Canadian Searches: experience with lenders when there is earnout
July 21, 2024
by a searcher in Kelowna, BC, Canada
What are your opinions and experiences with financing deals that include seller earn-out terms? How do lenders perceive this, especially when the earn-out is aggressive, such as up to 20% of the purchase price?
in Kelowna, BC, Canada
Because earnouts can be complex and variable, banks want to see terms that ensure their protection across all potential outcomes.
On the low end, the earnout should not cause global debt servicing to increase beyond what the business currently supports. On the high end, it should be sufficiently tied to the EBITDA increase of the business to ensure it doesn't impair the senior debt serviceability.
Seems like I have more to discuss on earnout structuring. I'll do some research and reach out to this fantastic group for feedback.
from Bowling Green State University in Surrey, BC, Canada
Provided the equity component is acceptable, generally, the VTB will need to be postponed and subordinated to the bank. Meaning, if things go badly, the bank has first dibs on the assets of the business and the VTB holder will only receive repayment after the bank is fully repaid.
What does that mean in the normal course of a business that is operating in a healthy way? Well, it depends. Some lenders may allow interest payments to the VTB-holder provided the client is onside with all of the bank's covenants, provided the rate of interest on the VTB is deemed acceptable (ie. less than the bank) - typically VTB interest is low and it's not an issue.
Principal repayments on the VTB are generally subject to the postponement. The bank will need to consent to principal payments going to the Vendor, and generally, VTB's are structured interest-only for at least three years in which case sometimes the bank will contemplate a refinancing of the VTB at maturity since they (the bank) would have deleveraged a fair bit by then, again, provided things have gone well.
The VTB, for all intents and purposes, is very much like equity from the bank's perspective, but they may still include the VTB debt in their ratios and covenants.
Like most things in life, it depends. There are lots of variations but the overriding theme is consistent - the bank is in the front seat, the VTB is in the back seat.
I've seen some deals where VTB has a structured payment plan (principal & interest) but it's super-rare.
When positioning VTB with sellers, best to position it as needing to be postponed to the bank, but we'll lobby the lender to allow interest payments. Then, later once we've paid down the bank debt, look at a refi to get you fully out. When it comes time to sign up the intercreditor agreement between the bank and the Vendor, it's going to be very clear the Vendor is a passenger.
On leverage, the bank is okay with a 20% VTB as they view this as a great way to keep the seller vested in the transition and ongoing viability of the business. And the fact that, in a pinch, they can stop payments on the VTB if need be. But more important is a) the cash equity coming in, b) debt service on the proposed funding, and c) where the next equity check might come from if this thing goes sideways.