When Selling, Do You Get the Value of Your Company at Closing?

In two words, “It’s unlikely.” Once you and the buyer agree on the value of your company, there are a number of factors that come into play that reduce the cash you receive at closing:

·      Business Debt Must Either Be Paid Off or Assumed by the Buyer. In either case, regardless of an asset sale or a stock sale, the repayment of debt by you or the buyer’s assumption of debt reduces the amount of cash you receive for the sale. In an asset sale, you will need to take the money that is paid to you for your assets and repay any business debt you owe. It could be that the buyer agrees to assume your business debt, but the buyer’s assumption simply means that it will come off the purchase price and leave you with the same amount of money as if you took some sales proceeds and paid off the debt yourself. In a stock sale, the buyer buys the entire business - all assets and all liabilities – and considers the assumption of debt as part of their payment.

·      The Price May Include Holdbacks. Most sales of businesses include holdbacks for various reasons. This is money that the buyer “holds back” from the seller to cover any number of cash needs that may arise after the closing that are rightfully the obligation of the seller. For instance, the seller may agree to indemnify the buyer for any warranty claims made in the 12 months following the closing. The buyer will likely require that an amount likely to cover any such claims will be held back, sometimes in escrow and sometimes not. It is not unusual to see 10%, even up to 20% of a sale price, held back for payment at a future date, usually in a year or less. Hopefully, if no claim is made by the buyer against the holdback, you ultimately receive this part of the purchase price.

·      The Parties May Have Agreed to an “Earn-Out.” An “earn out” is an agreement in the purchase and sale agreement (“PSA”) that part of the purchase price will be dependent upon the buyer being able to earn a certain amount of money after the sale, usually defined as either revenue, gross profit, or net profit. So, an agreement may say “Buyer will pay $10MM for the business, but $1MM will be conditioned upon the buyer being able to earn at least $5MM in revenue in the next fiscal year.” Or it may say, “Buyer will pay $10MM for the business at closing, plus an additional 5% of sales generated in the 12 months following the close of the purchase.” Or perhaps, “Buyer will pay $10MM for the business at closing, plus an additional 10% of EBITDA generated in the 12 months following the close of the purchase.”

Earn-outs can be very complicated and risky for a seller. You may be counting on this money as part of the purchase price, but there is significant risk that you will not receive part or all of it. This is, of course, because the buyer now controls the ability of your former business to earn the threshold for payment of your earn-out. And even if the buyer manages the business well, the market itself may let you down and prevent the business from earning what it needs to earn to justify your earn-out payment.

We generally advise our sell-side clients against accepting an earn-out that will be calculated on a net profit or an EBITDA amount. This is because the buyer, once in control of the business, has a lot of latitude to manage the business in a way that reduces the earn-out payments to the seller. When earn-outs are necessary, we strongly recommend that the earn-out be based on top line revenue measures, where a seller can be more comfortable that there will not be any manipulation of those numbers.

·      The Buyer May Only Agree to Pay Part of the Purchase Price in Cash at Closing and the Other Part as a Consulting Fee to You Over Time. This, of course, has tax implications, given a consulting fee would be subject to ordinary tax rates, versus capital gains rates that may apply to the sale of your business. And it is risky, given the buyer could default on your payments, and perhaps never pay them to you.

·      The Buyer May Demand You Finance Part of the Purchase Price. In other words, the buyer may want to pay you a portion of the purchase price at closing, and then sign a note that obligates them to pay the remainder at some future date. In general, we are opposed to seller financing unless you badly want out of your business and literally have no other options. The reason is the buyer may well default on the note, and you will be left with limited options to collect. You can try to foreclose, which will likely require a costly court action, and the buyer will likely assert all types of defenses to your action.

In fact, we generally advise, as between two offers – one significantly higher asking for seller financing and the other lower but all cash – to accept the lower all-cash offer at close.

If you are forced to finance part of the purchase price, try to (1) get as much collateral in the form of hard assets as you can (e.g., a deed on their home), (2) make the term of the financing as short as possible, given bad things often happen for a lender the longer the debt is outstanding, and (3) work with your lawyer to eliminate any contingencies affecting your right to collect on the note.

In coming posts, we’ll turn to deciding whether your business is ready to sell.

GROW and SELL Advisors, wholly-owned by Traversi & Co., LLC, is a premier sell-side M&A advisory firm – a boutique investment bank – serving the lower middle market.  Visit us here.

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