Over the past year or so, the credit crisis and economic downturn have impacted many sectors, including the mergers-and-acquisitions market, which involves purchases and sales of companies.

Historically, acquisition financing (that is, bank debt) has been one of the primary means for a buyer to finance an acquisition of a company. However, as banks have tightened their lending standards, buyers and sellers have been required to further explore alternative strategies in the absence of sufficient bank debt to support a particular transaction. To reconcile this financing gap, parties are increasingly turning to several alternative financing strategies - including the use of seller notes, earn-outs and rollover equity.

Seller notes

Seller promissory notes, in which the seller of a company provides financing to the buyer to fund a portion of the purchase price, have become the leading form of alternative financing. In a recent survey my firm conducted, 72 percent of respondents said they look to seller financing as their preferred method of alternative financing. The remaining respondents were evenly divided between earn-outs and rollover equity.

Seller financing in a transaction allows buyers to raise less bank debt and less equity financing. In certain cases, the use of a seller note can give the seller more certainty of closure and, sometimes, a higher selling price. Also, sellers are often able to negotiate favorable interest rates on their seller notes.

However, with seller notes, sellers receive less capital up front relative to an all-cash sale, and the seller carries the risk associated with the ability of the company to fulfill its payment obligations on the seller note. Also, seller notes are not typically secured, so they will rank junior in payment priority to the company's senior and subordinated debt. Consequently, sellers need to be cautious when considering the inclusion of a seller note as part of a sale price. Nevertheless, a seller's cooperation and willingness to work with a good-faith buyer on seller financing for a portion of the purchase price will often improve the chances of success in reaching an agreement on the funding of the purchase price.

Earn-outs

Parties may also be able to increase the likelihood of closing a deal by agreeing to an earn-out component for a portion of the purchase price.

An earn-out arrangement often helps the seller and buyer reach a compromise on what they feel the company is worth. Here, the buyer often pays a lower up-front purchase price, and the parties agree on a formula for future payments to the seller based on certain financial milestones being met following the closing. Buyers will typically not pay for potential up front anymore, but they will often pay for potential realized post-acquisition.

The primary downside to earn-outs can be the complexity in negotiating and documenting them. It is important that the parties involved clarify, in detail, the precise benchmarks against which the earn-out will be triggered. The earn-out provisions in the purchase agreement should state (1.) whether the financial benchmark is measured against EBITDA (earnings before interest, taxes, depreciation and amortization), revenues, sales, etc., in addition to providing for contingencies such as future acquisitions, changes in accounting practices, allocations of overhead among affiliated corporate groups, and a sale of the business during the earn-out period; (2.) the term of the earn-out period and the payment cycle; and (3.) whether the seller will be able to look back to previous years, if a future year during the period of the earn-out is successful.

The parties will also need to agree on reasonable procedures for the seller to be able to verify that the earn-out payments are calculated properly. Despite the tension that usually exists between buyers and sellers during the earn-out negotiations, if structured correctly, an earn-out can be a win-win for both parties.

Rollover equity

Sellers may also participate in acquisition financing by rolling over a portion of their equity in the target company. Similar to earn-outs, with rollover equity, buyers are concerned with post-acquisition value; therefore, the parties may prefer rollover equity to lower the amount of cash the buyer needs to come up with at closing and provide the seller with potential future compensation.

Rollover equity is often used in transactions where the former owners of the selling business are likely to be involved in some managerial or consulting capacity following the closing of the sale of the company to the new buyers.

Typical rollover equity percentages usually provide the seller with 10-20 percent equity of the company following the closing. A seller that endorses the strength of its business should consider the use of rollover equity. At the very least, the seller will often be able to obtain future liquidity and continue to capitalize on the success of the business going forward.

Sellers receiving rollover equity should consult with their advisers to ensure that any applicable tax concerns associated with the rollover equity are properly addressed, and that the legal documentation includes appropriate investor protections for their minority equity interest in the company following the closing.

While no one has a crystal ball as to the speed and strength of the economic recovery, buyers and sellers will be able to succeed at transactions if they remain flexible during negotiations, adjust their thinking on deal structure, and mutually explore the best alternative financing strategies for the particular transaction. Appropriate use of some of these alternative financing strategies may enable parties to continue to successfully pursue their desired transactions even during these turbulent economic times.

John Koeppel is a partner in the business and private-equity groups of Nixon Peabody LLP, and can be reached at jkoeppel@nixonpeabody.com. Three other Nixon Peabody attorneys, Dominick DeChiara, Ronelle Porter and Paul Dimoh, assisted in the preparation of this column.