Security for Payments After Closing in M&A Transactions

When it Comes to Payments After Closing in a Business Transaction, It’s Always Better to be Secured Than Sorry

By Delzad Kutky

What is Security in a Mergers and Acquisitions (M&A) Transaction?

When a business is sold, not every dollar of the purchase price is necessarily paid at closing. Deferred payment arrangements often allow buyers to complete acquisitions with less upfront capital while giving sellers flexibility to bridge valuation gaps. Buyers and sellers often agree to vendor take-back financing, instalment payments, or earn-outs that leave part of the purchase price outstanding after closing. While these arrangements can help complete a transaction, they also create an important question: what happens if the buyer doesn't pay?

A seller may think they can always sue for breach of contract to get the money they are owed, but one of the biggest issues in suing for money isn’t actually whether you have a good case, it’s whether the other party has enough money to pay you when you win.

To mitigate this risk, sellers frequently require the buyer to provide security for the unpaid purchase price. Security gives the seller additional rights that may be enforced if the buyer fails to make future payments, improving the seller's ability to recover what they are owed. The appropriate form of security depends on several factors, including the amount of deferred consideration, the buyer's financial strength, the assets of the acquired business, and the parties' respective bargaining power.

When Is Security Required?

Security is typically required where the seller agrees to receive part of the purchase price after closing. This often arises where the seller provides vendor take-back financing, effectively lending part of the purchase price to the buyer. In these circumstances, the seller essentially assumes the role of a creditor and faces the same risk as any lender: that the buyer/borrower may fail to repay the debt.

Security is also commonly arranged where the purchase price is payable over time or where an earn-out is included in the transaction. Even where the buyer is backed by investors or a parent company, the seller may seek security to reduce the risk of having only an unsecured contractual claim if payment obligations are not met.

By contrast, security may be less critical where the purchaser is a financially strong buyer with substantial assets and an established credit profile. Ultimately, whether security is required is a matter of negotiation and risk allocation between the parties.

Common Types of Security

General Security Agreements

A general security agreement (GSA) is one of the most common forms of security in Ontario. Under a GSA, a buyer grants the seller a security interest over all or most of its assets, whether currently owned or acquired after signing the GSA, including inventory, equipment, accounts receivable, personal property, and other business assets.

In Ontario, security interests in personal property are generally governed by Ontario’s Personal Property Security Act (PPSA). To ensure that the seller’s security interest is enforceable and to establish priority over other creditors of the buyer, the seller will usually perfect its security interest by registering a financing statement under the PPSA. If the buyer defaults, the seller may then have the right to seize and sell the collateral set out in the GSA and PPSA financing statement to recover what it is owed, subject to the rights of other creditors with higher-priority security interests.

Share Pledges

A share pledge is another form of security commonly used in M&A transactions. Instead of taking security over the buyer’s assets, the seller would require the buyer to pledge the shares of the company being acquired. If the buyer defaults in payment, the seller is usually entitled to take control of the pledged shares to recover the value of what it is owed subject to the terms and conditions of the share pledge agreement.

A share pledge can be particularly useful where the buyer itself may not have significant assets but the business being acquired holds significant value. This arrangement needs to be carefully prepared to ensure that procedures are specified in the event of default to avoid litigious disputes over what should be an essentially automated process that reduces the need for further cooperation from the defaulting party.

Guarantees and Letters of Credit

Guarantees are another commonly used form of security where a third party agrees to be liable for the obligations of the buyer. A guarantee can come from a wide variety of entities, including the buyer’s parent corporation or the buyer’s individual principal(s).

Guarantees don’t create an interest in any specific assets directly. Instead, they create a larger pool of people the seller can pursue to collect what they are owed. For that reason, the most important consideration for a seller when agreeing to accept a guarantee is whether the guarantor has sufficient assets to recover what the seller is owed.

Letters of credit serve a similar purpose to a guarantee but operate differently. A standby letter of credit is a credit facility created by a financial institution that allows the seller to collect money directly from that financial institution, and the financial institution will then seek compensation from the buyer. For example, a buyer may obtain a letter of credit for $100,000 from their bank (TD, RBC, Scotiabank, BMO, CIBC, a credit union, etc.) and present it to the seller as security for the balance of a purchase price owing from their transaction. If the buyer defaults in payment in the amount of $40,000, the seller can take that $40,000 directly from the bank under the letter of credit arrangement, and the bank will then try to get the $40,000 back from the buyer. This can reduce the seller’s risk significantly as it is backed by a strong financial institution, not the buyer’s own future financial health.

How to Secure Your Interests as a Seller or Buyer

Some transactions may require multiple forms of security (including methods of securitizing obligations that aren’t described above), while others may not need to be secured at all. The appropriate security package will depend on the structure of the transaction, the seller’s risk tolerance, and the bargaining power both sides hold. The parties should also consider existing secured lenders and how the seller's security may affect the buyer's ability to obtain future financing or operate the business after closing.

Properly structured security is an essential part of many private M&A transactions in Ontario involving deferred purchase price obligations. Well-drafted agreements can clearly define risk allocation between the parties and increase the likelihood of a transaction going smoothly, as well as the likelihood of recovery for the seller in the event a default occurs.

The skilled corporate lawyers at SorbaraLAW are ready to help you determine what form of security your transaction may need as a seller, or what key items should be negotiated to ensure operational flexibility as a buyer. Security isn’t an all-or-nothing matter, and there are several key issues to be negotiated and drafted properly. Buyers and sellers need to agree on priority and subordination, limits for guarantees, restrictions on use of collateral, carve-outs, and declining security as payments are made, among other things. Regardless of what side of the transaction you’re on, thoughtful and practical legal advice from our team at SorbaraLAW can help protect your interests.