Financing the Purchase

Types of Security

It is often the case that business purchase transactions are difficult to finance (or to fully finance) through conventional institutional lenders. As a result, vendors of businesses who wish to obtain full value for their assets or shares must often provide some or all of the financing themselves, through deferral of a portion of the purchase price or vendor financing. Vendor financing can be beneficial for both the purchaser and the vendor. The purchaser has the benefit of obtaining financing that he or she may not be able to get from institutional lenders and if structured properly (e.g., if the purchase agreement permits), the set-offs from financing repayment may give the purchaser a remedy for undisclosed liabilities and vendor misrepresentations. The vendor has the benefit of being able to obtain full value for the assets or shares being sold, with interest (often at rates above conventional lending rates) and depending on the type of security in place, of being able to “foreclose” against known assets in the event of default.

If you represent the vendor-financier, recommend that your client seek tax advice. For example, if a transaction is not properly structured, a vendor may be liable to pay capital gains tax in respect of the sale prior to having actually received all the sale proceeds (as the financing is repaid over time). There may be various ways to structure the transaction in order to ensure the most beneficial tax result.

Whether the purchaser obtains conventional financing or the vendor provides financing (or a combination of both), the purchaser’s obligation to repay the financing will almost invariably involve security, using one or more of the following:

  • a general security agreement (GSA) against personal property (non-land assets of the company or of the purchaser);
  • an escrow agreement under which the subject shares are held in escrow until the purchase price is paid;
  • a personal guarantee by the principal of the purchaser or another party (such as a relative); and/or
  • a mortgage against any real property (land) owned by the purchaser.

Part of the negotiation of the vendor security will involve settlement of the priority that vendor security will have in relation to bank security that the purchaser or business may also require for operational purposes.

1. Chattel Security over personal property (either a General Security Agreement or Specific Security Agreement)

The most common form of security in business purchase transactions is the security agreement (what used to be called a chattel mortgage or debenture). Security agreements can be either general (charging all of the personal property of the grantor) or specific (charging particular assets such as vehicles, valuable pieces of equipment, etc.). Under the Personal Property Security Act a financing statement must be registered in the Personal Property Registry in respect of any security agreement in order to protect the vendor’s interest in the personal property of the grantor and the priority of the charge, unless the secured party is in physical possession of the affected chattels.

Security agreements can be structured to secure only a specific obligation (for example, a promissory note for the balance of the purchase price delivered on closing) or they can be expressed to secure all of the purchaser’s obligations to the vendor, present and future, direct or indirect. Where a security agreement secures all obligations it will generally not specify a principal amount.

Where both conventional bank financing and vendor financing are involved in a transaction, generally the bank will insist upon its security ranking in first position and may require the unpaid vendor to sign a priority agreement under which the vendor’s security is postponed to the bank. In these situations, care must be taken to ensure that there are limits on the amount of credit that the bank can secure ahead of the vendor and that the vendor retains the ability to take steps to enforce its security should default occur.

Appendix H contains a sample general security agreement.

2. Escrow Agreement

Using an escrow of shares as security for the unpaid purchase price can allow the vendor to take back the shares of the company in the event of default. Until that happens, the purchaser has all rights of ownership, including the right to receive dividends and to vote. The shares of the company are registered in the name of the purchaser and the share certificate is then endorsed in blank for transfer and placed with a third party (the escrowholder), who holds the share certificate in trust on certain conditions (often the solicitor for the vendor acts as escrowholder). The escrowholder is directed to hand over the shares unconditionally to the purchaser when the obligations due the vendor are satisfied. In the event of a default, the escrowholder must go through certain procedures that end in the delivery of the shares to the unpaid vendor as the vendor’s property again. Escrow is often seen as weak security because of the potential of the purchaser ruining the business while under its control and leaving little for the vendor to repossess. However, in some industries, such as the purchase of taxi licenses, escrow is regarded as a standard and satisfactory method of security.

Where the solicitor for one of the parties is acting as escrowholder, the escrow agreement must provide for the solicitor to be able to continue to act for his or her client in the event of a default and to be able to interplead the shares into court if there are competing claims to them. Other terms that are recommended include promises by the purchaser and the company not to sell, mortgage or dispose of the shares or company assets (other than inventory in the course of business) without the consent of the vendor, borrowing restrictions, dividend restrictions, salary restrictions, loan or guarantee restrictions, management restrictions, etc., and to allow the books to remain open for the vendor to monitor the company’s financial status.

Since the escrow agreement creates, in substance, a security interest in the subject shares, it must be registered under the Personal Property Security Act as a security agreement to preserve the secured party’s rights. The anomalous situation with escrow agreements is that both the vendor and purchaser have claims to the subject shares, so two financing statements should be registered, the first listing the vendor as the secured party, and the purchaser and escrowholder as debtors; the second naming the purchaser as secured party and the vendor and the escrowholder as debtors, with the collateral description in both describing the shares and share certificate numbers.

Appendix I contains a sample Escrow Agreement.

3. The Personal or Corporate Guarantee

Where the purchaser of the business is a newly-incorporated company, vendors will usually want a personal guarantee from the principal of the purchaser company. If the principal is also of limited means, then additional personal guarantees from other parties, such as relatives of the principal, may also be obtained.

In a share purchase transaction, the target company (the company whose shares are being purchased) may also provide a guarantee of the purchase price, which can then be secured by the target company granting a real estate mortgage or security agreement over its own assets. This structure can provide vendors of shares with some assurance that the company will not be gutted of assets before the full purchase price has been paid.

Vendors who are asked to accept personal guarantees should look critically at the guaranteeing party and ensure that there is value to support the guarantee. For example, the principal of the purchaser may provide a personal net worth statement which lists a residence as an asset, but when you search the title to the property you discover that it is in fact registered in the name of the principal’s spouse or jointly with his or her spouse, with the result that the property may be of limited value in enforcement proceedings. In that situation it may be necessary to insist upon a further guarantee from the spouse and possible registered security over the real estate.

The enforceability of personal guarantees can be limited by a number of factors, including personal bankruptcy of the guaranteeing party.

If you are acting for the purchaser (or principal) who is being asked to provide the guarantee, ensure that your client is fully aware of all of the implications of granting the guarantee for his or her other assets in the event the guarantee is called upon. In particular, ensure your client understands that his or her obligation will not in most cases be limited to his or her proportionate interest in the business and that the secured party will be entitled to pursue him or her for the full amount owing even where there are other shareholders or guarantors of the same debt. Where possible, try to negotiate limits on the amount recoverable under the guarantee in order to ensure that the guarantor with the deepest pockets is not singled out for liability.

Appendix J contains a sample Guarantee.

4. Mortgage Against Real Property (Land Title Office mortgage)

Much like a security agreement, a purchaser can provide security by way of a mortgage over real estate owned by the purchaser (such as his or her residence) or where land is owned by the target company or is among the assets being purchased, a mortgage over that land can be granted by the purchaser (or by the target company in a share purchase transaction, as collateral security in support of a guarantee by the target company of the unpaid balance of the purchase price).