Deal consideration can come in almost unlimited forms with an even larger list of various structures and options. Understanding the various options available and how such options impact both buyers and sellers is an important component in completing a deal. One area where this is readily apparent is when it comes to choosing between subordinated debt and preferred stock. There are various scenarios where a buyer or seller may enter into an arrangement that includes one, the other, both or some eventual conversion between the two. Here are some general considerations in determining a proper fit.
Benefits of preferred stock:
1. Increases the equity line on the balance sheet
2. Protects companies with high debt to equity ratios from going insolvent
3. Makes the company more attractive to senior lenders, including those issuing junk bonds
Avoiding insolvency is perhaps one of the biggest benefits of issuing preferred stock. Because an insolvent company cannot transfer or divest property or assets without being paid full consideration, remaining solvent by using preferred stock can be extremely helpful. If assets are transferred when a company is insolvent, an illegal act has typically been committed as the creditors have been defrauded.
Typically a seller will prefer subordinated debt over preferred equity as consideration for a sale. There are a number of reasons for this. First, payments on subordinated debt are due whether or not the company has positive earnings (unless some subordinated provisions for some reason state otherwise). Second, a seller’s note could be worth more than preferred stock to the seller if s/he intends to sell it back to the company. Third, some seller notes may hold security interests to the company that–while junior to senior debt–are still one step in front of any stockholders in the event of insolvency.
Similarly, subordinated debt through a note or other instrument has the following key benefits:
1. Interest payments are tax deductible whereas dividend payments from preferred stock are not
2. Debt can allow the buyer to elect pass-through status with an S-corp as long as there is not some reclassification provision that requires the note or debt to be converted to equity. Unlike debt, preferred stock has some tax disadvantages as well.
Seller’s should not have any problem accepting a subordinated note over preferred stock. The hurdle is usually not convincing the seller, it is usually in convincing the other senior and junk bond lenders to allow the company to incur more debt as a seller’s note. If, for some reason, the other lenders reject a subordinated note over preferred stock (this is typically an argument over the company’s value before the time of sale), the buyer may be able to structure a deal with convertible, preferred stock that converts to a note once the company achieves a specific cash flow level or net worth. Furthermore, the buyer may be able to convince the seller to convert the preferred stock to a note after some time has lapsed and some of the other more senior lenders have been paid down a bit.
Deciding on the right structure for your purchase or sale will require a detailed look at the current capital stack, the future expected earnings, tax and the personal desire of both buyers and sellers. There is no one-size-fits-all approach.