An economic downturn can result in an M&A uptick: there can be more attractive targets on the market, and sellers can be more motivated to make a deal. But economic uncertainty (like that resulting from the COVID-19 Pandemic) poses challenges for both buyers and sellers looking to make an M&A deal happen. Buyers look to take advantage of acquisition opportunities without depleting their cash reserves by seeking terms that reduce their upfront cash payments. Sellers look to mitigate and manage the additional risks these terms present without jeopardizing the deal. Here are three of the top M&A financial terms that conserve the buyer's cash and still get the deal done.
1. Deferred Cash Consideration
Deferred cash consideration is the most straightforward approach. The buyer pays all cash, but rather than paying the full purchase price on closing, it pays a portion of the purchase price at a later date. The deferred portion of the purchase price can also replace a traditional escrow account, with indemnity and other claims being set-off against the deferred amount instead of being satisfied from the escrow account. For a buyer, this approach allows it to retain cash in its bank account until the deferred consideration is paid, and gives it more control over the exposed amount if there's an indemnity claim against the seller. For a seller, the increased risk lies in the fact the ultimate payment of the deferred consideration depends on the buyer's credit-worthiness. The seller might also be required to postpone its receipt of payment of the deferred consideration in favour of the buyer's existing lender(s). To account for this increased risk and the time value of money, sellers will try to negotiate interest on the deferred amount and might seek security over the buyer's assets, including those of the target business.
2. Equity Consideration
Equity consideration adds complication to the deal. The buyer pays a portion, or even all, of the purchase price in equity securities. For a buyer, this approach offers an immediate and permanent reduction in cash payments for the deal, but it comes with additional dilution for the buyer's existing investors. For a seller, the risk is significantly increased if there's no liquid market for the equity securities it's receiving as consideration, such as in private company shares, or if there's an extended hold period on the securities prohibiting trades. The seller will also face tax consequences for receiving equity, and will want to consider whether there's a way to defer an income inclusion for tax purposes. However, there are benefits to the seller. Equity consideration gives the seller the ability to participate in the upside value of the buyer, including in the target business, and obtain equity securities that it might not otherwise be able to obtain, such as in a private company. Sellers will want to seek some level of due diligence on the buyer's business, and representations and warranties from the buyer to support the valuation the buyer imputes to the equity securities it issues as consideration to the seller.
3. Earnouts
A potentially more complicated approach, earnouts are particularly attractive when forecasting profitability is difficult, as it is in many sectors during the COVID-19 Pandemic. The buyer makes one or more future purchase price payments based on the target business's achievement of specified performance criteria, such as revenue or EBITDA, after the sale closes. For a seller, the risk arises because the seller will have less control over how the target business is run, and therefore over its ability to meet the performance threshold, after closing. Sellers will want to carefully review the earnout terms in the acquisition agreement to ensure they clearly outline the performance criteria and restrict the buyer from making inappropriate changes in the target business that would negatively impact its ability to achieve the performance threshold.
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