The following is a guest post by Katie Smalley, a member of Bass, Berry & Sims PLC. The views expressed are solely those of the author.

When evaluating a potential acquisition, it is essential to consider how the target company and the acquisition structure will fit into the company's existing debt financing arrangements. In addition to analyzing how the target fits into business operations, understanding the key components of existing debt agreements related to acquisitions can help identify potential obstacles early in negotiations and facilitate a smooth closing.

In most debt financings, there are typically four main components related to acquisitions:

  1. Acquisition Restrictions and Requirements
  2. Incurrence of Debt Restrictions
  3. Pro Forma Target Financial Integration
  4. Additional Collateral Commitments and Joinders

Below is an overview of each component and how CFOs can work with legal counsel to anticipate pressure points in a potential acquisition.

Acquisition Restrictions and Requirements

Debt financings vary significantly in how they address acquisitions. Some provide borrowers with broad rights to make various acquisitions, while others may require lender consent even for small transactions. Therefore, understanding how your financing arrangement handles acquisitions is critical to identifying potential issues early.

CFOs can work with legal counsel to identify acquisition-related requirements typically embedded in "investment" covenants and gain a comprehensive understanding of how to execute a proposed transaction within the existing financing framework. Some financing arrangements impose single or aggregate caps on acquisition consideration, which may be based on the financing term or annual periods. Long-term monitoring of the usage of these "baskets" is essential.

Even in more borrower-friendly agreements, financings typically require notice of material acquisitions and the provision of pro forma compliance certificates. Paying attention to the timing and content of such notices is critical, especially when a transaction is progressing quickly.

Incurrence of Debt Restrictions

If the acquisition involves any form of deferred consideration (such as seller notes, earn-outs, or purchase price holdbacks), it is essential to understand how these obligations fit into the existing financing. Most loan agreements treat these payment obligations as "debt" and therefore subject to the restrictions of the debt financing agreement.

Identifying this "hidden" debt early helps provide a clear understanding of lender expectations. Even where permitted, such debt is typically capped and must be subordinated to the senior financing. Understanding these limitations helps manage seller expectations during negotiations.

If the senior financing includes leverage ratio tests, it is also important to assess how deferred consideration will affect these covenants. Although earn-outs are typically only included in leverage when earned and payable, negotiating an appropriate earn-out structure from the outset is critical to maintaining future covenant headroom.

Pro Forma Target Financial Integration

For financings with financial covenants (such as leverage or fixed charge coverage ratios), it is essential to understand how the target company's financials will be incorporated into future covenant testing. Even in financings without financial maintenance covenants, leverage calculations can affect pricing and flexibility events based on leverage metrics.

Most negotiated financings allow for the target company's assets and EBITDA (including historical performance) to be included in testing on a "pro forma" basis. However, integrating target financials can be challenging, especially when the target does not follow GAAP. Obtaining quality of earnings reports during due diligence can support more accurate financial modeling and pro forma adjustments.

It is also important to consider which acquisition-related EBITDA add-backs your credit agreement permits—such as cost savings, synergies, and transaction expenses—to more accurately project the combined entity's financial performance. Utilizing appropriate acquisition-related EBITDA add-backs will present the most favorable financial metrics under your senior debt financing.

Additional Collateral Commitments and Joinders

After closing, it is easy to overlook post-closing requirements such as adding new entities as credit parties and pledging newly acquired assets. Understanding these obligations in advance helps avoid technical defaults due to missed deadlines.

Most financings require that any wholly-owned subsidiary—whether acquired or newly formed—become a credit party. This applies to both equity acquisitions and asset deals, where new acquisition vehicles may be formed. If the credit agreement does not include a standard joinder form, legal counsel can coordinate with lender counsel to prepare the necessary documents.

Even if no new entities are involved in a particular acquisition, financing documents typically include obligations to provide documents and possessory collateral over newly acquired assets to protect the senior lender's security interest.

Carefully review any financing documents (particularly the security agreement) to understand whether there are requirements to provide: (1) information and pledges of newly acquired intellectual property; (2) landlord waivers for additional leased locations; (3) control agreements for new deposit accounts, which are the most common types of deliverables in acquisitions.

Carefully considering early in the acquisition process how a potential acquisition fits into the company's existing debt financing will enable you to proactively identify and address issues. Working with legal counsel and maintaining open communication with lenders can streamline the negotiation process and contribute to a successful closing.