EXIT STRATEGIES: A good deal structure

Good deals occur where parties are flexible, understand that no one wins if no deal is made and when everyone walk away feeling like they have won.

Good deals usually can be done quickly where both parties see a good result being achieved for both parties. A buyer who feels they have acquired a firm which can provide a good return on the purchase price, is a deal which can later absorb some problems. A seller who knows they achieved a sale which was worth more than the conventional financial value of the firm can also feel rightly proud of the deal. The key is to make everyone happy with the result.

Whether you are approached with an offer or you stimulate an offer by establishing the relationships as described in this process, you will end up negotiating a deal with many dimensions. Generally in this type of process it is important to meet somewhere on the same page and in the same book. If you are on another planet with respect to price and conditions, the time will be entirely wasted and both parties will end up frustrated.

In most cases, most elements of a deal are negotiable. Whatever constraints you have and whatever constraints they have in negotiating a deal should be uncovered as soon as possible. For example, you might decide you wish to retire and staying on for any period other than a short handover is not what you want.

There may be pressing family or personal reasons for your decision but it may be sufficiently important for you not to wish to compromise that part of the deal. It may be important for you to have some guarantees of further employment for some of the staff. The buyer may wish to have a guarantee that certain key staff stay on for some minimum period. Whatever these issues are, they should be set out before the serious process of negotiation begins because they help to determine whether they can be met.

I like to think of a deal as representing a certain target value to the buyer. That value represents their view of the balance between the risks in the deal and what they are prepared to pay for the opportunities it represents to them.

They will have perceptions of risks based on industry and personal experience. Part of the entrepreneur’s negotiating objective is to show how the risks have been minimised or removed and how the buyer can fully exploit the potential.

Imagine the target value as a point on a continuum which moves down with higher risk and up with greater opportunity actualisation. The initial task is to move the point up as high as possible by reducing risk and showing greater potential realisation.

Once the best price which can reasonably be expected is offered, you can start to break that value, the ‘deal value’, up into deal elements. The deal value can then be carved up in any number of ways but, at this point, the pie does not get any bigger.

With this approach, both parties can start to set out where they want the value to be spent.

The deal value may be achieved by the seller at some period in the future based on certain conditions being met. To the extent those conditions can be met, the buyer is normally willing to make available the whole deal value. However, to the extent it cannot be met or is not met, the deal value is reduced by some amount representing the cost of correcting the shortfall or the opportunity cost of not having that advantage.

Some minimum level of performance may not be negotiable. So, for example, if the deal depends on certain key employees staying on after the acquisition, additional incentives may be offered to them to gain such assurance. You should consider this additional incentive as a deduction from the deal value, but perhaps essential to satisfy the buyer. Some period of non-compete may also be required to prevent the key managers and shareholders from joining the competition or setting up a new company in competition. If three years was the desirable period but the sellers want only two, the deal value should be reduced by some amount representing the additional risk faced by the buyer.

This framework can provide a workable method of negotiating elements of the deal. Any reduction in risk moves the final deal value up, although this may appear as an increase in the purchase price to the seller. Any increase in risk or reduction in the ability to exploit the opportunity simply reduces the deal value.

In order to fully achieve the value from the deal, the buyer may wish the seller to complete R&D projects, sign up key customer contracts, cancel or negotiate specific obligations, negotiate redundancies or relocate staff. These could be framed as staged payments, earnout or fixed payments on achievements. In other words, the final acquisition price can be made up of many elements, each of which has a fixed or calculated value, which can be paid out in stages or accumulated to an end point and then paid out in some mixture of shares and cash. The period can be relatively short if it is expected that key objectives can be determined quickly, or it could be over a number of years if it requires a considerable period for the objectives to be achieved.

Elements which may be included in the final deal may include the following:

Base Price:

This should represent the minimum that will be paid for the firm. It may be subject to adjustments through a balance sheet audit which will verify valuations and liabilities. It also may be subject to adjustment through warranties and representations for some specified period of time. The base price may be offered in the form of shares in the acquiring corporation, or cash or some combination of both.

