Take it To the Bank: How to Get Paid What You Bargained For When Selling A Business
You have finally decided to sell your company. Perhaps you have worked with an investment banker who has taken your company through a formal “auction” process. You vetted the offer letters. Now you are ready to make a commitment and sign a letter of intent (LOI). Before you do, think about how certain you are that you will be paid the full purchase price.
Stress Test the LOI. When negotiating letters of intent for sellers, I generally prefer to stress test the deal at the LOI stage. I tend to put all the really thorny deal terms in the LOI to see if the buyer balks. It is better for everyone involved to know early that a deal is not going to close rather than spend months working on a deal that falls apart in the eleventh hour.
Show me the Money. Before signing an LOI, be sure the would-be buyer has the capital available to fund the purchase price. If you are working with a credible investment banker, they will have already done this for you. But, if you are not using an investment banker, do your own due diligence on the buyer. Is the person you are negotiating with the person paying the purchase price? Or, do they claim to represent a larger investor? If so, why aren’t you talking directly to the investor? Does the actual buyer have cash on hand or have they already secured financing to close the deal? If not, you should probably move on. They are likely wasting your time.
Beware of Holdbacks and Offset. By the time the buyer presents an LOI, the seller and buyer have discussed a nominal purchase price. I say nominal because the purchase price is often not paid as cash on the barrel head paid at closing. The best case scenario for a seller is to have the full purchase price paid at closing. You have probably heard the old proverb, a bird in the hand is worth two in the bush. All things being equal, I advise sellers to take as much of the purchase price in cash at closing as possible. But, it is very common that the purchase price is subject to various escrows, working capital holdbacks, offsets, and may include contingent consideration known as an “earn out”. Also, it is not unusual that a portion of the price is paid in the form of a promissory note that is paid out over a number of years. In my opinion, it is best to identify (or in some cases prohibit) these sort of holdbacks at the LOI stage so there are no major surprises later.
Indemnification and Escrow. When you sell your company, you will make many representations and warranties about your company to the buyer. If you make a material misrepresentation, the buyer will have a claim for “indemnification”. In other words, you will be required to make them whole for the amount of money or expected value they lost. If you look at most purchase agreements, much of the document involves detailed representations and warranties. It is critical that these statements are true. If they are not accurate, disclose to the buyer any exceptions to the representations in a disclosure statement.
To secure payment for indemnification claims, buyers often insist on a portion of the purchase price to be set aside in an escrow account. Using an escrow is common practice. There is nothing inherently unreasonable about escrow arrangements. But buyers and sellers will go round and round arguing about representations and warranties, indemnification obligations, the calculation of indemnification, various limits on indemnification, and the amount to be held in escrow. Indemnification and the issues that surround it are often the most contentious issues in a deal negotiation. Try to address the major issues at the LOI stage. And, even if these subjects give you migraines, take the time to understand them. Ask your attorney and investment banker lots of questions. Think through the worst case scenarios.
Earnouts. Sometimes buyers and sellers disagree about the value of the company but still want to do a deal. To overcome the valuation gap, buyers may propose an earnout. Typically, the buyer will pay a portion of the purchase price at closing. Then, the seller has an opportunity to earn a higher purchase price over a period of time if certain financial milestones are hit. An earnout is only appropriate if the seller will remain active with the company. Otherwise, the seller will have no influence over whether the company hits the financial milestones or not. Earnouts may make sense when a company is still growing. The earnout (or similar equity compensation arrangements) will align the interests of the buyer and seller for the future operations of the company. However, there is room for some mischief in earnouts. Sellers should ensure that the buyer does not have discretion to move critical resources out of the business into other affiliates. Doing so would give the buyer the benefit of those cash producing assets, but may remove them from the earnout calculations.
When negotiating a deal, the seller has to trust the buyer to abide by the terms of the deal and pay what the buyer owes. However, a dose of skepticism is warranted in all deals. Even when you trust the buyer, be sure to include reasonable protections in the agreements to ensure you are getting what you bargained for. Another thing to keep in mind is that whoever you are negotiating with today can get hit by a bus the day after closing. Write your sale agreements as if you may have to negotiate in the future with the buyer’s greedy heirs or some heartless conglomerate that buys out the buyer and doesn’t know you from Adam.
Photo credit: KGToh – 123rf.com
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