It’s easy for M&A sellers to become overly focused on the initial proposed price they see and to become star struck with that figure. However, there are numerous other elements to consider beyond just the price number on the page, some of which can materially impact what sellers actually “net” from the deal. This article examines some of the key elements Sellers should understand and scrutinize up front. By doing so, Sellers will go a long way toward “realizing” their price goals from a sale transaction. After all, a stated number on a page isn’t the same thing as “money in the bank.”
It’s a bit of a myth that private company owners sell their companies, pocket all the cash at closing, and ride off into the sunset to never worry about their business again. There’s typically much more to it than that, and most sellers are likely to be involved with the business after the sale. Selling owners and key employees of acquired private companies almost always play crucial post-closing roles, particularly when selling to private equity buyers. Given this, there are often one or more contingent aspects associated with receiving a portion of the price (and often this contingent portion can be substantial).
With this in mind, let’s look at some key points of consideration that go beyond a generic stated price.
1. What’s the amount of up-front purchase price payable at closing?
One important question that sellers should have in assessing the amount of the cash proceeds they will receive should always be “how much of this does the buyer expect to hold back or ‘escrow’ for some post-closing period”?
Escrows/holdbacks exist for most private company sales. There are typically two forms of escrows/holdbacks: (1) indemnity escrows to secure recovery of losses sustained by the buyer for the seller’s breach of representations and warranties (or other seller obligations or commitments contained in the definitive agreements); and (2) working capital escrows (the price adjusts post-closing, up or down, based on the actual working capital [current assets minus current liabilities] of the seller’s business on the closing date – which is determined and adjusted after the closing).
Sellers should advocate for smaller indemnity escrows for shorter periods. The more money a buyer holds back, or which is escrowed, and the longer the period, the more likely buyers will make claims, whether legitimate or simply given a longer lookback period to assess how the return on investment of their purchase is turning out post-closing. We’ve provided some particulars around what’s market on escrow/holdback periods and amounts in our free 10-point guide for M&A sellers.
In some cases, a seller may be better off with more cash payable at closing (and a smaller escrow) versus a higher overall price where the buyer is insistent on holding/escrowing a material portion of the cash portion of the price. There’s an old expression we’ve come to appreciate over many years of working on M&A deals, which is that “possession is 9/10ths of the law.” Sellers should take heed when it comes to negotiating and agreeing on the amounts and time periods of escrows and holdbacks.
2. Will there be an earnout?
Earnouts in M&A deals provide for a portion of the purchase price to be paid to the seller contingent upon the target company reaching certain financial goals or performance milestones after closing.
Earnouts are typically among the most heavily negotiated provisions in a private company acquisition and are highly susceptible to disputes following the closing. Note that earnout provisions can vary significantly from transaction to transaction. Even so, there are several key issues that should be considered with any earnout, including:
- The financial and/or non-financial targets to be achieved in the earnout. These should be objective, measurable, and clearly defined in the purchase agreement. Examples of financial targets include total revenue, net income, EBITDA, or some other financial measurement that is relevant to the target company’s operations. Non-financial targets may be appropriate when financial targets don’t provide for a relevant measure of a target company’s performance. This may be the case with an emerging technology company that has limited revenue on which to base a financial target; the parties may instead agree on non-financial targets, such as achievement of certain operational or product development milestones.
- The length of the earnout period, the timing of the earnout payments, and the formula for determining earnout payments. These terms are largely based on the financial or non-financial targets agreed upon by the parties as well as, with respect to the earnout period, potential tax considerations for each party.
- The form of earnout payment. The parties must determine if the earnout payment will be made in cash, which is typical, or in some other form of payment, such as the issuance of equity in the buyer.
- Procedures and dispute resolution. Parties should carefully consider the procedures for calculating and verifying any relevant financial target for each earnout payment. In most instances, the parties will agree to involve an independent third party, such as a mutually agreed upon accounting firm, to determine the calculations in the event of any objection to the earnout calculation.
3. Will there be rollover equity?
Rollover equity is the amount of money that a seller is expected to invest (e.g., “rollover”) into the equity of the acquired company. Again, this question involves certain key issues often negotiated by the parties as part of agreements:
- The rollover amount. While 20% is a commonly targeted number, the specific amount is based on various factors, such as the type and amount of other management equity-based incentives being offered to the sellers, the existing equity structure of the target company, the amount of risk the buyer investor believes management of the seller should retain in the post-closing company, the buyer investor’s financing needs in the acquisition, and tax considerations.
- Repurchase rights. Buyers will often seek the right to repurchase a seller’s rollover equity upon his or her termination of employment or services to the post-closing company for any reason. However, because a seller purchases (versus being granted) the equity in the post-closing company through the rollover structure, sellers will typically seek (and should be successful) in eliminating these restrictions.
- Vesting. Some aggressive buyers, particularly private equity acquirers, may want the rollover equity to vest over time, depending on the type and amount of equity rolled over by the seller. But a seller will typically (and should) object to these requirements with rollover structures because the seller has in effect made a capital contribution equal to the value of his or her rollover equity at the closing of the transaction.
- Management rights. The parties may need to determine if the rolled seller equity will have equal voting rights as that of the buyer, and whether the seller will have a right to appoint directors or LLC managers. Typically, the buyer r will maintain control of the board / management, but agreements vary by deal.
4. Will there be employment compensation?
Many selling owners are asked to continue in management after closing to help with continuity. As a result, employment terms (and often detailed employment agreements) will be expected and important for both parties.
The stakes in employment agreements can be especially high if a separation from employment can affect the rollover equity of the seller, or if an employment separation can impact the obligations of the parties related to earnout payments if part of the deal. Sellers should negotiate for severance on terminations “without cause” or for “good reason” and look to avoid the ability of the buyer to repurchase their rollover equity. Buyers, and particularly private equity buyers, will try to negotiate equity repurchase rights based on prices “determined in their subjective discretion” often payable over years with little or no collateral.
Sellers are expected to object to these positions to make certain they will receive the full benefit of the value of their rollover equity—no matter if they’re employed at the time of the second bite at the apple sale. Because the equity rights of sellers will be memorialized in an operating or shareholders agreement, there’s a substantial interrelationship with the employment agreement that should be identified and properly drafted.
5. Who do you look to if you’re not paid?
Of all of the overlooked elements, this is the one most neglected by sellers.
Most buyers set up a special purpose acquisition vehicle when they acquire a business. Often, the true financial wherewithal resides with a parent or holding company. A seller likely has limited control over post-closing management of the finances of the technical legal acquiring entity. Sellers should request a guaranty by the parent or holding entity to make certain that the seller will in fact be paid any contingent consideration earned. This avoids being stuck in a position of attempting to collect from an undercapitalized special purpose acquisition entity.
In addition, many buyers will try to subordinate the seller’s rights to continent compensation to their lenders or other financing sources. Sellers should resist this, and, if forced to be subordinate, understand the exact subordination terms. Sellers who fail to read and negotiate the fine print may find themselves in a provision effectively making their right to contingent consideration (even if earned) subject to the complete discretion of the bank or some other third party creditor.
Remember, the price is only as good as the money that hits your bank account.
It’s easy for M&A sellers to concentrate just on the stated price of a transaction, rather than these important and often overlooked issues that are critical to what sellers will net from the sale.
At Linden Law Partners we specialize in quarterbacking all aspects of M&A deals, and we’ve represented buyers and sellers in hundreds of M&A deals. While there are many common threads among the most successful transactions, we recognize the uniqueness and personal attention required for each deal. Contact us to discuss how we can help.