Using a Sale-Leaseback to Fund an Acquisition

Sale-leaseback proceeds can fund an acquisition or pay down debt taken on for one. In practice, the real estate comes from one of two places.

• Your own building. You sell a property your company already occupies, lease it back, and use the proceeds as part of the purchase price. The real estate work is independent of the target, and it can be done before any deal is signed, if you are prepared to hold the cash.
• The target's building. The company you are buying owns its operating property, either directly or through an entity owned by the sellers. An investor buys that property as part of the transaction and leases it to the operating company. The proceeds pay part of the price.

The reason this works is that the two assets are valued differently. A business is often priced on a multiple of earnings, and a property on its income and a cap rate, by different investors. Separating them can let each be priced by the buyer who specializes in it. Our guide on selling your company covers the same issue from the seller's side.

In many closely held companies, the owner holds the building personally or in a separate entity and charges the company rent. Then the real estate is not part of what you are buying unless you negotiate for it. There are a few common paths.

• Seller keeps the real estate and becomes your landlord. No sale-leaseback is needed, and you need less capital. You will need a new, longer lease at terms a lender accepts, since a short or informal lease between related parties may not give you the site security you need.
• You buy the building as well, then sell it to an investor. You may need to finance it for a period, so check how the bridge would work.
• Investor buys the building directly from the owner at closing and leases it to the operating company. The seller gets paid for the real estate and you never hold title.

Look closely at any existing rent between the seller and the company. If it is below market, the company's earnings may look better than they will once a market-rate lease is in place. If it is above market, the reverse may be true. Either can change how you value the business.

One M&A advisory explainer sets out three basic sequences, each with a trade-off.

• Pre-closing. The target sells the property and signs the leaseback before the acquisition closes. This takes the real estate off the critical path, but it raises tax questions and can affect price and working capital adjustments. It also leaves the target with a new lease if the acquisition then fails.
• Simultaneous. Property sale and acquisition close together, with proceeds flowing into the closing payments. You get the funds exactly when you need them. The documents are usually conditioned on each other, so a failure in one can derail both unless you have other funding.
• Post-closing. You buy the whole business, then sell the property to an investor. You control the timing and have time to run a real process, but you must finance the full price up front and repay debt later from the proceeds, and you carry the risk that the price is lower than you assumed.

A real estate buyer's diligence does not automatically fit an acquisition timetable. Title, survey, environmental and condition reports all take time, and the investor must also underwrite the company that will pay rent, which may be a newly combined company without a track record. Start the real estate process as early as confidentiality allows.

Debt agreements on both sides of a deal can affect this structure. Law firm Cleary Gottlieb advises checking whether agreements specifically restrict sale-leasebacks or limit them through an asset-sale covenant, whether a sale triggers mandatory prepayment or reinvestment of the proceeds, and how the lease obligation is treated in financial definitions such as leverage ratios and the debt and lien covenants.

Three practical consequences follow.

• Your existing lender. If proceeds must prepay existing debt, they may not be available for the acquisition unless the lender agrees otherwise. Existing financing or liens on the building need to be resolved by or at closing.
• The acquisition lender. It will want to see the lease, and it may have views on rent, term and landlord protections. It may also want landlord documents such as estoppels or subordination and non-disturbance agreements, and these should be negotiated up front.
• Covenant definitions. A lease liability may count as debt for covenant purposes unless the credit agreement excludes it, so that is a point to negotiate in the new credit agreement.

Bring your lender in before you sign a letter of intent with a real estate buyer. Learning about a prepayment sweep after you have committed the proceeds to a purchase price is a serious problem.

Compare it with the alternatives. A sale-leaseback can reduce the equity and senior debt a deal needs, but it adds a long-term fixed payment that rises over time, ahead of your other uses of cash. It is a claim on the company during the same period when you are working through integration and paying acquisition debt.

• ✓After acquisition debt service and rent, what cash does the combined company have in a weak year?
• ✓Is rent at a level the site could support if we later sold the business, or are we inflating price now?
• ✓How long will we actually need this building? Integration can make facilities redundant, so do not sign a long lease on a site you may consolidate.
• ✓Can the lease be assigned if we resell the company? Do not assume it can be without consent.
• ✓Who would guarantee the lease, and does it affect other financing?
• ✓If the sale-leaseback falls through, do we have other funding, or does the acquisition fail too?
• ✓Who pays for deferred maintenance that becomes the tenant's obligation under a net lease?
• ✓Does the environmental report reveal anything that passes to the tenant through the lease?

Confirm all of this with your advisors, since it depends on structure. A sale of the property is generally a taxable event, with gain measured against adjusted basis, and prior depreciation can be taxed differently from the rest of the gain. Lease payments are generally deductible as a business expense. Where the sale falls relative to the business closing, and any pre-closing distributions, can create entity and owner-level consequences, so your M&A and real estate tax advisors should coordinate.

For accounting, a transaction that qualifies as a sale under ASC 842 puts a right-of-use asset and lease liability on the seller's balance sheet. The proceeds fund your deal, but a lease obligation remains on the books. If the sale does not qualify, for example because of most repurchase options or finance lease classification, the proceeds are recorded as a liability and the building stays on the books. Rating agencies may also capitalize leases in their leverage analysis. Ask your CPA to run the numbers before you describe the deal to investors or lenders.

TAG represents the occupier in these transactions, so our focus is on the lease the operating company will have to live with long after the acquisition closes. We run that track alongside your M&A advisors and lawyers, and we coordinate with them on timing.