Blinded by the Price: From Enterprise Value to Net Payment at Closing
In the sale of a business, the difference between headline purchase price and net payment to the equityholders can be significant. Seller may have negotiated an attractive multiple to determine enterprise value, but there is often more to calculating the net payment than applying ownership percentages to that enterprise value. The deal may call for a rollover equity stake, or perhaps an earn-out or other deferred payment of purchase price. Many transactions involve purchase price adjustments and indemnification escrows or other holdbacks. A portion of the purchase price will also likely be used to pay off pre-closing indebtedness, returns on preferred stock and other debt-like items. There may be transaction bonuses or other payments to employees due in connection with the deal. And do not forget investment banker fees and other advisor expenses.
Each of these deal-specific amounts may come off the top before equityholders get paid. An experienced mergers and acquisitions attorney can help you understand and document whether certain items should (or should not) be paid at closing. This summary is generally written from the perspective of seller’s counsel. For simplicity, I also assume (i) the target is a domestic U.S. corporation, (ii) the target’s board of directors and shareholders have each unanimously approved the sale transaction, and (iii) the sale transaction is structured as a direct purchase of at least a majority of the equity interests in the target. Many of the considerations described in this summary also apply to transactions structured as mergers or sales of assets.
The following summary is illustrative only and does not purport to be a full description of each and every issue or consideration for successful completion of a sale transaction. Every transaction is different and seller should seek the advice of a licensed, qualified attorney in connection with any potential transaction.
Headline Purchase Price: Just a Starting Point
After a non-disclosure agreement, the first document that is usually negotiated in connection with a potential sale transaction is called a “letter of intent” or “term sheet” (an “LOI”). LOI’s are usually non-binding, except for certain specified provisions (like exclusivity, expenses and governing law). An LOI is most often a roadmap for the proposed transaction, rather than a final expression of the parties’ proposed terms. While the LOI can and will vary from deal to deal, the first dollar sign usually appears near the beginning – that dollar sign relates to the headline purchase price.
The headline purchase price (as its name implies) is meant to grab the attention of seller. Seller has worked hard to build the business and the decision to sell can be life-changing. Buyer wants to lead with the largest number available. And while the headline purchase price is an expression of the overall transaction value (sometimes called “enterprise value”), it can be a bit misleading. Very rarely will the net payment to the equityholders at closing equal the headline purchase price.
Rollover Equity: Skin in the Game
In some transactions, buyer purchases less than 100% of the total equity ownership of the business at closing. There are a few primary reasons for seller retaining a rollover equity stake.
If seller is a key employee who will remain with the business after the closing, buyer will commonly want to align seller’s interests with their own. This retained equity position, like other forms of equity incentive compensation, motivates seller to continue working hard for the business because the success of the post-closing business directly translates into additional value for seller.
In some cases, seller, not buyer, proposes a rollover equity stake. Seller may see significant upside (either for monetary or sentimental reasons) in continuing to own a piece of the business, even without an active role after the closing. The rollover stake may be part of a tax planning strategy of seller, such as installment sale treatment. In either case, the rollover stake may be held until some future liquidity event or sold off to buyer in one or more subsequent sales.
Whether seller should accept (or ask for) a rollover equity position is a case-by-case analysis. Rollover stakes typically come with certain negotiated rights and obligations that govern seller’s continued equity ownership and vary based on the size of the rollover position. In all cases, rollover equity must be properly structured to avoid undesirable tax treatment or other unintended consequences.
Seller should be aware, though, that the value of any rollover equity position directly reduces the cash consideration paid at closing.
Seller Financing and other Deferred Purchase Price: Timing is Everything
Even in the sale of 100% of the equity ownership of a business, the purchase price may not be paid in full at the closing. Receipt of any deferred purchase price may be assured, or it may be contingent on the business meeting some performance goal or other metric. But, like a rollover equity position, any deferred purchase price directly reduces the cash consideration paid at closing.
The most straightforward example of deferred purchase price is a seller-financed transaction where some or all of the purchase price is paid by delivery of a promissory note. The deferred purchase price is essentially a loan from seller to buyer in the amount to be deferred, which reduces the cash consideration paid at closing. A note is typically unsecured and bears interest. Depending on the creditworthiness of buyer, it may be guaranteed by a creditworthy affiliate of buyer or backed by a letter of credit from a bank. Even unsecured notes typically provide for acceleration upon a further change of control transaction or other customary events of default and grant seller certain creditor rights.
