Structure – The Final Variable in Your Selling Equation
By Brian Goodhart
The final component of Your Selling Equation is Structure. The very word gives me the chills as structure is such a big topic and covers so many potential areas. I often hesitate to treat it as a singular component because it’s just not. However, for the purposes of preparing most business owners for a sale, it is often advantageous to speak of structure in two components: sale type and deal structure. While the following content will mention taxes and liability concerns, none of it is meant to be considered tax or legal advice. These issues are complex, and this is where having the right transaction team really becomes crucial.
When we speak of sale type, we’re referring to whether this will be an asset sale or a stock sale. Very broadly speaking, an asset sale is when an acquirer purchases only the assets of a business. The seller essentially trades the assets that make up the business for cash or a series of payments (to be discussed later). After the closing of the transaction, the corporate shell remains behind as do any liabilities of that entity. The only thing the entity owns is the cash consideration received and any contingent future payments due to the seller.
A stock sale is very different. In a stock sale, an acquirer purchases the equity interests of a company directly from the existing owner(s). Here the owner essentially trades his stock certificates for consideration. After the transaction is complete, the owners have cash, or the promises of cash and the new owners have the company stock.
Each of these sale types have positive and negative attributes for both the buyer and the seller. Generally speaking, buyers prefer asset sales as they allow for a step up in basis on the acquired assets and any liabilities are the responsibility of the seller because they stay with the entity. Sellers generally prefer a stock sale because the entire transaction can be taxed at a lower capital gains tax rate and any liabilities the company had transfer to the new owner.
When planning your transaction, I encourage all business owners to speak with their accounting and legal counsel regarding these issues to gain a clear understanding of the implications and costs/benefits of each.
The second component of structure is the deal structure. Here I’m talking specifically about how the seller will receive value from the buyer. As I mentioned in earlier segments, sales are rarely as simple as someone writing a single number on a piece of paper and sliding it across the table. In most instances sales are a combination of things such as cash, equity in the acquirer, notes payable, earn-outs, etc. The seller will use a combination of these things to arrive at a value and risk sharing formula that works for them.
A sample offer may come in as follows:
Sale Price – Price not to exceed 4.7x 2022 Audited EBITDA or $37.4mm payable as follows:
65% – Cash due at closing
20% – 5 Year Promissory Note @ 6.5% Interest Payable Quarterly
15% – Class C LLC Member Units of Newco
Or conversely:
Sale Price – Price not to exceed 5.0X 2022 Audited EBITDA or $39.8mm payable as follows:
50% – Cash due at closing
35% – Earn Out based on EBITDA
15% – 10 Year Promissory Note @ 6.75% Interest Payable Quarterly
At first glance, and if we only look at the sale price, these offers are remarkably similar. They are only about $2.4 million apart with an average value of $38.6 million. However, that doesn’t actually tell us very much at all because these offers have radically different structures. The first offer gives the seller much more security as the initial down payment is larger and the contingency payment is a five-year note. However, there is an equity component as the seller would get an interest in the new company going forward. In Scenario #2, the buyer is offering slightly more value all-in, but the seller is offering less money down, an earn out based on EBITDA and a ten year promissory note instead of five. Neither of these structures is inherently good or bad. They simply must be viewed in context for the seller to understand what is best for him or her.
Given the myriad potential structures, I usually advise people to keep their planning simple at first. With the help of your tax adviser and financial planner, answer some basic questions:
- Would you prefer an asset or stock sale, and do you understand the potential tax ramifications of each?
- How much cash would you like to receive at close?
- Are you comfortable holding a promissory note? If so, for what amount of time and at what interest rate and payment frequency?
- Are you comfortable with an earn out where you share in the proceeds of the company going forward? If so, how much of the deal value would you like to receive this way and for how long?
- Are you comfortable receiving equity or an equity like device from the buyer? If so, how much of the total sale value would be appropriate given your risk tolerance?
Once you have some clear answers about what you want (or maybe what you definitely don’t want) then you’re ready to put it all together.
Brian Goodhart is Capstone’s Director of M&A Advisory Services. If you would like to speak with him about the process of selling a business, please email bgoodhart@capstonestrategic.com
