Intercreditor agreements
Article Date: Sep 11 2008
Joe Bedford, Stevens & Bolton
If you’re selling your business for a deferred consideration, you may be asked to sign an intercreditor agreement. Joe Bedford, partner at law firm Stevens & Bolton, looks at the implications of this and how you can minimise the risk of not receiving what you’re owed.
Intercreditor agreements come under many names: they may also be called subordination deals or postponement agreements. They’re generally required by banks or other institutional lenders when they are lending to a company alongside others and want to make sure they stand first in the creditor queue.
Lower-level creditors, such as venture capitalists (VCs) or banks with a smaller stake in the deal, may also wish to confirm their own ranking, behind the bank but ahead of other more junior creditors.
On the face of it, this all sounds pretty standard. After all, senior lenders get a lower return so it seems fair that they take less risk.
The problem is that a full-form increditor agreement will often prohibit payments being made to junior creditors if the senior creditors’ conditions are not met on any payment date. This could include where financial covenants in the senior facility documents have been breached, even where the company is solvent and the bank is still being paid on time.
Why does this matter?
Intercreditor agreements are now commonplace in all forms of transactions, from financings to refinancings to management buy-outs (MBOs). A vendor of an owner-managed business who is considering taking any element of the price by way of deferred consideration should be aware that he will effectively become a creditor of the purchaser, and is likely to find himself not only at the back of the queue behind the banks and VCs, but standing there with his hands and legs tied and a gag in his mouth.
Let’s say the deal is a straight share sale for £10 million, with the offer being £5 million up front and another £5 million over the next two years. There may even be loan notes issued by the purchaser in respect of the deferred £5 million. The purchaser is bank-funded, there are no other financiers involved, and the bank says it wants the sellers to sign an intercreditor agreement.
In this case, ranking second might appear commercially acceptable. However, an intercreditor agreement containing the sort of restrictions outlined above could leave the vendors holding a toothless debt instrument if the bank’s covenants are breached – covenants which the vendor is not in a position to assess at the time of the deal.
What can vendors do about it?
Forewarned is forearmed. Banks tend to get involved in the detailed documenting of transactions at a later stage than the buyer and sellers. If, however, those parties (in particular the sellers) know what is coming they can better assess the risks involved in the deal.
For example, the sellers in the above scenario might prefer to take £8 million up front rather than accept a full-form intercreditor subordination position. Alternatively, good corporate finance advisers will seek to tone down the strict intercreditor position: for example through “standstill provisions”, which allow enforcement of debt by junior creditors after a long notice period.
In the worst case scenario, you may decide that the risks and rewards don’t measure up, in which case you can pull out of the deal before wasting too much money on the negotiations.
In my view, the issue is not one of financiers imposing unreasonable terms or sellers expecting too much. It is about spotting a potential pitfall before it becomes a showstopper – which has to be in everyone’s best interests.
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