Escrow:

An escrow sets aside some portion of the purchase price against adjustments and warranty claims. Generally this will be held by an escrow agent and may be claimed against by providing specific evidence of claims. Usually it is limited in time, such as one year. At the end of the escrow period, the remaining shares are returned to the selling shareholders.

Options:

Options of selling employees may be converted to ordinary shares prior to the sale being consummated or may be carried over into options of the acquiring corporation. Options carried forward provide incentives for employees to stay with the buyer. Additional options may be offered to key employees to retain them.

Stage Payments:

Stage payments are normally aligned to the achievement of objectives. So, for example, they could be aligned to the delivery of certain key R&D milestones, or completion of certain contracts, or the signing of certain key contracts.

Earn Out:

An earnout aligns the purchase price with the achievement of specified revenue targets or other milestones. This may be set at specified increases in the purchase price or a percentage of the purchase price based on specified targets. The additional earnout would normally be for a set period and may or may not be capped. The earnout may be for all shareholders or limited to key shareholders who stay with the buyer.

Continued Employment:

Continued employment of former owner/managers and/or key employees may be sought by either or both of the parties depending on how important those staff are to achieving future objectives. Specific jobs could be negotiated. Specific management agreements and remuneration and incentives may be included in the deal. Some staff may prefer a short term consulting agreement.

Director Position:

Either or both parties may want former key executives to continue on a Board of Directors for some period.

Warranties and Representations:

The acquirer will not be able to verify everything in the deal. To overcome this limitation, they would normally require the Directors and/or shareholders, or some subset of them, to provide warranties and representations about key elements of the firm. This might be asset valuations, contingent liabilities, incomplete litigation, prior balance sheet and revenue statement assurances and so on. Any claims in this area might be taken against an escrow account if that is set up, adjust the final purchase price if some balance is still to be paid, or might be subject to a recall of value through arbitration or litigation.

Non-Compete:

Generally the buyer wants to protect themselves from competition from former key shareholders and executives of the selling firm. This is usually set for a limited period like 2 to 3 years. It would normally exclude the individual from working with a competitor or from undertaking a start-up which would compete.

Holding Period:

Where publicly listed shares are being taken as part of the purchase price, these may be subject to registration. That process may take some months.

During this period the selling shareholders will not be able to sell their shares. There also may be further restrictions on the sale of shares which the buyer requires in order to not flood the market or not to show a lack of faith in the future of the corporation. Shareholders continuing on as key executives may also be subject to non-trading or blackout periods or sale restrictions due to insider trading restrictions.

Specific Liabilities:

The selling shareholder may be asked to take over specific liabilities or contingent liabilities. This may happen where key shareholders have personal loans to the firm.

The buyer may regard their repayment as an obligation of the sellers and not theirs. They may also decide the risks inherent in specific contingent liabilities are too difficult to assess and ask the sellers absorb whatever is the eventual outcome. Since contingent liabilities are often deal killers, this is something which sellers need to give special consideration to.

If the alternatives are no deal or a deal with some possible downside, the latter may still be worth doing. At other times, the contingent liabilities may be capped on either side or may be handled through the escrow.

Costs:

Legal and Accounting professional fees incurred by each party are normally borne by the respective parties. However, these costs may be assigned in some proportion to one or both of the parties depending on the deal structure.

Use of Intellectual Property:

Normally full rights to any IP passes to the new owner, but this need not necessarily exclude use by the seller. It may be possible to negotiate the use of IP for personal or non-competing purposes post sale.

In negotiating the deal, both sides have issues which need to be addressed and both sides usually have some flexibility to trade. A higher risk taken by one side should result in a change in the purchase price. If the sellers absorb some contingent liability risk, this should result in some other advantage to them, such as a higher price or more options etc.

Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia. A series of free eBooks for entrepreneurs and angel and VC investors can be found at his site here.