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Leveraging the seller

John Wagner

When you get an offer for your company, the first thing your eyes will jump to on the letter of intent is the TEV, the Total Enterprise Value, a.k.a. the amount that the buyer is offering for your business in sum total.

“Boy, that’s an impressive number!” you’ll say to yourself.

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The next items your eyes will jump to are the terms of how the deal will be financed. That’s when you’ll call your Audi dealer to put your purchase of a new A7 on hold…at least for now. Here’s why: Very often the terms requested by the buyer ask you, the seller,  to  finance part  of the deal. This financing can take the form of seller notes, deferred cash payments, earn-outs, and “roll-over” equity in the Newco that’s being formed by the acquisition.

If you think there’s something unfair about this kind of financing (especially seller notes and deferred cash), you may have a point. You are, after all, essentially loaning money to the buyer to acquire your own company.

But don’t take it personally. These kinds of seller-financing requests are common. The buyer is just doing what buyers do: Trying to leverage the seller, to reduce the amount of cash due at closing, while making a portion of the purchase price dependent on future success.

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Here are a few examples of how a deal might be structured.

In a clean, straight-up deal, let’s say the buyer offers $20 million. If they really want your company, and there are other serious buyers hovering, they’ll pay $20 million in cash at close, and—on their own—seek senior and mezzanine debt to reduce their cash-due requirements. It’s not unusual for around one half of the deal value to be leveraged as debt. This debt is hung on the Newco created by the acquisition, paid down off by Newco’s future performance. For the seller, this deal structure is clean. Go ahead, get that Audi! I’d go cherry red, with the Prestige package.

Other buyers will offer $20 million, and ask for, say, $5 million to be a seller note that the buyer pays interest on (and sometimes principle) over a number of years. Typically, only at the end of the term of the loan is the note paid in full. (Seller notes can also be characterized as deferred cash payments.) However, if the company crashes during the loan term, this debt is very rarely secured. It’s often third in line to get paid in a bankruptcy. So, there’s some risk.

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Some buyers may offer $20 million, and ask for roll-over equity, where the seller leaves in, say, 20% of the deal value, taking ownership in NewCo in exchange. That’s smart for the buyer. 20% of $20 million is $4 million less that they have to come up with in cash. Want to roll the dice on a second bite of the apple? Now’s your chance.

Another common method that buyers use to leverage the sellers is to ask for an earn-out, where a portion of the deal is paid off over time, sometimes as long as three years, when the company meets certain financial performance goals. This column has thoroughly covered this topic, but just as a reminder, always peg the earn-out to gross profit dollars, not EBITDA, and make the payout a percentage of the goal you have achieved, not an all-or-none “cliff.”

In some deals that are highly “financially engineered,” we have seen the buyer putting up as little as 25% of the deal value in cash, or even less. The structure might look like this:

$20 million TEV, with 50% financed by debt; 12.5% financed by seller notes or earn-outs; and 12.5% in roll-over equity.

Ideally, your company is so attractive that there is enough buyer interest for you to set the acquisition terms. You can stipulate no roll-over equity, not seller notes, and no earn-out, while letting the acquirer assume the task of lining up the senior and mezzanine debt if they are leveraging the deal.

But if you don’t have that power to set the terms, you may have to accept at least an earn-out and perhaps some roll-over equity, while avoiding the least-popular option: seller notes. Your investment banker is worth his or her weight in gold at that point and—having seen this all before—they should offer advice on how to avoid the “rocky shoals” of any negotiation and leveraged deal structuring.

John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at j.wagner@1stwestma.com

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