the buyer could be attempting to raise capital to fund the equity portion of the purchase alongside negotiating the deal.

For business owners, understanding these risks and the potential impact on your transaction is vital. In navigating these waters, the key is to engage in thorough due diligence and direct communication with potential buyers about their financing plans and capabilities. At the LOI stage, it is customary to conduct interviews with key buyer personnel, and appropriate to ask direct questions about the ability of the buyer to purchase and then operate your business. If a buyer cannot commit to make a purchase of your business from available cash, you should ask the buyer to provide you with copies of any written equity or debt term sheets from outside parties in order to assure yourself of the buyer’s ability to rely upon outside financing. You should review those term sheets alongside your financial advisors and attorneys to understand what conditions attend the release of funds for the purchase of your business. Additionally, you should also ask your potential buyer whether they have existing credit arrangements and what conditions those arrangements might impose upon your transaction. In situations where you have the good fortune of evaluating LOIs from different counterparties at the same time, you should obviously preference favorable offers that also present the greatest certainty that the buyer can accomplish a closing of your transaction. This proactive approach can help mitigate risks and ensure that you’re entering into a transaction with a clear understanding of the potential hurdles, saving you time and protecting the investment you’ve made in pursuing the sale.

You might determine that there is still substantial uncertainty about your buyer’s ability to close. For example, if your buyer will be reliant upon an equity capital raise to partially fund your purchase price, it may be reasonable to conclude that the closing could be delayed, or cancelled, if their capital raising efforts are unsuccessful. In such events, you should discuss your options with your advisors to determine the customary protective measures you can take, or agree upon with your buyer, in the event the buyer is unable to close. For example, in smaller transactions (where the purchase price is $5mm or less) requiring a deposit of some portion of the purchase price for the seller’s security is not uncommon and even recently I have seen deposits used in much larger transactions (>$50mm purchase price). Some private equity sponsors are agreeable contribute up to 100% of the purchase price in equity (called a “full equity backstop”) if they are unable to obtain sufficient debt financing to fund a purchase. Although they are uncommon in middle-market transactions, reverse termination fees (where a buyer pays the seller a fee if it cannot close a transaction within some period) and arrangements to pay seller costs where a buyer is unable to close a transaction are other options that should be considered.

In conclusion, while the prospect of selling your business is an exciting one, it’s accompanied by significant risks that need careful consideration. By focusing on counterparty risk at the LOI stage, especially related to financing contingencies, you can better navigate the complexities of M&A transactions, ensuring a smoother journey towards a successful sale. We at Troutman would be delighted to help you evaluate both the counterparty risk related to your buyer and all available strategies to mitigate that risk.