Transaction
Financing
and Breakup Fee
Backstops

DEFINITIONS

An equity commitment letter is a binding agreement delivered by a creditworthy party on the buy-side (usually a sponsor) to a buyer where the sponsor commits to provide a certain amount of equity capital to fund a transaction.

A debt commitment letter is a binding agreement delivered by a third-party lender to a buyer where the lender commits to provide a certain amount of debt financing to complete a transaction.

A limited guarantee (or limited guaranty) is a binding agreement delivered by a creditworthy party on the buy-side (usually a sponsor) to a seller or target company where the sponsor agrees to stand behind specified obligations of the buyer, principally reverse termination fees.

A seller note is a binding agreement where a seller agrees to provide a certain amount of debt financing to a buyer in connection with a transaction.

INTERPLAY WITH TRANSACTION TIMING

• COMMITMENT LETTERS AND LIMITED GUARANTEES

ECLs, DCLs, and LGs only appear in staggered sign-and-close transactions. 

In simultaneous transactions, commitment letters are not necessary, because a buyer will not sign transaction agreements and authorize closing until it has all funds required to close. LGs are not required, because termination obligations (like RTFs) are irrelevant. 

In staggered transactions, ECLs appear in transactions with equity financing, DCLs appear in transactions with debt financing, and LGs mainly appear in transactions with RTFs.

For example, transactions where a large corporate enterprise or other standalone creditworthy entity is the buyer typically do not require ECLs or LGs. In these transactions, balance sheets are robust enough to obviate equity financing and fee backstops. Where debt financing is contemplated, a DCL or other proof of the availability of debt may be—but is not always—provided.

Leveraged buyouts backed by private equity sponsors usually deploy a mix of equity and debt financing, and buyers are typically newly formed acquisition vehicles with no assets. Accordingly, in connection with signing, the buy-side will obtain ECLs, DCLs, and—where termination obligations apply—LGs to give a seller comfort that the buyer has the resources to stand behind its contractual commitments.

• SELLER NOTES

Where seller-backed financing is contemplated, seller notes are always relevant to a transaction.

If the transaction is simultaneous, the debt instrument relating to seller financing must be completed prior to and signed at signing/closing.

In a staggered transaction, there are several common approaches to documentation. Arranged from highest certainty, because all terms are agreed at signing, to lowest certainty, because the bulk of negotiating is left to the interim period, they are as follows: (i) negotiate a form-final version of the seller note prior to signing; (ii) negotiate a term sheet setting out the material terms of the seller note prior to signing, and finalize the note itself during the interim period; or (iii) rely on general descriptions of the seller note appearing in the main transaction agreement and negotiate a final form of the note during the interim period.

Different paths may be appropriate depending on the circumstances, and counsel can help determine a strategy for maintaining deal speed while balancing a transaction’s certainty.

PITFALLS

• OPEN LOOPS

The interplay between a main transaction agreement’s specific performance, injunctive relief, effect of termination, third-party beneficiary, release, and exclusive remedy provisions (among others) with ECLs, DCLs, and LGs must be carefully choreographed to reflect the business deal. All transaction parties must understand what happens in a financing failure.

Typically, among other things, if a transaction fails to close on time due to financing, a seller has two options.

First, if the seller believes the debt financing is actually available, the seller may decide to sue the buyer to force the buyer to obtain the debt financing. (A seller typically will not be permitted to directly sue a buyer’s lenders.) If the debt financing becomes available and the buyer still refuses to close, the seller can then sue to force the equity funding under the ECL. (But a seller will not be able to force equity funding if debt financing is not available.)

Second, the seller can terminate and collect the RTF. If the buyer refuses, the seller can sue under the LG—but not for an amount larger than the RTF and any agreed-upon carve-outs, like for debt cooperation covenant reimbursement.

When drafted correctly, the loop is closed and the caps are real. Meaning, a seller should not be able to sue both to complete the deal and for a termination fee at the same time. In addition, termination fees should serve as actual caps, subject to minor exceptions.

• DAYLIGHT BETWEEN DCL & COOPERATION COVENANT

The debt commitment letter provided by a buyer at signing will sometimes contain a list of information and materials, like pro forma financial statements, that will need to be provided for the debt to fund at closing. It may also require a marketing period.

The terms of the debt financing cooperation covenant must require the target to provide the assistance, information, and materials the buyer needs to satisfy the DCL’s funding conditions. The main transaction agreement’s closing mechanics must account for any marketing period.

Otherwise, the buyer will not be able to obtain the debt financing and could be—at the same time—liable for a financing failure.

• NOT APPROACHING NOTES AS BONA FIDE LOANS

Sellers extending seller financing should approach the financing as bona fide lenders.

When evaluating, structuring, and negotiating a seller note, the process should be similar to other third-party debt financing. This includes: (i) undertaking financial due diligence of a buyer to confirm creditworthiness; (ii) consulting with tax, financial, and other advisors to ensure the note is structured in an optimal way and its tax implications are known; (iii) confirming whether any guarantees (corporate, personal, or otherwise) are warranted; (iv) determining if the note should be secured and, if so, whether intercreditor agreements need to be negotiated with other sources of debt financing; (v) hiring a third-party servicer to manage the loan during its life if the seller does not have professional back-office functions to do so; and (vi) carefully considering what constitutes—and the consequences of—events of default.

Seller financing requires a seller to change hats, transitioning from selling owner to future creditor.