Morne Patterson - Mitigating Risks in Business Acquisitions Using Preferred Returns

1. Morne Pa?erson - Mi?ga?ng Risks in Business Acquisi?ons 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 complexi?es and uncertain?es. Safeguarding your interests is paramount and must be one of your biggest focuses. One method that o?en serves as a pragma?c approach to ensure your investment is well-protected is through preferred returns. In this ar?cle I’ll elaborate on the preferred return concept and shed light on their role in safeguarding the buyer's posi?on in a business acquisi?on. Understanding Preferred Returns: A Strategic Safeguard Preferred returns, in the context of business acquisi?ons, are a mechanism designed to priori?se the buyer's interests, par?cularly 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 par?es. Preferred returns are o?en structured as a percentage of the ini?al investment and are calculated annually or periodically, depending on the agreement.

2. Preferred Returns in Purchase Agreements Within the framework of a purchase agreement, preferred returns shield the buyer from poten?al 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 uncertain?es of business performance. Cumula?ve 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 distribu?ons. Non-Cumula?ve Preferred Returns: Unlike cumula?ve 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. Par?cipa?ng Preferred Returns: This approach combines the preferred return with a share in the business's profits. A?er the preferred return is sa?sfied, the buyer par?cipates in addi?onal profits alongside other stakeholders. Preferred returns can be se?led 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 ?mes the sellers own cash flow). Another approach entails the seller gran?ng the buyer addi?onal equity at no cost, essen?ally enhancing the buyer's ownership stake. This method is par?cularly effec?ve if the seller remains a par?al 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 un?l their preferred return is met, a?er which the distribu?on structure could shi? to benefit other stakeholders.

3. Prudence Through Preferred Returns Preferred returns reflect prudent planning and risk management in business acquisi?ons. By embedding these provisions in the purchase agreement, buyers create financial security, ensuring their returns are safeguarded even if the business faces challenges. Nego?a?ng and structuring preferred returns requires careful analysis, legal exper?se, and a clear understanding of the business's financial prospects.