Another common form of deferred purchase price is called an “earn-out”. At its core, an earn-out is contingent purchase price that will not be paid to seller unless some goal is met or event occurs1. The parties have significant flexibility in structuring the earn-out and the triggers for payment. An earn-out could be based on the overall performance of the acquired business by comparing revenue during a defined period to a threshold amount. Or the earn-out could relate to the success of a single product or business line and be paid (like a royalty) on each unit sold. Still another type of earn-out ties to the business securing an anticipated customer contract or a product obtaining regulatory approval and going to market.
Earn-outs are commonly used in several situations. Where seller is a key employee with an ongoing role, an achievable revenue-based earn-out can serve the same purpose as a rollover equity position by motivating seller to continue working hard for the success of the business. An earn-out (whether tied to a specific event or some performance metric) can also bridge a valuation gap where buyer and seller disagree on the enterprise value of the business as of the closing. An easily-achievable earn-out can also provide payment flexibility by functioning much like true seller financing.
In any event, a properly structured earn-out should be unambiguous about the trigger to payment, and contain meaningful restrictions on buyer’s ability to actively frustrate seller’s ability to achieve it. It also must provide for payment timing that considers both desired tax treatment and appropriate risk allocation among the parties.
Purchase Price Adjustment: Delivering a Functioning Business
Many LOIs contemplate that seller will deliver a “cash-free, debt-free business, with a normalized level of working capital” or that the “purchase price will be subject to customary adjustments for net working capital and indebtedness”. These few words often become source of the most contentious parts of negotiating definitive documentation. Like its name implies, the purchase price adjustment will increase or decrease the overall purchase price to reflect the actual financial condition of the as-delivered business.
Cash-free and Debt-free
The “cash-free” aspect is straightforward enough. Money is usually fungible, and buyer typically does not want to pay for cash. While some level of “required cash” sufficient to cover immediate operation may be left in the tills, seller is typically permitted to remove and distribute excess cash from the business prior to closing. Regardless, buyer typically pays (through a positive adjustment to the overall purchase price) for any cash that is left in the business by seller.
“Debt-free” seems simple as well, but generally requires more effort to unpack. Buyer typically expects the target to be delivered free and clear of liens and other encumbrances. Buyer also typically does not want to assume the business’ outstanding indebtedness for borrowed money and most other types of indebtedness. Nor will a third-party lender agree to release any liens on business assets before the applicable loan is repaid in full. As a result, outstanding indebtedness for borrowed money and all other types of indebtedness are almost always repaid at closing by buyer (on behalf of seller) from a portion of the cash consideration. Any indebtedness that cannot actually be repaid typically reduces the purchase price as a dollar for dollar negative purchase price adjustment to reflect that such indebtedness is assumed by buyer.
Net Working Capital
Delivering the business cash-free and debt-free is usually uncontroversial. What makes purchase price adjustments so contentious is the meaning of “normalized level of working capital”. Without getting into the accounting aspects of the analysis, the net working capital balance of a business compares certain assets and liabilities on balance sheet. On one side of the calculation, a business typically has cash and cash equivalents, accounts receivable, prepaid expenses and other “current assets” on its balance sheet. Offsetting these current assets are usually accounts payable, accrued expenses, accrued payroll and other “current liabilities” of the business. Net working capital, for sale transaction purposes, is therefore (x) the sum of all agreed-upon “current assets”, minus (y) the sum of all agreed-upon “current liabilities”. This net working capital is then compared to an agreed-upon “target working capital” (usually based on some trailing average of historical net working capital) to determine the working capital adjustment. Seller and buyer thus have to agree on (i) what to include in “current assets” and in “current liabilities” and (ii) how to calculate target working capital.
Regarding how to calculate “current assets” and “current liabilities”, there may be certain items on the balance sheet which are not appropriate to include in “normalized” net working capital. For example, a particular account receivable may be extraordinary (such as a receivable from an affiliate or a non-collectible receivable from a bankrupt customer) or a prepaid item may be something that buyer will not get the benefit of following the closing (such as a security deposit under a lease that is not being assumed). Or a particular liability may be more appropriately included in “indebtedness” than “current liabilities” (like an upcoming payment of deferred purchase price from a previous acquisition) or may be a one-time, non-recurring event (such as a tax penalty). Any of these items, if included in the equation, could skew not only the calculation of net working capital at the closing, but also result in a target working capital that does not accurately reflect the true historical working capital profile of the business. In either case, the number of months included in the trailing average for target working capital purposes could give improper weight to seasonal shifts or other fluctuations.
