What is Proof of Funds?
Proof of Funds (POF) refers to documentation – typically in the form of a letter – confirming that a buyer has sufficient funds to complete the transaction.
How the Proof of Funds Letter Works in Real Estate
The proof of funds document verifies the legitimacy of a purchase offer by demonstrating that the potential buyer has sufficient funds to execute the deal.
To provide a simple illustration, imagine that you are purchasing a house and need to secure a mortgage.
Upon expressing your interest in buying the home, the subsequent step is to provide certain documentation requested by the seller.
Sellers often request a POF letter to ensure the buyer has enough cash available to cover the purchase costs of the home, which can include:
- Down Payment
- Escrow
- Closing Costs
Unless the buyer can prove it has adequate cash, the seller is unlikely to proceed with the sale process.
Here, the buyer would likely share documentation such as:
- Recent Bank Statements
- Letter of Recommendation from Previous Landlords
- Signed Letter from Bank on Liquid Funds Available
- Background Check from Credit Agency
The buyer’s credibility can be assessed by the seller using these documents to eventually determine if the purchase offer is viable.
What is the Role of a Proof of Funds Letter in M&A?
In M&A transactions, a proof of funds letter is conceptually similar but can be much more complex with more moving pieces.
When purchasing a home, a POF letter can be as simple as a bank statement showing the buyer’s account balance. However, in M&A deals where entire companies are purchased, funding often comes from third-party lenders of debt financing.
Hence, this process is much more formalized and time-consuming compared to simpler residential real estate deals (e.g. single-family homes, multifamily homes).
In practically all M&A transactions, there will be an investment bank providing advisory services to the seller – which is called sell-side M&A.
Moreover, upon compiling a buyer list (i.e. the potential acquirers that have expressed interest in participating in the sale process), the investment bank is also responsible for vetting each buyer’s profile, namely its ability to pay.
Similar to the seller of a home, the investment bank seeks to trim the list and filter out any buyers with:
- Inadequate Funding (e.g. Minimal Deployable Capital)
- Bad Creditability (i.e. History of Incomplete Deals)
- No Tangible Progress in Proof of Financing (e.g. Commitment Letters)
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Enroll TodayPOF Commitment Letter: Failed M&A Transaction Cause
On the sell-side, the offer price is one of the main considerations as the process drags on – however, an offer must be backed by documents proving the bid amount can be financed.
Otherwise, the seller might receive an offer (i.e. valuation) that prioritizes that buyer, only to later find out that the buyer does not have enough capital to complete the deal.
In the meantime, other more serious bidders may be neglected because of lower offer prices and may even be removed from the process entirely.
Therefore, to prevent such circumstances that would lead to a “broken deal,” M&A advisors request documentation from all buyers on how they intend to fund the transaction, such as:
- Financial Statements – i.e. Cash Balance in Bank
- Commitment Letter from Lenders
- Appraisals from Independent Accountants and/or Valuation Firms
Failed M&A transactions can be attributable to a lack of buyer interest in the market, among other factors.
Yet one major sell-side risk to look out for is bids from buyers with inadequate funding sources (e.g. cash, equity, debt).
POF Letter and Buyer Profile: Financial vs. Strategic Buyer
When financing acquisitions, proof of fund letters (POF) pertain more to financial buyers because of their increased reliance on debt.
- Financial Buyer: For example, a private equity firm could fund a leveraged buyout (LBO) with 50% to 75% of the purchase price comprised of debt – and the remainder coming from an equity contribution which consists of capital raised from its limited partners (LPs).
- Strategic Buyer: By contrast, a strategic buyer (i.e. a competitor) is more likely to fund the transaction using cash sitting on its balance sheet.
In-depth diligence to verify that the interested buyer has enough funds to complete the purchase is thus more important when more of the purchase consideration is composed of debt.
While the current cash balance of a buyer can be relatively easily checked, their ability to receive future debt financing is not as straightforward to verify.
With that said, a transaction contingent on the buyer receiving financing commitments from lenders is a risk that M&A advisors attempt to mitigate.
Proof of Funds Letter (POF): What are the Pros and Cons?
If debt represents a significant component of the funding structure, financing commitments from lenders play an integral role in developing legitimacy as a prospective buyer.
The buyer must receive a commitment letter from a lender stating that a certain amount of financing will be provided to the buyer to fund the deal.
But the negotiation process lengthens the larger the financing package is, as well as the credit risk of the borrower.
In addition, another factor to consider in M&A is escrow accounts.
Escrow accounts are frequently established in M&A as a preventive risk measure in case there was a breach of the purchase agreement or other undisclosed material issues (i.e. “bad faith”).
Thus, to ensure there are mechanisms in place in case of a potential breach (and/or purchase price adjustment), escrow funds can be agreed upon for the following benefits:
- Seller’s Benefit – The buyer is likely more willing to offer higher purchase prices given that there is money in an escrow account in case any issues arise that lower the value of the company post-deal.
- Buyer’s Benefit – If the seller breached a contractual provision (e.g. overstated value of assets/revenue sources, hidden liabilities/risks), then the buyer can receive some capital as negotiated in the contract.
For all transactions – whether it be real estate or M&A – one of the primary seller considerations is the certainty of closure, which the buyer aims to bolster with the proof of funds.
