Classification: Deal Driver
Section: Purchase and Sale
Negotiation Time: Substantial
Transaction Costs: Insignificant
Major Impact: Risk Management, Deal Value, and Transaction Completion
The Middle Ground: The Purchase Price provision provides payment specifics, including when payment is due, to whom, and any conditions to payment (such as an adjustment to the purchase price). Depending on the situation, this section may include details about a promissory note, escrow arrangement, set-off rights, and/or earnout payments.
Purpose: This provision gives in-depth information on deal value and can include various risk management tools. The use of a promissory note, earnout payments, set-offs, or escrow shifts the risk between parties and can ultimately change the value of the deal for both sides. Structural payment tools like these are often used to align the Seller’s interests with those of the Business and the Buyer, especially in situations where the Seller will remain actively involved in the company post-close. By using such tools, the Buyer mitigates some risk and the Seller almost always ends up with more money than if the entire Purchase Price was paid in cash at Closing.
Buyer Preference: The Buyer typically looks to utilize a combination of the structural tools discussed above to reduce its initial risk on the transaction. A promissory note allows the Buyer to pay less cash up front and spread the Purchase Price over a set time period. Escrow and set-offs reduce the Buyer’s risk by preventing the Seller from taking possession of disputed payments. Earnouts and Purchase Price adjustments may increase the overall Purchase Price, but only if the Business meets certain milestones at predetermined points in time. By deferring a portion of the Purchase Price to the future and tying it to the performance of the Business, earnouts and adjustments can also help the parties close a valuation gap if one exists, which in turn helps close the transaction without the Buyer assuming greater risk.
Not all structural tools are useful in every transaction. The Buyer determines where its greatest areas of concern lie and chooses the appropriate tools to manage those areas of risk.
Seller Preference: There is no “best strategy” or combination of strategies that works for every Seller; the desirability of each option depends on the Seller’s post-Closing plans and desired level of liquidity. Some sellers may want upwards of 90% cash at Closing with no strings attached. However, the Seller can put a higher price tag on the Business if it allows the Buyer to manage its risk using one or more of the aforementioned strategies. A Seller who is confident about the future performance of the Business may actively seek an earnout structure so that it can benefit from that future success right along with the Buyer.
Differences in a Stock Sale Transaction Structure: Due to tax, liability, and operational consequences, the total Purchase Price of a stock sale is likely to differ from the amount for an asset acquisition of the same company. However, all of the structural tools discussed in this section are available for use in both stock and asset sales.
We want The Middle Ground to be an ongoing dialogue for and resource to the lower middle market M&A community. The outline above is generally applicable, but there is always specific case law and nuance around certain industries that can be useful in helping buyers and sellers come together. If you are a lawyer or deal professional, we encourage you to add your perspective below.