Small Business Valuation - Deal Structure (Part 3)

Now that a fair value is determined, the next step is capturing that value. This post describes some of the levers available to make a deal. If an agreement on a total price is the music starting and getting your toe tapping, agreeing on the structure is getting you on the dance floor with a partner. Due diligence is dating and closing a deal is marriage/divorce to a partner/the business.

Stock vs. Asset sale. This can sound simple at first, but the implications are complex. Please consult an accountant and attorney to have a complete picture of the business and transaction to find an amenable agreement. A stock sale entails the buyer purchasing the stock certificates, owning all of the assets, liabilities (known and unknown), and the legal entity. The buyer hands over a bag of cash, the seller hands over the keys, they shake hands, and that’s it. This depiction is a tongue in cheek simplification. In a stock purchase, there is more risk on the buyer. An asset purchase can be appealing for the purchaser when they are focused on assets (fixed and intangible) as they won’t have to deal with liabilities. A set of assets is negotiated which can include specific equipment, accounts receivable, as well as intangibles – such as patents and designs, customer lists and contracts, and web domains. It can go down to the level of office chairs. Asset sales/purchases require detailed records and create greater risk and effort for the seller. Understanding permits, customer and supplier contracts, and their transferability is essential as are the tax consequences, ability to settle liabilities, and wind down operations and legal entities.

Escrow. In some transactions, it is appropriate for a portion of the payment to be withheld and put into a trust for some time. Percentages can vary widely, but most will fall between 5-20% of the total deal value in an all-cash transaction. An escrow will also have a term – between 3 months and two years, although certain risky situations could arise and warrant a more extended period. Often a modest and safe interest rate will apply, similar to a certificate of deposit. Escrow is a form of insurance, and many terms will dictate if a claim is eligible against the escrow. The reason for this is that there are degrees of errors in scope and monetary value. If the seller had been disposing of waste chemicals in a hole on the property causing contamination and needing environmental remediation – that is significant and costly. The buyer should use the escrow as a form of protection to get that money back to solve the environmental claim. However, there could be a smaller claim – when doing an inventory of tools and supplies, there was a miscount and instead of twenty tools there were eighteen, and instead of ten inventory barrels, there were nine. While annoying, these couple of miscounts won’t likely be enough to warrant a claim of the escrow. An escrow is favorable for the buyer as it reduces the risk of a loss in case something goes wrong or was misrepresented. The escrow is negative to the seller as it delays cash receipt and increases the likelihood that the full deal value will not be received.

Payment Options aka Consideration:

Cash at Closing. Hand over a bag of cash – or more likely a wire transfer. An escrow could still apply.

Deferred Payment Schedule or Earn-out. This can also be called seller financing. Instead of payment at closing, the seller receives payments over time. A payment schedule would make fixed payments (sometimes including an increase for interest). In the case of a $3 million purchase, $1 million could be paid at closing, $1.05 million in twelve months, and $1.1 million in 24 months, using a 5% interest rate. An earnout ties the future payments to financial metrics or results, such as profitability. This variability can be unsettling for an owner who is no longer in control of the business. With a strong alignment of interests, this can be a win-win for both parties, even if the buyer pays more than the original price as the business would be performing above expectations. It could also cost the seller if results fall short or the business struggles.

Retained equity ownership. Whether the stock owned is of the seller’s business or paid in stock of the acquiring company, isn’t material economically but could have governance implications. Retained ownership aligns the seller with the success of the go forward organization and reduces the cash need up front or in the near-term. I recommend having a thoughtful plan for a future buyout of the minority interest and the rights of the parties.

Continued Employment. This is possible in succession transactions or with retained ownership transactions, but rarer in the event of a cash sale or even one with seller financing. Continued employment includes paying a full salary or above market salary while the selling owner-operator plays a reduced role or helps train and transition the company. Buyers should use employment, non-compete, and non-solicit agreements to protect the business – the buyer doesn’t want to pay a significant sum for the seller to hang a shingle, get the band back together, and be a direct competitor months after closing. There are also tax considerations between income and capital gains and the timing across multiple tax years. Other perks are negotiable such as continued participation in employee benefits such as health insurance, but a new owner will want to set a term limit for such benefits.

Personal Guarantee. A personal guarantee and understanding the sources of funds for payment should be discussed prior to due diligence. A personal guarantee is scary. In the event the business craters and additional payments are negotiated, the buyer's house and retirement savings are on the line. If using deferred payments, make conservative estimates and include a margin of safety to maintain a high degree of certainty of meeting payment obligations.

I believe in viewing any negotiation and agreement in totality. If the buyer and seller don’t agree on a stock versus asset sale, adjusting the purchase price or timing of payments is negotiable. The simpler and closer to an all-cash transaction, the lower the calculated consideration should be – expect to pay a higher price if using seller financing or earnouts. Offering seller financing and earn-outs have the benefit of broadening the pool of potential buyers – and a competitive auction or process will raise the price or offer more favorable terms.