Equity Contribution: a Worked Example

An acquisition loan is repaid from the earnings of a business the borrower has just bought, often at a price that assumes those earnings will grow. If the price proves too high, someone absorbs the difference. The equity contribution says who goes first. A buyer who has funded a large share of the cost loses that money before the bank loses any, and has every reason to support the business through a bad year rather than hand over the keys.

It also tells the lender something about conviction. A buyer who funds a tenth of the price is betting mostly with the bank's money; one who funds half is betting with its own. Neither is right or wrong in itself, and the level a lender accepts depends on the business, the price and the debt. But the number shapes every other term in the file, from the leverage the bank will offer to the covenants it asks for.

The arithmetic is simple; the classification is where the reading happens. Ordinary shares subscribed for cash count without argument. Rollover, where the sellers or managers take shares in the buying company instead of part of their cash, counts as well: no money changes hands, but the rolled shares lose value first alongside the buyer's.

Shareholder loans are the common grey area. In the buyer's accounts a loan with a fixed obligation to repay is a liability, not equity, under the accounting standards' test of whether there is an obligation to deliver cash. A lender may still count it with the equity if it is subordinated to the bank by deed, pays no cash interest while the bank is owed, matures after the bank, and carries no right to enforce. A shareholder loan that pays cash interest from the first year is debt service by another name. A vendor loan, price the seller has agreed to wait for, is read the same way and divides lenders: some count it when it is deeply subordinated, others add it to debt.

A private investor, constructed for this page like every figure in it, buys a specialist electrical wholesaler with EBITDA of US$6.0m. Its sources and uses table:

The investor's presentation describes the deal as nearly half equity. The lender reads the same table three ways:

Each line is defensible, and each depends on a document. The loan notes accrue interest and are repayable a year after the bank's loan, under a subordination deed the investor will sign at completion; on those terms many lenders would count them. The vendor loan pays 7% in cash from the first year, about US$0.3m a year out of the same cash that services the bank, and the seller can demand repayment if a payment is missed. On those terms it is debt, and the deal is 37% equity at 4.92 times leverage. If the seller agrees to accrue its interest and stand still while the bank is owed, the lender has reason to move the vendor loan up a line.

The equity contribution measures the cushion against the price paid. Leverage measures debt against the earnings that repay it. The two are read together because a high price inflates the first without helping the second. Had the investor paid ten times EBITDA, US$60m, the same US$25m senior loan would leave an equity contribution of about 60% ((61.8 − 25.0) ÷ 61.8). The bank would be no safer: its loan would still be 4.17 times the wholesaler's earnings. A large equity share bought by overpaying protects the bank only if a later buyer would pay the same price.

The contribution also differs from where the money sits. Equity paid into a holding company and lent down to the operating company as an intercompany loan can leave the bank's borrower with more debt than the table suggests, and a bank lending only to the holding company, without guarantees and security from the operating companies, ranks behind their own creditors. Structural subordination is read beside the percentage.

DEFINED IN ONE PARAGRAPH → · VENDOR FINANCE → · DEBT TO EBITDA →

The contribution is a number in the credit paper and a condition in the facility agreement. Before first drawing, the bank asks for evidence that the equity has been paid in, in the form agreed, and for the subordination deeds that make loan notes and vendor loans rank behind it. Where the bank lends on certain funds terms, as it in practice must for a UK cash takeover offer, whose offer document has to carry a third party's confirmation that the cash is available, the equity commitment is checked before the bank commits its own money, because afterwards it cannot easily walk away.

After completion the classification keeps mattering. A distribution lock-up or a restricted-payments clause decides when loan notes and vendor loans may be paid, so that money counted as equity on day one does not leave as debt service in year one. An equity cure, where the agreement allows one, lets the owners put in more later, and the lender reads that as a test of the same conviction the first contribution showed.

CORPORATE LENDING AND CREDIT RISK → · SUBORDINATION, DEFINED → · DEBT-LIKE ITEMS →