Morne Patterson - Mitigating Risks in Business Acquisitions Using Preferred Returns
Acquiring a business is an endeavor that holds promise for
growth and expansion. However, the path to business ownership is not without
its share of complexities and uncertainties. Safeguarding your interests is
paramount and must be one of your biggest focuses. One method that often serves
as a pragmatic approach to ensure your investment is well-protected is through
preferred returns. In this article I’ll elaborate on the preferred return
concept and shed light on their role in safeguarding the buyer's position in a
business acquisition.
Understanding Preferred Returns: A Strategic Safeguard
Preferred returns, in the context of business acquisitions,
are a mechanism designed to prioritise the buyer's interests, particularly in
terms of financial gains. They operate as a way to secure a fixed or minimum
rate of return on the buyer's investment before other stakeholders, such as the
seller or equity holders, receive their share of profits. This structure
ensures that the buyer receives their due returns before any surplus is
distributed to other parties. Preferred returns are often structured as a
percentage of the initial investment and are calculated annually or
periodically, depending on the agreement.
Preferred Returns in Purchase Agreements
Within the framework of a purchase agreement, preferred
returns shield the buyer from potential financial underperformance of the
acquired business. These returns are a contractual commitment from the seller,
adding an extra layer of security for the buyer's investment. While the
specifics of preferred returns can vary based on the nature of the deal,
certain types are commonly found:
Fixed Preferred Returns: This structure guarantees the buyer
a fixed percentage of return on their investment. It provides a steady stream
of income, offering predictability amidst the uncertainties of business
performance.
Cumulative Preferred Returns: In this arrangement, if the
business's financial performance falls short and cannot cover the preferred
return in a given period, the unpaid amount accumulates and must be paid back
to the buyer in the future before other distributions.
Non-Cumulative Preferred Returns: Unlike cumulative
preferred returns, this structure doesn't accumulate unpaid returns. If the
business fails to meet the preferred return in a specific period, the buyer
doesn't accumulate a debt that needs to be repaid later.
Participating Preferred Returns: This approach combines the
preferred return with a share in the business's profits. After the preferred
return is satisfied, the buyer participates in additional profits alongside
other stakeholders.
Preferred returns can be settled through various mechanisms.
One common method involves cash transfers from the seller to the buyer. In this
scenario, the seller commits to providing the buyer with a fixed or minimum
rate of return, disbursed periodically, directly from the business's generated
cash flow (or at times the sellers own cash flow). Another approach entails the
seller granting the buyer additional equity at no cost, essentially enhancing
the buyer's ownership stake. This method is particularly effective if the
seller remains a partial shareholder and benefits from the business's future
success. Some preferred return agreements might include provisions for the
buyer to receive a higher percentage of profits until their preferred return is
met, after which the distribution structure could shift to benefit other
stakeholders.
Prudence Through Preferred Returns
Preferred returns reflect prudent planning and risk
management in business acquisitions. By embedding these provisions in the
purchase agreement, buyers create financial security, ensuring their returns
are safeguarded even if the business faces challenges. Negotiating and structuring
preferred returns requires careful analysis, legal expertise, and a clear
understanding of the business's financial prospects.
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