In many transactions, the purchase price adjustment is estimated at closing and then later verified after closing (once the books have been closed on the pre-closing period). There may be a “collar” on the adjustment, such that no adjustment is made if the overall purchase price adjustment is less than some amount one way or the other. This discourages expensive disputes over small amounts. And if there are disputes about the purchase price adjustment that cannot be resolved through negotiation among the parties, those disputes are typically decided by an independent third party accountant.
Negotiating a purchase price adjustment is a hybrid accounting and legal exercise. Both the numbers and the words must work together to reflect reality and achieve the correct result.
Escrows: Securing Seller’s Payment Obligations
Money does not always flow one way in a sale transaction. In a typical purchase agreement, seller will make certain statements of fact about the business (called “representations and warranties”) to buyer. Seller will also make certain promises to buyer (called “covenants”) 2. These representations and warranties and covenants cannot be made lightly. If seller is not candid with buyer in its representations and warranties, or if seller refuses to comply with its covenants, seller may have liability to buyer for “breach” of its representations and warranties or covenants. In such case, seller will likely be required to make buyer whole for the losses buyer incurs as a result of seller’s breach by paying money damages (subject to negotiated per claim thresholds, caps, baskets and other limitations). This is typically referred to as “indemnification”.
Buyer will likely require seller post some short-term security for seller’s general indemnification obligations. In a sale transaction, this security takes the form of an escrow held by an escrow agent (typically a third-party bank) which acts as the first or only source of funds for potential indemnification obligations. Escrows are just one facet of the overall indemnification package for a sale transaction, and they directly reduce the net payment at closing.
The size of the general indemnification escrow varies from transaction to transaction, but for ordinary sale transactions it is typically 5%-20% of the overall purchase price. In the presence of third-party representations and warranties insurance, the escrow can be lower (as low as 1% of the overall purchase price).
In addition to a general indemnification escrow, buyer may require a “special escrow” as a source of funds for losses with respect to specifically-identified issues (for example, a known litigation or regulatory fine) or for a potentially large purchase price adjustment. These special escrows are typically available only for the specified purposes, but can sometimes also be available for general indemnification purposes. Offsets against rollover shares, buyer notes, earn-outs and other deferred purchase price might also be used as a source of funds for seller’s indemnification obligations. Buyer may also be able to seek recovery directly from seller after an escrow is depleted.
An escrow, if required, is funded from a portion of the purchase price and held for some agreed-upon amount of time before any remaining escrow funds are released to seller.
Other Amounts Payable at Closing: Advisors and Preferred Equity
After taking into account any rollover equity, deferred purchase price, purchase price adjustments and escrows, there is also the matter of expenses incurred in connection with the sale transaction. Employees of the business may receive transaction bonuses or other compensation payments. In addition to legal counsel, seller may have retained an investment banker which is owed a success fee (and expenses) and other advisors or representatives each of whose invoice is likely to be the responsibility of seller (and not buyer). If the parties have obtained third-party representations and warranty insurance, the premium and fees for that policy may be borne partially by seller. If there is not enough excess cash in the target to cover these invoices, these amounts are likely to get paid from a portion of the purchase price, whether by buyer on behalf of seller or shortly after the closing by seller directly.
When the target has multiple classes of equity securities, there may be liquidation preferences or other priority on distributions (such as “catch-up” payments on equity incentive grants) before any amounts are paid on the common equity. These priorities will be set forth in the organizational documents of the target.
Conclusion: What is Left Over?
After deducting each of the applicable amounts described above, the net amount is then available for distribution to the equityholders. Depending on the structure of the transaction, the capitalization and working capital profile of the target and the negotiated indemnification package, the net payment to the equityholders can be significantly lower than the headline purchase price. All of these payments should be clearly included in a funds flow memorandum that tracks the payments required under the definitive documentation and shows the agreed-upon sources and uses of funds.
Very few sale transactions involve every type of payment described above, but any given transaction almost assuredly contemplates at least one such payment. By focusing too much on headline purchase price, seller may be disappointed when the closing wire to the equityholders actually clears.
1 Similar to an earn-out is a “contingent value right”. CVR’s are derivative securities that can arise in different contexts and have value based on some future goal or event. The legal requirements for CVR’s is outside scope of this summary.
2 An escrow held directly by buyer (rather than a third-party escrow agent) is often referred to as a “holdback”. For simplicity, I use the word “escrow” to describe both a third-party escrow and a holdback.