You’ve decided to sell your privately-held business. You’ve refined all your business processes and procedures, and the company financials are all in line. IAG M & A Advisors has had a professional M&A Readiness Valuation performed on your business, established realistic goals and expectations, and designated one of their highly-qualified M&A Transaction Advisors to help you secure a qualified buyer. Now what?
When it comes time to review the various forms of purchase consideration, it is important to understand the various forms and determine which will benefit you the most based upon your personal goals. In some cases, it will be a straight-forward purchase, but in other cases, the terms will be more intricate. Knowing this information will help you at the time you and your advisory team are determining which suitor is the best candidate to succeed you and are negotiating final terms with this buyer and their team.
In the context of an acquisition, purchase consideration is the total payment made by the buyer to the seller based on the agreed-upon value of the business (commonly known as its Enterprise Value) and typically includes both cash and non-cash considerations. Non-cash considerations can include securities, financial instruments, equipment, and other assets that are agreed upon by both parties.
Let’s review some purchase considerations and how they would benefit you.
Cash at Close
Cash at close consideration is self-explanatory. It’s the amount of cash a buyer will pay the seller at the time of closing. This is obviously the most desirable form of consideration for a seller because there will basically be no delay between deal close and receipt of the payment. However, experience has shown that only a very few instances occur where a business purchase will be exclusively a cash-at-close scenario. (Simple explanation: (1) Almost all buyers want or need to leverage their money with the business paying off some part of the purchase and (2) paying 100% of the purchase price upfront puts 100% of the risk on the buyer.)
Deferred consideration can be in the form of an earn out or a seller note. Since deferred consideration is usually paid out with future cash flows of the business, this form of purchase consideration can ease a buyer’s concern over any equity gaps the seller may have. (Simple explanation: (1) A seller note insures the seller has some stake (some might say “confidence”) in the reliable future revenue and profit of the business and (2) an “earn out” scenario is not guaranteed but allows the seller to benefit from the future revenue of the business if it meets the earn out targeted numbers where past business does not justify those additional earn out compensation possibilities.)
An earn out is deferred compensation that is dependent on the business reaching certain milestones, achieving certain performance or retention obligations, etc. Earn outs are not guaranteed payments, which makes them both deferred and contingent.
A seller note essentially means the seller is self-financing all or part of the transaction and involves fixed amounts of cash paid from buyer to seller over a specific period (with interest and payable monthly or quarterly or on some other term). Seller notes are most common in small business transactions since attractive seller financing often translates into a higher selling price than an all-cash deal.
Seller notes are also often used when a business has challenging characteristics – for example:
- There is high customer concentration
- There are additional capital growth needs
- The business is highly capital intensive
- The business is cyclical in nature
- There are unpredictable or seasonal revenue patterns
Amortized Seller Notes: When a buyer is not able to finance an acquisition in full (often because a lender will not provide sufficient capital based on the business’ financials), a portion of the acquisition can be funded by the seller. The buyer repays principal and interest to the seller over a fixed amount of time. This is often referred to as an installment note. The repayment period could be 5, 7, or 10 years (or whatever is agreed between buyer and seller and accepted by the lender) and is utilized to maximize leverage and reduce the amount of required buyer equity. This type of consideration can prove beneficial to a seller in search of residual income and the potential tax benefits of receiving payment over time instead of in a lump sum. Amortized seller notes are also looked upon rather favorably by lenders who can see that the seller still has “skin in the game.”
Forgivable Seller Notes: Much like an amortized seller note, a forgivable seller note requires repayment of principal and interest over a fixed period. The difference is there are trigger events that could make the debt forgivable. An example might be retaining the top three customers for the next two years after closing. As a seller, forgivable seller notes will benefit you most if you have a buyer that is hesitant or less interested. A forgivable seller note consideration serves to mitigate key risk factors for a buyer that could adversely impact the value of the business moving forward.
Practically every small business sale requires a Non-Compete Agreement from the Seller (and, possibly, Seller’s family). This is basic insurance that the Seller will not compete with the buyer for the very same clientele that has been the source of that business’ revenue and profit. These Non-Compete Agreements have a time limit (typically 2 to 5 years) and a distance limit (typically a few hundred miles from the business being sold, but may go wider if the business has clients in a wider geographic area). These agreements also restrict the Seller from any efforts to secure either the clients of that business or its employees for Seller’s future efforts (during the time period of the agreement). This is, of course, a necessary agreement for a buyer to feel reasonably comfortable that the Seller is being upfront about the business and has no intentions of causing it harm in any way.
Often, especially with small businesses, there is a “Transition Period” of some amount of time (from a few weeks to a few months) where the Seller agrees to “educate” the Buyer about the inner workings of the business – to help them successfully operate the business – that is included “without compensation” to the Seller as part of the Purchase itself. This only makes sense, as long as the transition period is reasonable, because the Seller wants the Buyer to succeed and, as is usually the case, to be able to easily pay the Deferred Compensation (whether Seller Note or Earn Out) down the road.
This list is not exhaustive but covers the most often used purchase considerations in the sale of a business. Armed with this information, you will hopefully be better equipped to negotiate terms that meet your personal goals and are favorable to you. IAG M & A Advisors experienced Transaction Specialists will always provide you with guidance on the pros and any cons of each consideration, but it never hurts to know what to expect at the time of negotiations.