Jul 30, 201512:34 PMOpen Mic
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M&A negotiations don't end at purchase price
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In our roles as investment bankers, the professionals at Waypoint Private Capital have the opportunity to discuss mergers and acquisitions with many business owners. During those discussions we find that almost the only topic business owners are interested in is the purchase price for their company. Purchase price is certainly the most important term when selling a company, and it is always one of the defined terms in a letter of intent, but there are many other important terms that sellers need to be aware of and negotiate carefully, because they all impact how much money the seller will put in their pockets at the end of the day. The following terms should be carefully negotiated before the letter of intent (LOI) is agreed to.
The sale of a business can be structured as a stock sale or asset sale. The legal structure is important to the seller because it has tax and liability implications that will impact the amount of money the seller receives and keeps after the sale. If the transaction is structured as a stock sale (or partnership sale), the proceeds of the sale will generally be taxed at the lower capital gains tax rate and can lead to a significant tax savings for the seller. Conversely, asset sales are typically taxed at the higher ordinary income tax rate, and in some cases result in double taxation when the proceeds are distributed. Stock sales also pass all known and unknown liabilities of the company to the buyer, whereas asset sales pass none of, or only specific, liabilities to the buyer. For those reasons, structuring a transaction as a stock sale is more favorable for sellers, while structuring the transaction as an asset sale is more favorable for buyers. Despite these divergent interests, only 30% of private deals are structured as stock sales because most buyers just refuse to assume the unknown liabilities of companies they are acquiring. Nonetheless, this is not a throw away term when negotiating a transaction and should be negotiated seriously. If the seller must agree to an asset sale they should use it as leverage to gain favor on another contested term.
Structure of purchase price
The purchase price offered in an acquisition might be a straightforward all-cash-at-close offer, but more times than not will be structured in a way that is difficult to reconcile with the seller’s valuation target. If a seller’s target is $22 million, which of the following purchase structures is closest to the target:
- $20 million purchase price, structured as 100% of the price paid at the close of the transaction;
- $23 million purchase price, structured as $18 million paid at the close of the transaction and the remaining $5 million issued as a note, which is payable to the seller over the next five years; or
- $25 million purchase price, structured as $15 million paid at close and $10 million paid over the next three years as an earn-out to be paid only if certain conditions are met.
There is no easy answer to the question because there are many factors affecting the last two structures. There is no risk in the offer that pays everything at close, but it is the lowest overall purchase price. The second alternative, with the seller note, looks interesting because the offer is higher and the payment is not contingent on anything, but what if the buyer gets into financial trouble and cannot make the required payments? The third offer, with the earn-out, has the highest overall purchase price, but how much risk is there in reaching the earn-out targets? What if there is a major disruption in the economy, industry, or management team?
Modifying the structure of the purchase price is a tool that can be used by both buyers and sellers to reach valuation targets and manage risks. Sellers just need to be very aware that any portion of the purchase price not paid at close is at risk, so they must consider whether they are willing to accept those risks, and how much they need to be compensated for taking the risks.