Private equity (PE) firms have many ways of structuring a merger or acquisition deal to entice sellers to get to “yes” in the sale of their business. Each of these structural elements will have a real and significant impact on the actual purchase price a seller will walk away with as well as their rights and obligations post-closing. It’s therefore critical for sellers to closely analyze and understand how structure affects deal outcome from the get-go with any prospective PE acquirer. In this article, we dive into three key structural elements that every selling owner should know in the context of the overall deal calculus so that they can make the best decisions with respect to whether they are truly getting the deal they want in a company sale to PE.
For purposes of this article, we assume that the seller has already established an enterprise valuation for their business. It’s advisable that sellers engage an experienced and knowledgeable investment banker or M&A valuation specialist to assist in the development and negotiation of an accurate valuation on which a purchase price for the business can be based.
1. Payment Structure.
In today’s M&A environment, the payment structure for an M&A sale to PE will almost always consist of some portion of cash and some portion of a deferred and/or contingent payment whether by earnout, rollover equity, or promissory note (or some combination thereof). Too often, sellers bullish on the future prospects for their business and the buyer’s financial wherewithal post-closing view deferred or contingent consideration as almost guaranteed, but the reality is that payment of most deferred or contingent consideration is rarely, if ever, guaranteed and is in fact at risk. The degree to which a deferred or contingent payment is at risk varies depending on the specific structure and requirements agreed to by the parties, and so sellers should look very closely at the terms and conditions placed by the PE buyer around payment of these amounts.
In an earnout arrangement, the buyer agrees to pay the seller a portion of the purchase price upon achievement of specific post-M&A financial milestones or objectives. Our previous article provides a deeper discussion of M&A earnouts, where we touch on common risks to sellers with respect to earnouts, such as prolonged attachment to the acquired company, inability to control achievement of the milestones or financial targets, and the inherent difficulty of calculating the earnout amount.
One component of the earnout that many sellers and their advisors may overlook at the letter of intent stage and in the purchase agreement is the subordination of the earnout to the payment of the acquired company’s senior debt. PE buyers will often require that the acquired company incur substantial debt in the form of a line of credit and other loans in order to finance the PE acquirer’s purchase of the business, as well as for the acquired company’s working capital post-closing. The PE buyer and its lender may then require that the earnout payment be subordinated to the senior debt, meaning that the PE buyer will be prohibited from paying the seller the earnout if the buyer / acquired company is in default to its senior lenders, which can create significant problems for sellers who have earned the payment but are then told they can’t be paid because of the acquired entity’s noncompliance with a financial covenant under their senior loan agreements (and the seller will have no control over these senior loan covenants).
In addition, if there will be an earnout, aside from the subordination issue, it is important to obtain a guarantee either directly from the PE fund or another affiliate entity of the PE that has financial wherewithal to ensure there is an independent source of backstop to pay the earnout if is achieved. Without this, if the PE buyer defaults on paying the earnout, sellers may find they are seeking recovery from an entity with no assets, making it impossible to recover on those amounts.
Seller Rollover Equity Consideration
More and more PE buyers are requiring that sellers “rollover” a portion of the purchase price into equity of the acquired company (or an affiliate of the buyer, such as one of its PE funds). We covered rollover structures in M&A deals in a previous article. As much as 20% (and usually at least 10%) of the purchase price can be required to be rolled over. Some of the more important components of rollover equity structures for sellers to consider include:
- Ensuring the rollover equity is the same class as the equity acquired by the PE buyer.
- Limiting the triggers for a premature buyout or forfeiture of the seller’s rollover equity, such as upon the selling owner’s separation of service without cause. The goal is to allow the seller to hold the rollover equity until the exit event on the same terms as the PE investor given that the rollover equity is in effect just like a cash investment by the selling owner (in contrast to it being a cash-free grant in exchange for services to the company such as one would expect to see with key employees who receive equity but didn’t roll potentially millions of dollars of their sale proceeds as selling founders often do as part of sales to PE buyers).
- Limiting the percentage or amount of payments, such as excessive management fees, to the PE firm that may unduly reduce the amount realizable to the founders as it pertains to their rollover equity.
- Implementing come-along (sometimes called “tag-along”) rights in the event of both full and partial exits to provide the selling owner with the same rights to sell their equity in the event the PE buyer decides to sell some or all of its equity to a third-party.
- Using preemptive rights, which allow the selling owners to maintain their pro rata share of their equity should the acquired company issue new equity (such as to the PE investors or their affiliates) or anti-dilution measures to address the potential for dilution of the selling owners’ rollover without their consent.
2. Employment Agreements for Sellers.
Selling owners typically continue in management employee capacities after the closing. Therefore, employment terms (and often detailed employment agreements) will be expected and important for both PE buyers and sellers. Any employment agreement should address the salary, term, authority, benefits, bonus potential, and severance (if triggered upon a termination without cause) of the selling owners. For more information on post-closing considerations for sellers, see our prior article covering these items.
Sellers need to negotiate appropriate terms like severance upon termination of their employment “without cause” or for “good reason” (not forgetting to also negotiate the meanings of these terms, which can differ dramatically from deal to deal). PE buyers routinely endeavor to negotiate repurchase rights on the rollover equity of sellers in the event of their termination for any reason—normally on less-than-optimal terms. For instance, there could be a payout at a price determined by the management board of the PE buyer which is payable over a period of several years with no collateral.
Sellers should push back on this to ensure they maintain their rollover equity until there is a subsequent exit event by the target. At a minimum, sellers should insist any such repurchase rights would exist only on a “cause” termination (illuminating the importance of having an appropriate “cause” definition that is not open-ended or vague and is attached to an event unlikely to occur, such as fraud on the part of the seller). See one of our previous articles here that utilized a prominent public figure to analyze the importance and impact of “cause” and “no cause” separations and financial ramifications associated with those distinctions (and which also includes important tips when it comes to negotiating the terms of executive employment agreements).
3. Equity Incentive Plans for Key Employees.
In PE deals, both the buyer and seller will want to incentivize key personnel of the acquired company to stay on post-sale. Profits interests are common incentives that help align the interests of a private equity buyer and employees of the target company. Other equity incentive plans include stock options, restricted stock, or bonus pools. These incentive plans are not just for key employees other than founders. In most cases, the selling founders are also eligible to participate in them.
Payment structure, employment agreements, and equity incentive plans for key personnel are critical elements in any M&A sale to a PE acquirer. At Linden Law Partners, we have represented numerous sellers in all aspects of once-in-a-lifetime sale events to PE firms, including for the development and negotiation of the key elements outlined in this article. Contact us today to discuss how we can help.