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Now that both the stand alone (fair market value ) and synergistic (investment value) have been determined, it is time to get to the real action ….. making a deal. Price can certainly be affected by deal terms:

•  Amount of Cash
•  Stock Sale vs. Asset Purchase
•  Covenant not to Compete
•  Alternatives to Provide Seller Value
•  Seller Financing / Collateral and Security Agreement

 Bridging the Gap

What do you do when buyer and seller professionally and respectfully disagree about the value? First, look to the deal structure and the after tax net proceeds available to the seller. Under different assumptions and allocations (capital gain vs. ordinary income; single level tax vs. double taxation) consider different structures that are tax efficient to buyer and seller to bridge the gap. The after tax net proceeds amount is usually a smaller gap to bridge than the actual purchase price itself. After all, it is net realized amount that is the true measurement of price to the seller.

When deal structure is not sufficient to make the deal, an earnout might. Usually defined as a percentage of an important measure of value to the buyer, the earnout is really the opportunity for the seller to “prove it”.

•  % of Revenues in excess of base for unmatched expectations
•  % of EBITDA when free cash flows is most important (leverage)
•  % of Buyer Net Income and % of Seller Net Income (if competition for future capital and     resources is an issue)

Most important to any earnout agreement is the definition of terms. What does the term profit mean? Before or after taxes? Before or after year end bonuses? Should there be limits on the amount of overhead that can be allocated? Is the calculation pro-forma? If so, attach a detailed example. For that matter, any earnout calculation should have an example in the Exhibits to the Definitive Agreement.

 Allocation of the Purchase Price

If the transaction is an asset sale/purchase, one of the very first things both buyer and seller should do is prepare a Preliminary/Draft Purchase Price Allocation even if the purchase price is not yet fully developed or determined. The purpose of the draft allocation is to understand the concepts and taxation of the planned transaction as both buyer and seller see it. Form 8594 is required by the IRS and is an excellent tool to start these discussions. From experience, it is a wonder how many parties can get agreement on price, terms, financing, etc and even talk to each other about the concept of allocation without really dealing with the allocation and related taxability in detail, up front. Not understanding the purchase price allocation can be (and often has been) the source of a failed transaction and hard feelings at the end of deal negotiations. Be aware !!!

 Employment Agreements

Used by buyers to assist in the transition of value from buyer to seller and to allocate value to the seller (tax deductible to buyer; ordinary income to seller), employment agreements can either reflect true market value for services or pay “disguised” purchase price proceeds on a tax advantageous deductible basis to buyer. The theory centers around fair market value compensation for services to be rendered.

For lots of other reasons, employment agreements are also very important to sellers. Besides compensation and allowances for employee benefits, participation in stock options, vacation, etc., it is also the employment contract process that is used to “guarantee” continued employment. It is customary that employment agreements “protect” the seller from unwarranted termination. Such contracts are usually for a term certain, the seller cannot be terminated except for moral reasons and provision is made for payment in full if both parties agree to terminate the contract at an earlier date.

 Collars and Packaging Adjustments

When a buyer purchases the shares of a company it also purchases the “current position”. That is, working capital (defined as current assets less current liabilities) is part of the value of the company. However, the current position is often added to the value and then “guaranteed” by the seller of being within a range (say 15%) of the agreed value at the closing date.

Example: Company A has had an average working capital balance of $1,500,000 for the last two years. The value is added and considered as part of the value exchange for a purchase of all of the outstanding common shares of Company A. As part of the Definitive Agreements, a “collar” is negotiated that says if working capital is less than $1,350,000 a reduction in the purchase price will result. Similarly, if working capital is more than $1,650,000 additional consideration will be paid.


Collars also extend to the price of buyer shares sometimes used to purchase the outstanding shares of the target (seller). That is, in a stock for stock purchase, a price will be set for the shares of the buyer being exchanged for those of the seller. If, at the date of close, the price of the shares is “out of the money”, that is, lower than a previously agreed price, then buyer or seller (probably both) can terminate the transaction. The stock price collar goes both ways (a price less than agreed and a price more than agreed) for fairness reasons to both buyer and seller.

Not all transactions are stock purchases. There are also asset purchase agreements. In an asset sale, the assets included in the purchase generally include what is needed for the buyer to assume and then continue operations. Generally, sellers retain cash and receivables and pay off accounts payable, interest bearing debt, etc. Debt assumed by the buyer is really an increase in the purchase price and additional consideration. Sellers should be mindful to add the “selected” assets to the transaction value and carefully exclude those assets not meant to be sold as an Exhibit to the Definitive Agreement. Buyers should be aware of the short and intermediate term financing needs (45-60 days) to start new operations.
 Events Subsequent to the Planned Transaction

As important as it is for sellers to focus on the transaction at hand, it is a prudent seller who also thinks about the future. What if the buyer is later acquired or merged? Usually called change in control it is not unusual for sellers to have their entire purchase price consideration come due and/or even the original price increased if the buyer has a change in control within a 24 to 36 month period. If the subsequent transaction is done at values greater than given in the original transaction, the difference can be measured and added to the original deal.

  Stock for Stock Transactions

If the seller is to receive shares (rather than cash) in the sale, it is important that the seller understands the rights that accompany the shares received. Are there bring along rights (similar to change in control provisions) that allow the seller to have the shares already received to be “brought along” in a subsequent transaction…….to the public capital markets or another business combination of some type.

Similarly, put rights are most valuable and important to sellers who take stock in a transaction. That is, can the seller require the buyer or capital markets to buy the shares and, if so, in what amounts, at what price and at what terms? Obviously, the marketability of the shares (the put right) would increase the value to the seller (now holder) of the securities.

  Timeline/Sequence for a Transaction

Reference Documents
  Prepare Company for Sale
Series A
  Normalization Adjustments
Corporate Records
Bank Financing
Security Agreements
  Prepare Selling Memorandum    
  Executive Summary (Revenues, Gross Profits, EBITDA, summarized)
  Interview / Hire Transaction Assistance
Series B
  Circulate Selling Memorandum    
  Terms, Conditions, Timeline Confidentiality Agreement
  Letter of Intent
Series C
Due Diligence
  Definitive Agreements
Series D
  Closing the Deal
Series E
  Sensitivity Analysis
Working Capital Effect
Sample Earnout

  Series A
  Normalization Adjustments Analysis

  Series B
  Transaction Advisory Services
Engagement Letters

  Series C
  Letters of Intent

  Series D
  Definitive Agreements

  Series E
  Closing the Deal
and Sensitivity Analysis
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