M&A negotiations don't end at purchase price
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.
If the purchase price is structured with an earn-out, the details of that earn-out needs to be carefully evaluated and negotiated. Earn-outs are a fantastic tool to close the gap between differing seller and buyer valuations, but they place the risk of performance on the seller. When reviewing proposed earn-outs, sellers should focus on the likelihood that they can meet the earn-out goals, who will control the factors that influence whether the goals can be met, and how many numbers or factors involved in the earn-out can be manipulated. For example, will the earn-out be based on revenue or earnings goals? Revenue is a cleaner number that is harder to manipulate, while earnings are subject to many more factors and interpretations. All of these points should be considered and negotiated when an earn-out is part of the deal structure because missing earn-out targets directly impacts the final purchase price.
A portion of the purchase price is typically placed in escrow at the close of the transaction and used to satisfy any post-close indemnification claims or adjustments owed by the seller. The amount of the indemnification can be negotiated at 5% to 15% of the purchase price, and the escrow is usually in place between one and two years. Those are obvious points to negotiate during the letter of intent. But sellers should also define the basics of the baskets and deductibles during the LOI negotiations when the buyer is still anxious to get a deal signed. Buyers will often want the ability to make dollar for dollar indemnification claims against the escrow, but will typically agree to indemnity baskets and true deductibles against those baskets. For example, the basket might be set at $50,000, which means the buyer cannot make claims against the escrow until those claims reach the basket level, then only aggregate claims exceeding $50,000 will be paid. The seller should also negotiate a cap for indemnification that does not exceed the amount of the escrow. These can become contentious points during the negotiation of the purchase agreement, but will go smoother during the LOI negotiation and can save the seller a significant amount of money when everything is settled.
Working capital level
M&A transactions usually set a target for the working capital level expected on the closing date. This level is established to ensure that after the acquisition the company has adequate liquidity to maintain its operations without a cash infusion. Buyers want to set the level high, while sellers want to set it low. Sellers should pay close attention to this term and perform adequate historical analysis on their financials before agreeing to a number. Variations from the working capital target at close result in a dollar for dollar adjustment to the purchase price and can be costly to the seller if they are not given adequate attention during the initial negotiation.
In summary, all of the terms listed above are material financial terms that will impact how much money the seller takes home and keeps when the transaction closes and the dust settles. Paying close attention to these terms during the negotiation of the letter of intent rather than the purchase agreement will result in a better outcome for the sellers.
Steven G. Sprindis, CFA, is managing director for Waypoint Private Capital, Inc.
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