Structure Plays an Integral Role for Sellers and Buyers
It can be said that while the seller determines the price of their company, the buyer sets the terms or “structure.” While sellers tend to prefer all cash for their companies, such a structure may not produce the highest overall value for the business and can limit the prospective buyer pool.
Depending on the nature of the deal, a seller can use structure to:
- Defer taxes
- Participate in future success of the business, and
- Maximize the purchase price from the sale of the company
Buyers use structure as a way to:
- Manage cash flow
- Aid in the transition of an owner-dependent business
- Bridge the gap between buyer and seller value expectations, and
- Finance the transaction
Like price, the deal structure is negotiable and can vary from one transaction to the next. Both the individual needs of sellers and buyers must be taken into account in structuring each transaction in the most appealing manner to meet both parties’ objectives.
Deal “Type”… Is Not to Be Confused with “Structure”
At the broadest level, the deal “type” is the key decision of whether the deal will be structured as a stock or an asset purchase.
Stock Purchase: In a stock purchase, the shares of the stock are transferred from seller to buyer. Therefore, the buyer assumes all assets, liabilities, contingent liabilities, and operations of the business, unless specifically excluded in the Stock Purchase Agreement.
Asset Purchase: Under this structure, only the assets and liabilities specified in the Asset Purchase Agreement are transferred to the buyer, who must either create a new entity or use an existing entity to acquire the business.
Sellers generally prefer stock sales, which allow for an easier transition and usually entitle them to pay taxes on the sale at the lower capital gains rate. Buyers often prefer an asset purchase that identifies the exact assets acquired and liabilities assumed. This type of transaction creates a barrier of contingent liabilities flowing through from seller to buyer. An asset purchase may offer tax benefits to the buyer through a step-up in asset basis.
The term “structure” generally refers to the methods of payment used to acquire a company. M&A transactions often incorporate a variety of payment methods, consisting of a combination of the following: Cash, Stock, Promissory Notes, Contingent Payments, and Other Consideration.
Cash: Cash and stock are the most common forms of payment. The cash portion of a deal includes both the buyer’s equity as well as cash that the buyer borrows from banks and other financing sources by leveraging the seller’s assets and cash flow. Typically, a higher proportion of cash is used to fund transactions when interest rates are low and buyers have ready access to cash at affordable rates.
Stock: Use of the acquiring company’s stock is common to purchase companies for both asset and stock type transactions, and is even more prevalent when stock prices are high and this currency will purchase more with fewer shares.
If the buyer is a public company, sellers often view the receipt of stock as equivalent to cash. However, SEC regulations often limit the ability to liquidate the shares, subjecting the seller to the volatility (both positive and negative) of the public markets. Methods are available to minimize this risk.
Promissory Notes: These are payments for a fixed amount and made according to a specified payment schedule. Collateral might include a guarantee from the acquiring entity, their holding company or parent entity, or a lien against the acquired assets (in both cases subordinate to the claims of senior leaders).
Contingent Payments: Such structure is used when the company’s potential for future sales and profits is substantially higher than its historical performance, to bridge a price gap between buyer and seller, or when the buyer perceives a high risk in the ownership change, A buyer is likely to pay for a portion of the projected potential now, and the rest as the business meets or exceeds the stated projections.
Because these payments are subject to the company’s performance, they offset some of the buyer’s risk in addition to spreading the payments over time. Oftentimes, the seller remains involved with the business in some capacity during all or part of the contingent payment period, thereby influencing the performance of the business and increasing the likelihood that they will receive the contingent payments. Contingent payments include earnouts, royalties, and licensing agreements.
Other Consideration: Consulting and Non-Compete Agreements are ways to provide the seller with additional consideration that does not adjust based on the performance of the business.
In summary, different types of situations merit different structures. More asset-intensive manufacturing companies, for example, may see a higher cash component; unless there are customer concentration or key person dependency issues. Less asset-intensive Service or IT companies may see a lower cash component unless they have proprietary technology or a very diverse customer base.
The ultimate type and structure of a transaction will dictate the price paid for the company. Generally the more deal structure a seller is willing to accept, the higher the purchase price.
Recognizing that deal structure will directly impact the purchase price, many sellers need to consider the potential risk included in accepting deal structure:
- What is the credit history of the acquiring company and/or its parent company?
- Does the management team have the business experience to manage and grow the company?
- Will the amount of debt service (the principal and interest being paid out) leave enough earnings to manage and grow the business?
- Perhaps most importantly, does the seller trust the buyer? Sellers should “listen to their gut.”
There is no way to sell and exit a privately-held company without risk. Even if the sale is a stock sale with a buyer assuming all continent liabilities and paying 100% cash, the Stock Purchase Agreement will include provisions for indemnification and post-closing liabilities.
Sellers are advised to consider and choose between as many buyers as possible to structure a transaction that yields them the highest purchase price within the boundaries of good business sense.