Is the Stated Purchase Price the Real Deal?
Consider this scenario: the owner has identified the best buyer for their company and they are in agreement with respect to business value. With that said, how will the business value (“consideration”) be paid to the owner? You may have heard the saying: “You name the price and I will name the terms.” In other words, the owner can dictate how much they would like for their company, but the buyer can choose from a myriad of structuring techniques to pay that price. If the owner requests an unreasonably high price for their company, the buyer may be willing to offer that price; however, it will be structured in a way that there is a low probability that the owner will realize the full price.
Owners generally think about consideration in terms of cash paid for their company. In many transactions, the price paid for the company will include multiple forms of consideration in addition to the cash paid at closing. Therefore, the likelihood of achieving and the time to receive each form of consideration must be evaluated to estimate the total transaction value.
The most common consideration in addition to cash is a seller note. Specifically, the owner finances a portion of the purchase price which is paid through the cash flow of the company. Typical features include:
- Term: 5 years
- Interest Rate: Modest to the Prime rate of interest plus 2% to 6%
- Amortization: At maturity or amortization beginning in year 2 or later
- Subordination: Subordinated to the buyer’s senior lender. he subordination agreement allows for the payment of interest provided that the senior credit facility is not in default. Subordination agreements often do not allow for the payment on principal while the senior loan is outstanding.
- Security: The senior lender may allow a second security interest in the assets.
- Personal Guarantees: It depends on the type of buyer and the senior lender’s view of personal guarantees.
The next form of consideration is an earn-out. An earn-out id contingent consideration that is based on the future results of the company. Earn-outs can be useful in several scenarios including i) if the company has made investments to increase revenue or operating cash flow that have yet to mature, ii) there is uncertainty with respect to customer/client retention, iii) the owner has made assertions about the business and its operating cash flow that are difficult to confirm, and/or iv) bridging the owner’s and buyer’s view of value. An earn-out can be tricky based on:
- How it is structured, i.e., the term, if the value is capped, and if the stated value can be earned in tranches or is all or nothing;
- The likelihood of achieving the metric(s) to earn the contingent payment;
- The ease in observing or calculating the metric(s) to determine the value of the earn-out;
- The buyer’s ability to negatively influence the metric(s), and;
- The owner’s involvement post-closing to positively influence the metric(s).
Other forms of consideration include payments for consulting services, payments in the form of royalties for retained intellectual property, and/or above market payments for real estate or equipment leases. In each case, the excess over market represents consideration.
As is evident from the list above, the only firm source of consideration is the cash received at closing. Owners need to ask themselves, “If I only receive the cash at closing, is that sufficient consideration for he sale of the company?” Also, what is the likelihood of receiving the principal and interest from the seller not and, notwithstanding the term, how long will the owner need to wait to to receive the principal and interest? Finally, what is the likelihood of realizing some or all of the earn-out? Were the thresholds established to facilitate receiving the earn-out or were they set unreasonably high to limit the chance of achieving the earn-out? Is the calculation of the metric clear and will the value of the earn-out be obvious or subject to negotiation?
As a side note, the manner in which each form of consideration is paid must be evaluated by a tax specialist to determine its tax treatment, i.e., will it be taxed at capital gains or ordinary income tax rates.
In conclusion, each form of consideration must be evaluated to determine the expected value of the offer, i.e., the likelihood of receiving each component of the consideration. After all, the actual amount and timing of cash received is infinitely more important that the “stated value” of the transaction which may include consideration that will never be received.