June 4, 2020
You Name the Price and I’ll Set the Terms
Key Deal Components Beyond the Economics
- There is a lot more to a deal than the purchase price.
- Critical pre- and post-closing terms and conditions need to be understood and negotiated up front.
- Don’t commit to one buyer or investor until all critical details are agreed upon.
As the old saying goes, the devil’s in the details. When it comes to selling a business or introducing third- party investment capital, the details can be far from inconsequential. The purchase price or proposed valuation is understandably the point of focus for most business owners. However, there are multiple other components that can make or break any deal.
Most transactions progress from initial conversations and preliminary proposals, through management meetings and information review, and eventually to a formal letter of intent (LOI). Signing an LOI effectively takes the company off the market, committing the owner – for a set time period at least – to dealing exclusively with a chosen buyer or investor. In terms of having viable and actionable alternatives, this is obviously a key dividing line and should only be crossed when there is high confidence in the buyer and the deal, in all respects.
Cash, Stock or Magic Beans?
First, what form of consideration is being proposed? Not all deals are 100% cash. If shares of stock in the buyer’s entity – or a new entity formed to complete the transaction – are included, what is the value attributed to that equity at closing? Is it reasonable? Also, what liquidity rights and mechanisms are attached to those shares? Assuming the seller stays with the company, what happens to that stock if her employment is terminated, voluntarily or involuntarily?
The buyer also may agree to assume certain financial or other liabilities that the seller would otherwise have to repay, the basis and amounts of which need to be clearly established. If a portion of consideration will be tied to a consulting or non-compete agreement, the terms governing those payments – and the tax implications – should be fully understood.
I’d Gladly Pay you Tuesday for a Hamburger Today
We all recognize that a dollar in hand today is worth more than the same dollar next week or next year. However, seller financing – where a portion of the cash consideration is paid over time as a seller note – is a common component in private company transactions. Sometimes it’s the only way to realize the total value the seller is looking for. That seller note may yield a higher price, but it can look very different depending on the interest rate and the amortization schedule, not to mention the overall capital structure and how much debt sits senior to the note.
Contingent earn-outs represent a form of seller financing that go one step further by tying payments to future financial or operational benchmarks. This form of consideration should be approached with extreme caution because, of course, the buyer is in control after the close. Performance targets need to be clearly defined and ideally align the interests of both seller and buyer.
Staying on the Hook
It often comes as somewhat of a surprise to sellers, but equity risk doesn’t always end at the closing of the deal. The purchase agreement will contain mechanisms for indemnifying the buyer against certain losses going forward. The extent and expiration of these protections, as well as the limits of the seller’s potential exposure, are all negotiated items and can meaningfully impact the profile of the deal. There isn’t much security in knowing, for example, that millions of dollars remain at risk for three years post-closing after management – and shot-calling – has changed hands.
Closely related is any proposed holdback or escrow, whereby a portion of the cash payment is reserved to cover potential indemnification obligations or other adjustments after closing. Again, establish the specifics up front. Determine the portion of the overall price that will be held up and exactly when that cash will be available.
There are a number of insurance products designed to address these ongoing risks. So-called rep and warranty policies can meaningfully improve the economics and risk profile of a deal and have become common in the lower middle market. If included in the transaction, the LOI should define the extent of coverage, limits, exclusions and who bears the cost of the premium.
But Wait…There’s More!
Establish and carefully evaluate any key conditions to closing since these could be landmines laying in wait. Examples include receiving regulatory approval or landlord consents, or the buyer successfully securing bank financing. Knowing what will be required allows a seller to get ahead of the train and manage these variables where possible to avoid last-minute roadblocks to closing.
There may also be mechanisms or conditions that can result in an adjustment to the purchase price at or after closing. The most common is a requirement for a minimum level of working capital to be delivered with the business. Any shortfall would result in a proportionate reduction in the purchase price. While it may not be possible to agree on the net working capital target at the LOI stage, buyer and seller can establish the methodology and the balance sheet components that will be included in the calculation.
Punching the Clock
Many transactions require the seller to stay with the business after closing, at least for a transition period, to ease integration and the transfer of key stakeholder relationships. The buyer and seller should be on the same page regarding role, expectations and compensation.
This transition phase can create a strange dynamic, so some honest self-inquiry becomes appropriate. Imagine yourself working with the buyer – it’s perhaps the first time you have ever had a boss. Are your cultures and approach to business and people compatible? Do you understand their growth strategy for the business? Are you comfortable with it? And while you are being paid well through the purchase price for the company you have built, you should still be compensated fairly for your time and expertise post-closing. Remember however, you will have to eat your cooking if you normalized your salary in the EBITDA that was used to arrive at the purchase price.
A robust and targeted process will produce multiple viable options for an owner considering selling or raising outside equity capital. Executed properly, this horse race will ensure the business commands the maximum value attainable in the market. But there is a lot more beyond the price to flush out when comparing offers.
Most buyers and investors have done many more transactions than a typical seller and advantage is in their court when it comes to the fine print of a deal. Advice from experienced M&A and legal counsel is critical in making sure the deal is right for you before signing that LOI.
For more insights from the series, The Path to Private Company Liquidity: A practical guide to M&A for business owners, click here.