This article was written by John Rogers, Senior Consultant at the Bonadio Group, Investment Banking and Transaction Advisory
When a business owner contemplates the sale of their business, the first question that typically comes to mind is “how much can I sell my business for?” While certainly a valid question, the intricacies of deal structure are just as important. Throughout this article, we will explore why it is not just the price, but the deal structure that plays a critical role in the sale of a middle market business.
Before talking about the components of deal consideration, let’s revisit the two primary forms that M&A transactions take: asset deals and stock deals. If a buyer of a business only wants (or is only willing) to take certain assets and liabilities of the business, an “asset deal” structure is utilized. Conversely, a “stock deal” involves the purchase of the equity shares of the business, in which case the buyer gets all of the business’s assets and liabilities (whether known or unknown). So why does a seller care which type of structure is utilized? The answer is simple, taxes. Different deal structures may result in wildly different after-tax proceeds to the owner. For additional information on this topic, I encourage you to read our article Stock Versus Asset Deals - What's the Difference?.
Beyond the primary transaction form, deal structures could involve cash, seller notes, earnouts, rollover equity, or any combination of those. Let’s take a look at each.
The most simplistic transaction form is an all-cash deal. While certainly the easiest and cleanest structure, many buyers prefer not to deploy as much capital (or take as much risk) as an all-cash deal would entail. From a buyer’s perspective, seller notes, rollover equity and earnouts all help delay their deployment of capital (resulting in a higher potential internal rate of return) and may shift some of their risk back on the seller. Sellers would naturally prefer an all-cash deal, but what’s good for the seller is often bad for the buyer, and therefore there is some inherent friction as deals are negotiated, which often lead to the inclusion of other types of deal consideration.
This deal structure involves payment of a portion of the deal consideration over time. The seller holds a note issued by the buyer and (typically) receives monthly payments. In some cases, a seller note may bridge the gap between the transaction value and the how much capital the buyer has access to, in which case the seller is essentially acting in the same function as a bank. Intuitively, seller notes can help sellers achieve higher valuations for the business because the buyer has to come up with less capital at closing.
An earnout is a deal structure that allows the seller to earn additional transaction consideration if certain financial metrics are achieved after the business is sold. Metrics could be tied to the achievement of revenue, margins, profitability, or EBITDA thresholds to name a few. Upon meeting these thresholds, the seller is rewarded with additional transaction consideration. In many cases, an earnout helps bridge a valuation gap (where the seller negotiates a higher price, but the buyer only has to pay it in the event that certain conditions are met post-closing). While this potentially aligns the interests of the buyer and seller, especially if the seller is going to remain active in the business after the sale, the seller often has little control over whether or not the metrics are actually achieved. Therefore, it’s important to note that an earnout structure effectively shifts risk from the buyer to the seller. Careful consideration should be made as to the likelihood of future payment and the ability of the seller to control the metrics upon which the earnout it based.
Rollover equity is essentially a deal structure whereby the seller retains a portion of their ownership after the transaction. For example, a seller may sell 90% of the business to a buyer and retain 10% in the form of rollover equity. This allows the seller to receive a “second bite at the apple” when the buyer sells the business in the future. In theory, buyer and seller interests are aligned post-transaction. Similar to an earnout, rollover equity effectively shifts risk from the buyer to the seller, and also reduces the amount of capital the buyer needs to consummate the transaction. Careful consideration should be made as to the buyer’s plans for the business, and the likelihood that the second bite at the apple will be more valuable than the equity left in the business at closing.
The following example explores three potential transaction structures for a $25 million deal:
- $25 million cash at closing.
- $20 million cash at closing and a 5-year seller note for the remaining $5 million.
- $15 million cash at closing, 5-year seller note for $5 million, and a $5 million earn out.
Although each of the above could be described as a $25 million deal, it is clear that they are significantly different. When considering the time value of money and the likelihood of receiving the full $25 million, it becomes clear that, from the seller’s perspective, the deal structures are in order of most favorable to least. After all, should the business fail in the future, there is a possibility the seller note becomes uncollectible and earnout is never achieved. In a worst-case scenario, the deals described above could result in the seller only receiving $25 million, $20 million, and $15 million, respectively. Deal structures clearly play an important role. From a seller’s perspective, cash is king.
To take this a step further, depending on the seller’s appetite for risk and their confidence in the business going forward, an all-cash deal of, say, $23 million may very well be preferred over a $25 million deal structured like example #3 above (especially if the earnout metrics are aggressive). Clearly, it’s not just the price, but the deal structure. This makes answering the question “how much can I sell my business for” extremely difficult due to the complex and sophisticated factors involved.
Finally, you must consider the tax implications of the deal. After-all, it’s the after-tax proceeds that wind up in the seller’s pocket, not the stated purchase price.
I would be remiss not to mention the relatively long journey that ensues prior to the point in the potential transaction where the parties are talking about deal structures. To name a few: the company assessment, preparation of historical financials and marketing materials, identification and outreach to potential buyers, marketing strategy and execution, as well as initiation of the bidding process and receipt of offers. Having a candid conversation, early on, with your trusted M&A advisor about your transaction desires and objectives is critical.
If you are thinking about selling your business and are curious about learning more about deal structures or anything else described in this article, feel free to contact us.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.