Business owners who are selling their company typically want to be paid the highest price. While this is certainly expected, they should be aware that the highest price may not reflect the best value for their company. This is because the terms of the deal are just as important as the stated purchase price. The terms of the deal dictate when, how and under what conditions the purchase price is (or is not) paid, and the tax consequences to the seller. Deal structuring can be complex, and appropriate legal and tax advice should be obtained.
Apart from cash at closing, deal terms often include holdbacks, promissory notes, share exchanges and earnouts. These alternatives are addressed in this newsletter. Business owners also have to consider whether to sell the shares or assets of their company – which can have income tax, legal and other consequences. It bears mentioning that different deal terms (commonly referred to as deal structuring) applies only to privately held businesses (or divisions / subsidiaries of public or private companies). Where a public company is acquired, securities legislation typically requires that the transaction be entirely financed with cash or the buyer’s treasury shares at closing.
A buyer will insist on a holdback in virtually all transactions involving the purchase of a privately held company. Holdbacks protect the buyer against the risk that certain assets acquired at the closing date will not be realized (e.g. uncollectible accounts receivable) or that hidden liabilities exist. A holdback in the range of 5% to 15% of the purchase price, for a period of 6 months to 24 months is not unusual. The magnitude and length of the holdback depends on several factors, including:
- The nature of the seller’s business. Where the seller’s company is exposed to significant risks such as major inventory write-offs or lawsuits, the holdback will generally be larger and longer;
- Whether the seller’s financial statements have been audited. If not, the buyer may perceive greater risk of hidden liabilities;
- The representations and warranties agreed to. In particular, the buyer and seller typically establish “baskets and caps” (i.e. minimum and maximum amounts) for indemnifications. The amount and duration of a holdback often mirrors those provisions; and
- Whether pre-existing liabilities exist. For example, if the seller’s company is the defendant in a legal claim, a portion of the holdback may be “carved out” pending the outcome of that claim.
From the seller’s perspective, a holdback is usually not a major issue, since the hidden liability or asset deficiency would have impacted the seller’s in any event, had the business not been sold. However, the seller should insist that the holdback amount be placed in escrow, to reduce the collection risk once the holdback conditions have been satisfied.
In some cases the seller acquires representation and warranty insurance, so that the funds are immediately available for use. Representation and warranty insurance is only cost-beneficial in larger transactions, where the income that can be generated on the funds that would otherwise be in escrow exceeds the cost of the insurance policy.
Buyers sometimes use promissory notes where they do not have sufficient cash on hand, and cannot obtain debt financing on reasonable terms in order to consummate a transaction. Promissory notes are also used in cases where the buyer and seller have agreed to a longer-term holdback (e.g. where environmental issues exist).
Promissory notes are normally one to five years in length. In some cases, the buyer will issue redeemable preferred shares instead of notes. Promissory notes are usually unsecured or rank subordinate to senior lenders. Therefore, they pose a collection risk to the seller.
Sellers often look for a high interest rate in order to compensate them for the collection risk inherent in promissory notes. However, interest income is taxable to the seller at high tax rates. Therefore, a more advisable strategy may be to increase the purchase price and accept a low-interest (or no interest) rate promissory note. The higher purchase price is treated as a capital gain, of which only 50% is taxable.
Share exchanges involve the seller exchanging shares of their company for treasury shares of the buyer. Share exchanges are sometimes used by small-cap and mid-cap public companies that use their shares as currency in lieu of cash. Share exchanges with a buyer that is a privately-held company are unusual because of the challenges in establishing the value of the shares received, the uncertainty surrounding liquidity, and the complexities of negotiating a shareholder agreement.
A share exchange can be structured to defer taxes to the seller. The seller pays taxes once the shares that were received as consideration are sold. However, the seller should be aware of the risks they assume when accepting shares of a small-cap or mid-cap public company as payment. In many cases, there are restrictions on liquidating the shares received, often for a period of six to 12 months, depending on prevailing securities legislation. Even when no legal restrictions exist, there may be practical limitations on selling the shares where the buyer’s stock is thinly traded.
Pursuant to an earnout, a portion of the purchase price is conditional upon the seller’s company achieving agreed criteria after the closing date. There are five parameters to consider when negotiating an earnout:
- The basis of measurement. Earnouts are typically expressed in terms of revenue or profitability (e.g. gross profit or operating income). Whatever basis is used, the rules for calculating it must be clearly defined;
- The duration of the earnout. A period of one to five years is not uncommon. The longer the earnout, the less likely that it will be received;
- The seller’s ability to control the company’s results following the transaction. In most cases, the seller will be employed pursuant to a management or consulting contract for the duration of the earnout period, so they can influence the likelihood that the earnout criteria will be achieved;
- Whether or not the earnout is cumulative. That is, whether the seller has an opportunity to recover an earnout that was missed in one year by overachieving in a subsequent year; and
- Minimum and maximum amounts. Most earnouts are structured as “cliff payments”, meaning that no portion of the earnout is payable unless a minimum threshold is met (e.g. no earnout is payable unless the company achieves at least 90% of the agreed revenue target). Buyers typically insist that earnouts be capped at a maximum amount as well. Earnout limits are usually advisable from the seller’s perspective as well, to ensure that the proceeds received are treated as a capital gain for income tax purposes (rather than ordinary income).
The terms of a deal are just as important as the stated purchase price. Sellers should recognize that any dollar not received at the closing date of a transaction represents a dollar at risk. They must be satisfied that the prospective reward is worth the risk. In some cases, it may be prudent to accept a lower cash purchase price than to deal with the risks and complexities of non-cash deal terms.