Tip 2 – Determine the Right Sales Structure for You

There are different kinds of buyers and different kinds of deal structures designed for different situations. First, think about what you’re trying to accomplish.  Is it a full exiting of the business, the need for an investor with the cash and market muscle to accelerate your company’s growth, or support for a management buyout (MBO)?

Asset vs Stock Purchase

Each of these objectives will dramatically change the structure of the deal, but for the purposes of this article, let’s focus on the most common scenario, which is a full buyout sale. Most buyers will prefer an asset purchase versus a stock purchase. A stock purchase can be a cleaner and simpler transaction, but it means the buyer takes on all legal liabilities and contractual obligations of the seller’s company.  In an asset purchase, the assets are acquired without taking on all of your company’s previous liabilities. The buyer should be willing to pay a higher purchase price to avoid the added risks of a stock purchase.

Debt-Free/Cash-Free Transactions 

Most business owners don’t realize that sale transactions are typically executed on a debt-free, cash-free basis. This is critical to understand, as it’s an important structural element that has a dramatic impact on the seller’s payout.

This means that the purchase price assumes the seller pays off all of his company’s debts at the closing of the transaction. Those debts include all interest-bearing loans, even operating credit lines, bank loans, and equipment financing. The accounts receivable and payable are typically assumed by the new owner, and the cash that must be left in the business is determined by a complex calculation to estimate an appropriate level of working capital.

Contingent Components

The seller must be prepared to negotiate and plan for several contingent components that are also very common. As with most terms of the purchase agreement, they are designed to manage risk and are usually directly linked to the purchase price.

In almost all cases the buyer will expect you to stay through a transition period; depending on the circumstances, that period can range from months to years.

Another very common contingent component is an “earnout.” An earnout establishes a portion of the purchase price to be held back from the initial purchase payment; its payout is contingent on one or more performance metrics being met over time. The performance metrics are usually linked to items such as revenue, profitability, customer/supplier/employee retention, or accounts receivable collections.

Earnouts can be significant, and commonly range from 25% to 45% of the purchase price;   they may payout over a period of 1 to 5 years. Obviously, you should do what you can to minimize the size and term of the earnout, because there is an inherent threat to payouts from earnouts.  As your company becomes integrated into the buyer’s operations, you lose control of the accounting, policies affecting employees, customers, and suppliers, future market and product strategies, etc. This loss of control can greatly impact the assumptions that you make when accepting the earnout terms and how they’re measured.  To keep it in perspective, a common industry rule of thumb is that earnouts do payout as planned about 70% of the time. 

Escrows and Holdbacks are another form of risk mitigation that is commonly embedded in purchase agreements. As their names imply, these are simply funds that are held back by the buyer to cover potential risks that were identified in diligence, such as known or potential legal action, insurance claims, etc.

Deferred Payments are payments that are scheduled to be made in the future, such as seller financing, or payments that cannot be calculated at the time of closing and require additional time, such as truing-up net working capital calculations, accounting reconciliations, or physical inventories.

 

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