Rollover Equity
Often, the purchaser of a business wants the owners/operators of the seller to retain an interest, sometimes called “skin in the game,” in the purchased business to help ensure a smooth transition and continued success. For some businesses that are regulated as professional corporations or companies, such as attorneys, architects, engineers, public accountants and physicians, ensuring representation of the former owners on the cap table is critical to ensure that the business retains its professional status. For others, the former owners can provide invaluable knowledge and experience as the business undergoes a transition, and the former owners’ continued role with the company may be crucial to the deal. Rollover equity is a component of the purchase price, commonly employed in private equity deals, that enables a seller to “roll” a portion of their existing equity stake into the capital structure of the post-closing business and retain skin in the game. Rollover equity can be beneficial to sellers who may find the prospect of a “second bite at the apple” (i.e., additional consideration from dividends or a future sale of the post-closing business), and can be beneficial to purchasers who may wish to reduce the amount of cash they need to bring to the closing table.
Seller Financing / Deferred Payments
Seller financing is a process by which the seller offers funding to the purchaser as part of the transaction, obviating the necessity of a third party lender or investor. Seller financing is usually achieved by drafting the purchase price such that the purchaser pays an initial negotiated down payment, and subsequently pays the remainder of the purchase price in installments over time. In this way, the purchaser need not have the funds sufficient to pay the purchase price at closing. Seller financing via deferred payments can be a suitable way to bridge the valuation gap between the sale and purchase price, but it involves the negotiation of other critical terms such as interest, the deferral period, and covenants to safeguard the future payments and adequately align the interests of the seller and purchaser.
Earnout
Another way to bridge the valuation gap between the seller’s sale price and the purchaser’s purchase price is to utilize earnouts. If the proposed sale price is in excess of the proposed purchase price, a mechanism that enables the parties to “meet in the middle” is for the seller to “earn” a portion of the purchase price over time by achieving certain target milestones. These milestones are often tied to specified revenue or earnings targets. If the target milestones are not achieved, then the purchaser retains the unpaid remainder of the purchase price. If the target milestones are achieved, then the seller “earns out” the remainder. Earnouts involve careful drafting by deal lawyers to ensure (1) the value of the earnout precisely tracks the intent of the parties, and (2) the earnout language is clear on the methodology for determining how and when the future payments are earned. This process usually involves the preparation of an “earnout statement” by the purchaser at some point after closing, and the opportunity for the seller to object to or dispute the purchaser’s calculation. Deal lawyers are often involved not only in the drafting of the provisions, but also in the tracking and enforcement of these post-closing requirements. Earnouts, in particular, are so commonly litigated that some deal lawyers typically recommend that purchasers discount the purchase price by 20% so they have extra cushion for litigation initiated by sellers.
Indebtedness and Transaction Expenses
Many first-time business sellers expect to receive the full amount of the purchase price at closing, but usually there are other wires that come out of the flow of funds before the seller sees their proceeds. Two of the most common expenses that come out of the proceeds before the seller is renumerated are (1) the payoff of business-related indebtedness incurred by the seller, and (2) transaction expenses. Indebtedness is usually paid off out of the closing wire to ensure that the purchaser is not encumbered with any lingering liabilities that may arise from third-party debtholders of the seller after closing. Any party that is owed money by the seller will want to make sure they are repaid before the ownership of the target equity or assets changes hands. Often such indebtedness will be secured by liens, and so it is the responsibility of the deal lawyer to ensure that any outstanding liens are identified and terminated as a part of the diligence process.
Similarly, any third parties that expended time, costs, and professional resources to ensure the successful execution of the deal (e.g., lawyers, accountants, brokers, and investment bankers) will want to make sure that they are paid for their services rendered at closing. As such, sellers and purchasers alike should take special care to ensure they have identified all outstanding business-related indebtedness of the seller and have negotiated how any transaction expenses should be handled at closing. While these elements do not necessarily impact the value of the target equity or assets or the purchase price, they likely affect the amount of cash available to the seller after these considerations are dealt with, which may in turn affect the seller’s calculation of the sale price.
Indemnity Escrow
Another provision that sellers should track is the indemnity escrow. If an indemnity escrow is a feature of the purchase agreement, then a portion of the sale proceeds will be held in escrow to cover any successful indemnity claims the purchaser (and often any other indemnified parties affiliated with the purchaser) makes against the seller during a negotiated period. For instance, and depending on the drafting of the purchase agreement, if the seller, during such negotiated period, is discovered to have breached any of the representations and warranties made under the purchase agreement to which indemnification applies, then the portion of the purchase price being held in escrow for indemnity may be paid out to the purchaser. This effectively reduces the proceeds received by the seller, and therefore, the indemnity escrow is typically a hotly contested point during negotiations between the seller and purchaser.
Adjustment Escrow
Like the indemnity escrow considerations, an adjustment escrow is also a common feature of a purchase agreement that can directly impact the purchase price. Adjustment escrows are included in deals to ensure that if an adjustment to the purchase price occurs after the closing, a portion of the proceeds are set aside and held in escrow by a mutually agreed third party who is authorized to release the funds in accordance with certain parameters. Deal lawyers should carefully consider whether it is appropriate to draft an Escrow Agreement that explicitly governs the relationship between the purchaser, the seller and the selected Escrow Agent. Escrow Agreements should clearly define (1) what an Escrow Agent is and is not authorized to do with the funds in its custody, (2) what actions require the purchaser’s and seller’s joint written consent, as opposed to those actions that should occur automatically, and (3) what liability the Escrow Agent will have with respect to the handling of the funds. Unclear or missing instructions with respect to funds held in escrow can result in costly litigation in order for a party to petition a court for a final, non-appealable judgment ordering the release of the funds.
Conclusion
This article began with a simple definition of a transaction: the sale of assets or equity by a seller in exchange for cash from a purchaser. However, as we have discussed, there are many complex considerations that can greatly affect the purchase price. At best, thoughtful drafting by a deal lawyer can help a purchaser and seller craft a deal where there might not otherwise be one. An effective deal lawyer can help bridge valuation gaps, mitigate risk, and protect both immediate and long-term interests. On the other hand, superficial analysis and drafting can have catastrophic consequences in dealmaking, and lead to results like overexposure to risk, avoidable litigation, and money left on the table for a client. It is therefore essential to have a professional understanding of the concepts discussed above, and many others that dealmakers rely on counsel to get right.
