Does Your Buyer Really Have Capital in an M&A Transaction? The Importance of Proof of Funds with an LOI

In the world of mergers and acquisitions (M&A), ensuring the financial stability of a buyer is critical to a successful transaction. It’s not uncommon for sellers to receive a Letter of Intent (LOI) from a potential buyer that seems promising, only to later discover that the buyer doesn’t actually have the capital they initially indicated. This issue is especially prevalent with capital-backed independent sponsors who, despite having an impressive track record or backing from capital partners, might not always have the ability to execute the contract they've signed.

Understanding the importance of proof of funds and engaging directly with the buyer’s capital partner can save both parties valuable time and resources, ensuring that everyone involved is on the same page when it comes to financing the deal.

Capital-Backed Independent Sponsors: The Illusion of Funds

Many independent sponsors in the M&A space work with private equity firms, family offices, or institutional investors to fund their acquisitions. These independent sponsors are not necessarily the ones providing the capital; rather, they act as intermediaries who seek and secure funding for deals. While they often have the expertise to identify valuable acquisitions and negotiate terms, their true ability to fund the transaction often hinges on securing backing from their capital partners.

The problem arises when these independent sponsors don’t have the financial capacity to execute a deal on their own. They may approach a seller with an LOI and appear ready to move forward, but if they don’t have direct access to the funds, the transaction could fall through.

Independent Sponsors: Buying a Job, Not Just a Business

It’s also important to understand the unique role that independent sponsors play in the M&A market. While they are technically buyers, independent sponsors are essentially buying a job. They are compensated with a small percentage of EBITDA, typically around 5%, for their efforts in monitoring and managing the business after the acquisition. This is a hands-on, operational role that requires them to stay actively involved in the business to ensure its growth and success.

In addition to their compensation from the EBITDA, independent sponsors also stand to gain when the business is sold. They typically receive a payout upon exit—when the company is sold or goes public—based on their agreement with their capital partner. This aligns their financial interests with the long-term success of the business.

Given this structure, independent sponsors are highly motivated to ensure that the business performs well during their stewardship, but it’s important to recognize that their compensation is not necessarily tied to the immediate financial resources they have available to close the transaction. Rather, their income is often contingent on the growth and eventual exit of the business.

Independent sponsors make up a vast number of buyers in the M&A market, and while they bring valuable expertise and capital efficiency to deals, their ability to execute the deal is often dependent on external funding from capital partners.

Double Due Diligence: A Two-Phase Process with Independent Sponsors

When dealing with an independent sponsor, sellers should be aware that the due diligence process may not be as straightforward as it seems. Instead of a simple back-and-forth between the buyer and seller, you may have to go through a double diligence phase.

Initially, the independent sponsor conducts their own due diligence to vet the deal and prepare it for presentation to their capital partner. Once the sponsor has completed their diligence and made an internal decision, they then need to present the opportunity to their capital partner—be it a private equity firm, family office, or another investor. The capital partner will, in turn, conduct their own review of the deal before they decide whether to commit the funds necessary to close the transaction.

This extended due diligence process can result in delays and additional hurdles, especially if the capital partner’s investment committee needs time to evaluate the opportunity. This may involve multiple rounds of discussions and approvals before the buyer is truly ready to move forward.

For the seller, this means that it’s crucial to understand that this double diligence process can add time and complexity to the transaction. It’s not just the independent sponsor who needs to be convinced; the capital partner also needs to be onboard, and they might have different priorities or requirements that affect the timeline.

Why Proof of Funds Matters

Proof of funds (POF) is a critical component of any serious transaction. For a seller, it's a safeguard against deals falling apart due to lack of financing. When a buyer submits an LOI, it's important for the seller to request proof that the buyer (or their capital partner) has the ability to fund the transaction. This could be in the form of bank statements, letters from financial institutions, or other verifiable documentation that demonstrates their financial capacity.

Without proper proof of funds, there is no guarantee that the buyer can meet their obligations in the contract. In the worst case, a seller could spend months negotiating terms, only to find that the deal falls through at the last minute due to lack of available capital.

The Importance of Talking to the Capital Partner

When working with an independent sponsor, it's crucial to understand that the sponsor may not be the ultimate source of the capital. Therefore, direct communication with the capital partner is essential. By speaking with the buyer's capital partner, you can gauge their interest in the deal and confirm that they are genuinely willing to provide the necessary funding.

Here are a few key reasons why this is so important:

1. Verification of Commitment: By engaging directly with the capital partner, you can ensure that they have vetted the deal and are fully committed to moving forward. This can also give you insight into their decision-making process and timeline.

2. Understanding Capital Availability: Sometimes, a sponsor may have access to capital but not in the form or amount needed for the deal. By confirming the capital partner’s backing, you can get a clear picture of the funding structure, whether it be debt, equity, or a combination of both.

3. Mitigating Risk: In M&A transactions, time is money. A deal that falls apart because of financing issues can waste valuable time and resources. By verifying the buyer's financial capacity early, you can avoid wasting time on buyers who may not be able to execute the deal.

4. Strategic Insights: Talking with the capital partner can also provide you with more strategic insights into how the buyer plans to finance the deal. Are they open to adjusting their funding structure if necessary? Are they considering other financing options like debt or mezzanine financing? These conversations can help you better understand the long-term feasibility of the deal.

5. Redundant Relationships: Given the complex, multi-phase nature of the diligence process, it is also advisable to build a redundant relationship with both the independent sponsor and their capital partner. By staying engaged with both parties, you’ll ensure that you’re not left in the dark about any potential hurdles that might arise on either side.

What to Ask When Speaking with the Capital Partner

If you find yourself in a situation where you need to speak with the capital partner, here are a few questions to guide your conversation:

• What is your level of commitment to this transaction? Can you confirm that the necessary funds are readily available?

• Are there any conditions that need to be met before the funds are released?

• What is your timeline for funding the transaction?

• Are there any contingencies on your side that could delay or derail the funding process?

• Can you share any prior deals that demonstrate your ability to fund similar transactions?

Conclusion

In any M&A transaction, confirming the buyer's ability to finance the deal is paramount to ensuring a smooth and successful outcome. While independent sponsors may seem like a viable option, their ability to close the deal often depends on their capital partners. Asking for proof of funds and directly speaking with the capital partner can provide critical insights into the financial strength behind the deal.

Additionally, understanding the double diligence process and building a redundant relationship with both the independent sponsor and their capital partner will help mitigate risks and prevent costly delays. By doing your due diligence upfront, you’ll increase the likelihood of closing a successful deal and avoid the risk of falling victim to an illusory commitment.

When in doubt, always verify the funding behind the buyer to avoid the risk of a deal falling through at the last minute.

If you need help with the process reach out to Golden Shield Business Brokers and we can help navigate the complex world of M&A. Email Lee Henry at lee@goldenshieldbiz.com