The Purchase Price (Part 2)
The Purchase Price (Part 2)
In my last post, we began looking at the purchase price, including the difference between 100% cash-on-close versus asking the seller to finance part of the deal.
In this post, we’ll keep looking at the purchase price. In particular, we’ll review escrows, forgivability, and rollovers.
Let’s keep looking at examples.
Example 3 – Cash at Close, Seller Note, Escrow/Forgivability
Are there specific risks keeping you up at night? Or are your concerns more generalized—will the company succeed without the seller?
In either case, you may want to place conditions on the purchase price to mitigate these risks.
Let’s again return to our table. We still see the sources of capital. But now, in addition, we also see a condition placed on the full purchase price.
With (1), the buyer wants to place $400,000 of the purchase price in escrow. This means the seller will only receive $4,100,000 cash at close—the sum of the SBA loan and the equity less the sum of the seller note and the escrow.
Purchase price escrows are used when the buyer knows about a specific risk that is likely to occur. For instance, perhaps there is significant warranty exposure.
At the closing, the buyer will deliver $400,000 to an independent third party (the escrow agent). If the buyer incurs indemnified warranty costs, the escrow agent will release part or all of that $400,000 to the buyer.
The seller may not receive that money—there is no guarantee that the seller will receive the full purchase price.
Instead of an escrow, a buyer could opt for a holdback. With a holdback, the buyer keeps the $400,000, not an independent third party. For obvious reasons, buyers generally prefer holdbacks; sellers find escrows easier to swallow.
With (2), the buyer wants to make $400,000 of the seller note forgivable.
A forgivable seller note is usually (although not always) less targeted than an escrow. The concern here is that the company won’t perform as well as history suggests. By tying all or a part of the note to, for example, historic levels of revenue, the buyer can hedge against that risk.
In contrast to an escrow, the seller will still receive $4,500,000 cash at close. But if a triggering event occurs, the buyer will owe the seller less in the future.
Again, there is no guarantee that the seller will receive the full purchase price.
Since the seller receives more cash at close, a forgivable seller note may be easier for the seller to take than an escrow or holdback. But this raises the question: If the seller rejects the idea of an escrow, can you use a forgivable seller note to mitigate against the same specific risks (e.g., warranty exposure).
Yes, but there is a big difference between the two approaches.
With an escrow, you are holding back cash. With a forgivable seller note, you are no longer obligated to pay a debt. In other words, a forgivable seller note may not help you if you incur indemnified losses and have insufficient cash to cover those losses.
There is nothing to stop you from proposing an escrow/holdback and a forgivable seller note. But don’t just ask for these concessions because it makes you feel more comfortable. The seller will take convincing. As always, negotiate with purpose.
Here's how you could describe a purchase price escrow in your LOI.
$400,000 to be deposited with a mutually agreeable escrow agent, to be held for a period of one year after the closing, in order to secure the performance of the seller’s post-closing obligations under the purchase agreement.
And you could add this line to indicate forgivability on the seller note.
$400,000 of principal of the note will be forgiven if, [describe conditions here].
The parties normally choose to treat any amount the seller does not receive as an adjustment to the Purchase Price for tax purposes. You should state this in the LOI too.
But wait!
You’ve yet to complete diligence. How do you know whether there are risks lurking in the shadows?
You can’t.
You can only act on the information you have. If a red flag comes up during diligence. There is nothing to stop you from later requesting appropriate protections.
You may also be asking, instead of making the seller note forgivable, why not just offer a lower purchase price and agree to increase it if certain future targets are met?
This is called an earnout. Our example relies on SBA financing. Under current SBA rules, buyers cannot offer an earnout—you’re limited to forgivability based on historic performance. Otherwise, yes, you could offer an earnout.
Example 4 – Cash at Close, Seller Note, Rollover
What if the buyer wants to offer the seller potential upside to sweeten the deal but doesn’t have the cash? Under recent SBA rule changes, the buyer can now offer the seller retained equity.
Let’s go back to our table one last time.
Here, the buyer is offering the seller a higher purchase price ($5,500,000). Yet the buyer is neither taking out a larger loan, nor requesting more seller financing (the buyer is actually requesting less), nor bringing more cash to the table. Instead, the buyer is offering the seller $550,000 of retained equity.
The seller will receive $4,500,000 cash at close, as with Example 2. But in addition, the seller is keeping 10% of the company. The seller therefore gets future upside in the event that the buyer’s proposed plans to grow the company are realized.
At a cost, the buyer also gets upside. The seller’s and the buyer’s incentives are now even more aligned. They both have a common interest in seeing the company succeed.
In the near term, the buyer also benefits from continuity of ownership—if there is key man risk, it is mitigated somewhat by the seller retaining equity.
Since the SBA revised its rules to permit this type of deal structure, buyers, sellers, and lenders (who also benefit from reduced transition risk) have all gotten on board.
Rollovers are more and more common in the SMB M&A space.
Yet there are reasons for buyers to stop and think before offering retained equity:
The buyer is taking on a partner, and that partner may be difficult.
The SBA rules only permit a rollover if the buyer is acquiring the equity of the target company, which comes with some downsides (see Assets or Stock).
A rollover is more complicated to execute. The buyer and the seller will have to negotiate an operating agreement to describe their various rights and responsibilities.
In your LOI, you won’t describe the purchase price as including retained equity. Instead, you will describe the rollover in terms of purchasing less equity:
Subject to the satisfaction of the conditions described in this letter, at the closing of the transaction, Buyer will acquire 90% of the outstanding membership interests of the company, free and clear of all encumbrances, at the purchase price stated below:
You will also need to mention that, as a condition to closing, the buyer and the seller must negotiate an operating agreement.
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That’s it for structuring the purchase price. In my next post, we will focus on purchase price adjustments.