How to buy a business if the price exceeds the amount that can be financed
The Equity Gap – how you can still close a deal when the purchase price of a business exceeds the amount that can be financed
Lachlan and Philippa Nagle started Nagle Building and Construction in 1975 at the ages of 23 and 20 respectively. The first few years were extremely difficult as they struggled to build their client base and reputation.
The two believed strongly in the great quality and service of their company and after 3 years of hard work, their fortune began to turn. Word was spreading about this small building company who left every client with the perception of “better than expected”. This word-of-mouth reputation led to Con Niarchos of Niarchos Properties hiring them to build his new private residence, which not only came in on time and on budget, but the quality was impressive. He promptly put them on his list of top builders which was where the company sat with every major developer in Australia by 2005.
Thirty-one years later, with a thriving business of 60 employees and a well-established brand and reputation, Lachlan and Philippa realized it was nearing time to pass on the reigns to their children. The idea was to issue shares in the business to their two sons and one daughter. The three children would then have effective control of the company when the parents retired. The crisis began when none of the children wanted the business. The children wanted to move into finance, go out on their own, or study the arts.
Auspiciously, the couple mentioned to the staff that they were planning to sell the business and retire. A group of employees, one who had been around almost as long as the founders, decided to purchase the business. Their only obstacle was the headline price Lachlan and Philippa expected to achieve from the sale. The two knew the employees would run the company as if it were their own but were hesitant to accept a reduction in sales price after more than thirty years of hard work.
Too often mergers and acquisitions are hindered by an “equity gap” that develops between the vendor’s expected headline price and the purchaser’s ability to leverage finance. Unfortunately the result is deals do not succeed even when the purchaser and vendor would like to conclude the transaction.
Deferred consideration insurance solves the equity gap by guaranteeing payment to the vendor in a deferred transaction. In essence, deferred finance insurance is a contractual agreement that guarantees that the purchase price, in part or in its entirety, will be paid at a specific time in the future. This allows the purchaser to pay for the acquisition using future profits rather than equity or debt now. It also allows for the vendor to receive payment regardless of the future success of the company as the underwriters will step in if the purchaser is unable to pay. The policy is non cancellable and irrevocable.
Deferred finance insurance is most suitable for the following types of situations:
Management Buy Outs
Management Buy Ins
Succession plan driven divestments
Public to Private Transactions
In addition to enhancing deal success rates it also has numerous advantages, such as being significantly cheaper than other types of financing. For example, the typical premiums are between 2% to 4% pa.
As our scenario demonstrates, the maturing of the baby-boomers is poised to leave a succession planning dilemma. Deferred finance insurance can alleviate many of the issues posed allowing business owners the security and peace of mind of guaranteed payment.
If you would like to know more please feel free to contact us.