Every company sooner or later faces a change in its shareholder structure. Over time, shareholder expectations may diverge both in terms of investment horizon and risk-taking. In the case of a minority shareholder, we may end up with a breach of trust on the part of the majority shareholder with regard to his decisions.
More specific, in family businesses, exit is considered when the entrepreneur is planning his or her succession and none of his or her children want to take over the business. In addition, an exit may also be considered when the non-active heirs decide to sell their shareholding after the death of the entrepreneur.
Other possibilities include a shareholder who wants to sell his or her stake in order to take advantage of another, more interesting investment opportunity; or shareholders who see a better future for their company and want to enter into a partnership with a professional investor (private equity, MBI candidate) for this purpose, which results in a (partial) exit.
As soon as there is a shareholder exit, an agreement on the share price must first be reached. The valuation and subsequent negotiations to determine the final price can be very difficult, especially if one of the parties has unrealistic expectations and if no proper prior agreement has been reached between the historical shareholders.
It is always best to avoid such problems, although Deminor has noted that in many companies there are no prior contractual agreements and that price negotiations in such a context become very dependent on the respective (strength) positions of sellers and buyers.
In this article, however, we would like to focus on a second important topic: the financing of the exit or purchase of the stake of a (minority) shareholder. What methods are possible and/or common?
Structuring the transaction according to the type of buyer(s)
In SMEs, the most obvious transaction is the sale of shares to an existing shareholder when there is a group of controlling shareholders. A sale to a third party is a second option when the remaining shareholders are not willing to increase their stake or when the sellers act jointly and sell a controlling stake.
In this case, the buyer (the remaining shareholders or an external buyer) has the choice of acquiring the seller’s shares in its own name or through a company. This choice depends not only on how the buyer holds or wishes to structure its assets for tax purposes, but also on the size of the investment, the financing needs and possibilities.
If the buyer already owns a holding company, he will prefer to acquire the shares through this company. In other cases, a new company will be created for the transaction as a purchase vehicle. The use of a (holding) company as an acquisition vehicle facilitates access to external financing (resulting in a lower equity contribution and a potentially higher return on equity) and also offers a number of tax advantages. The tax-efficient flow of dividends (from cash and surplus earnings) from the holding company facilitates the repayment of the acquisition loan. The disadvantage is that the operating company must still be able to retain sufficient funds to finance its growth and investment needs. However, it can also be argued that this often leads to greater financial discipline on the part of the operating company.
Another way of structuring the operation is to buy back all or part of its own shares, i.e. the company itself buys back the shares of one or more outgoing shareholders. The remaining shareholders then receive a proportionally larger stake and do not have to finance the purchase. If the company does not have sufficient cash, a loan can be taken out to finance the purchase of the own shares. After this transaction, the company can keep, resell or destroy the shares. This has special tax consequences and also requires compliance with strict legal and statutory rules (including equal treatment of all shareholders). Again, the caveat applies: this should not be to the detriment of the company’s growth or business plan. In this sense, the regulations on share buybacks have recently been relaxed.
Direct purchase by a private buyer is also a common structure for buying and selling shares. There are advantages and disadvantages to this option. For a private individual, it is in principle not possible to deduct financing costs (interest on a loan to acquire the shares) for tax purposes. When dividends are distributed, withholding tax must also be taken into account (which can be avoided with a holding company if a number of conditions are met).
Taking out a loan with a bank is the most obvious choice for financing the purchase of shares. Banks usually require an equity contribution of around 25-30%, depending on the risk profile of the underlying company and the creditworthiness of the buyer. Although interest rates have risen sharply recently, bank loans are still one of the cheapest forms of financing.
In order to obtain a loan, the buyer will have to present a well-founded business plan, as the granting of the loan will almost always depend on it. If there is already a business relationship between the company concerned and the bank, this can facilitate the granting of the loan, as the bank already knows the company’s activities and repayment capacity (as well as the background of its shareholders). The financing period for the purchase of shares is usually 6-7 years. If real estate is also included in the transaction, the financing can usually be spread over +/- 10 years.
It is expected that the bank will also require collateral from the buyer and pledge the purchased shares until the loan is fully repaid. In any case, a pledge on the purchased shares offers only limited protection to the bank, as the shares of an SME are not publicly tradable and an auction of the shares is therefore not an obvious way out.
Subordinated loan, mezzanine financing and guarantee arrangements
In recent years, the government has made great efforts to encourage entrepreneurship. Several initiatives have been taken in the three regions; state-owned enterprises have the resources to offer commercial loans or guarantee schemes to entrepreneurs to facilitate acquisition financing. However, again, the rule is that this loan or guarantee scheme is provided as an additional source of finance, in addition to a capital contribution and possibly in addition to a bank loan. In this case, the technique of “subordinated loan” or “mezzanine financing” is usually used. These are more expensive forms of financing because, as a rule, the financing must be repaid only after the bank has been fully repaid, which makes it easier to obtain bank loan approval.
In addition to these public companies, there are also many private funds and entities or so-called “business angels” that offer these alternative forms of financing. In practice, there are different forms of alternative financing tools today. The cost is always determined by the risk. The greater the subordination, the higher the risk and therefore the cost.
Finding a co-investor through a private equity fund
In addition to the forms of financing already mentioned, it is also possible to use an external investor, also known as a private equity investor. They act as buyers and therefore bear the same risk as other shareholders. The entry of a private equity investor requires that the company meets certain criteria, e.g. sufficient size of the investment, good growth potential, high degree of professionalism. It can also provide a solution for a partial buy-out of (family) minority shareholders.
A large number of private equity investors operate via the closed-end fund system. This means that they have a predetermined term. Within a reasonable period of time (5 to 10 years) they want to exit in order to create added value for their own investor group. In this context, private equity investors are often described as sharks with almost exclusively financial motivations. This image needs to be nuanced. Indeed, there are many other private equity investors in the market whose teams or owners come from entrepreneurial families (single family offices). In contrast, they take a long-term view and are well aware of the importance of adding value for other shareholders and the board. These investors can help the company to progress strategically, financially and organisationally.
An departing shareholder can also agree to a deferred payment. This is called a vendor loan. It is the buyer who borrows money from the seller, so to speak, by deferring the payment of part of the price. This is quite different from an “earn out”, which is an agreed additional price on top of the initial share price based on future results. With a vendor loan, the price is fixed but the payment is deferred. However, an interest rate is usually agreed for this, which is higher than the interest on a traditional bank financing, given its subordinated nature. This financing solution will only be possible if the seller does not need money and there is sufficient trust between the seller(s) and the buyer(s).
It is worth mentioning that the buyer can also negotiate a negative earn-out (which will be acquired, for example, if the historical figures are also achieved at least over several future years) and keep part of the share price for this purpose via a vendor loan. In this case, the buyer will also receive interest, but the repayment of the borrowed capital is not guaranteed.
Combination of forms of financing and structuring
In transactions between existing shareholders, a simple form of structuring and financing is usually chosen. Where the transaction is large, and there is little excess cash within the company and among the other shareholders, the seller(s) and buyer(s) may use a variety of financing sources, each with its own rules, terms and conditions. Experience shows that it is worth exploring the different possibilities. A combination of multiple sources is sometimes a wise choice.