Forms of Consideration
From the M&A Information Series - (January 2020)
While an all-cash transaction is typically preferred, business owners looking to maximize the valuation and/or sell to a specific buyer will often need to agree to some combination of alternative forms of consideration in order to get the desired transaction completed.
CASH AT CLOSE
We’ve all heard the saying “Cash is king,” which holds true in M&A deals. It is the least risky form of consideration because you know what you are getting and payment is not contingent upon the future performance of the business under new ownership. The cash payment is sourced from a combination of equity from the buyer and third party financing. From a buyer’s perspective, equity is the most expensive way to finance a deal, and utilizing debt can improve financing costs and returns. Depending on how much financing the buyer is willing and able to secure, another of the three forms of consideration discussed below might be required to achieve the desired total purchase price.
When a buyer is not able or willing to finance the entire transaction, or they want the seller to share in some risk, the buyer may look to the seller to “carry paper,” or finance a portion of the purchase price through a seller note. An interest rate, payment schedule, and other terms are agreed upon in advance. It is important for the seller to earn an interest rate commensurate with the risk involved, be comfortable that the buyer will operate the business successfully, and understand that the seller note will be subordinate to any primary lenders.
Earn-outs, like seller notes, are payments made in the future for a portion of the purchase price, but the earn-out payments are contingent upon the acquired business meeting a future objective such as maintaining existing customers post-transaction (particularly if the business has a high customer concentration risk) or achieving certain financial objectives. This reduces the buyer’s risk if the company underperforms while incenting the seller to help maintain and grow the business. It is key that the objectives are achievable and clearly outlined (e.g. if a gross profit target is established, the costs to be included in calculating cost of goods sold should be clear). Earn-outs are obviously riskier for the seller but can be a useful way to bridge a gap in valuation and can provide upside potential for the seller.
The last primary form of consideration in an M&A transaction is an ownership interest in either the acquired business or the acquirer (particularly if publicly traded). This is a riskier form of consideration but can also provide significant upside in the event the stock the seller continues to hold post-transaction appreciates over time. A seller should be comfortable with the operating outlook of the acquiring entity. It is important to be mindful of lockup periods that prevent the sale of stock for a period of time and the overall liquidity of the shares, both of which can affect the value a business owner receives when the continuing ownership interest is sold.
Each offer received during a sale process is likely to consist of different valuations and payment structures. Your advisory team can help evaluate these offers and outline the risks and benefits associated with each so you can make an informed decision based on your unique circumstances and objectives.