What Does Financing Contingency Mean?
A financing contingency is a condition that allows the buyer to walk away from a transaction if it is unable to secure financing. Much like the purchase of a home, the financing contingency is in place to protect the buyer from any legal ramifications that may arise if it is unable to close. However, unlike real estate contracts, the financing contingency in a company purchase and sale agreement is not as rigidly defined and has no set date when the contingency is waived.
The financing contingency is usually included in the letter of intent (LOI) which will stipulate the date when financing is expected to be finalized (typically not more than a few days prior to close). Sometimes, the financing contingency may refer to specific terms that need to be in place rather than whether the financing can or cannot be obtained. These terms may include securing a specific rate or amortization schedule to provide for the buyer's return modeled in the target's valuation.
Divestopedia Explains Financing Contingency
Since the financing contingency gives the buyer an out, assessing the quality and financial capacity of the buyer is therefore critical. A seller must determine whether the buyer has secured capital to close the transaction, and this review and due diligence should occur well in advance of signing the LOI.
If the transaction is being conducted with a corporate buyer, the seller should review the buyer's balance sheet to determine how much debt the buyer already has, and if additional financing capacity is available. If a financial buyer such as a PE firm is being considered, the seller should review the PE firm's track record of closing transactions, and whether the fund being used has committed capital available and a dedicated banking facility.
There are some buyers including PE firms that look to tie target companies to an LOI, and then go seek the capital to close the transaction relying on the financing contingency as an out. It is best for sellers to stay away from buyers that operate this way.