Research

Congratulations you are the majority shareholder and just received several offers to sell your company for $100 million! The question is, at the end of the day, how much will you keep? A lot depends on how well you structure and negotiate the transaction. In the example below, if you sell your company for $100 million, you net $16 million at the closing. But do not despair, this is a worst case scenario.

The buyer may propose an earnout for 33% of the sales proceeds since there is a significant price gap. You have to pay other shareholders. You have to pay federal, state and local taxes. You will be responsible for working capital adjustments, which can be a significant amount. You need to negotiate a holdback taken out of the purchase price at close to go against potential liabilities post-transaction. Finally, you have to pay your advisors transaction fees. This article will explore how to maximize how much you keep of the sales proceeds.

Does the Buyer Propose an Earnout?

An “earnout” is an acquisition payment mechanism where a portion of the purchase price of the selling company will only be paid by the buyer if the seller attains agreed-upon performance goals after the closing.

Well-structured earnouts allow growing companies to increase their sales price and incentivize the seller’s management team to stay with the buyer after the closing of a transaction. By contrast, poorly structured earnouts reduce the seller’s value to the acquirer, demotivate management, and result in litigation. For more on earnouts, please see my LinkedIn article: How to Structure Effective Earnouts

Pay Other Shareholders

This sounds obvious, but cap tables can get complicated after successive rounds of fundraising. It is worth using cap table software to keep track of the cap table at the earliest stages of a company.

Be careful of the minority shareholder who is a founder but no longer an operating manager. He can hold up a transaction with a lawsuit as a dissenting shareholder not agreeing to the sale of the company. It is worthwhile to buy out founders early, when they leave a company, to make sure you have a clean cap table when it comes time to sell.

Minimize Taxes

Like any other transaction that makes you money, the sale of a business is considered income and you are required by law to pay taxes on it. This income is often classified as a capital gain and it applies whether you’re selling the assets of a company or shares of a company’s stock. A 20% long-term capital gains tax rate applies to taxpayers in the highest (39.6%) tax bracket. However, the tax consequences and liabilities that you’ll endure will depend on the type of sale in which you have made with the buyer.

Tax Free Exchange

One kind of tax-free deal you can make is with stock exchanges. For example, let’s say your buyer has their own corporation and they want to give you stock in their company in exchange for you giving them stock in your company. As long as certain IRS provisions are met which pertain to a reorganization, you can conduct a stock exchange like this and not have to pay any taxes. The IRS states that the seller must receive between 50% to 100% of the buyer’s stock in order for it to be tax-free.

State and Local Taxes

Make sure you pay attention to state and local tax implications, too. While federal taxes are going to require you to pay on the profit from selling your business, things may be different at the state or local level. While there are sure to be state taxes, you’ll want to check into the implications of what those might be in your particular state.

Private Wealth Transfer

At the beginning of the process, you should hire a private wealth advisor regarding how to transfer shares at a lower valuation now than when the offers are on the table at the LOI stage. Planning in advance of a sale can help owners to take advantage of valuation opportunities in transferring wealth to younger members of the family. Evaluating long-term philanthropic goals and implementing a plan in connection with the sale may fund a charitable strategy at a minimal income tax cost.

Optimize Deal Structure

Deciding whether to structure a business sale as an asset sale or a stock sale is complicated because the parties involved benefit from opposing structures. Generally, buyers prefer asset sales, whereas sellers prefer stock sales. An asset sale is the purchase of individual assets and liabilities, whereas a stock sale is the purchase of the owner’s shares of a corporation. While there are many considerations when negotiating the type of transaction, tax implications and potential liabilities are the primary concerns. Furthermore, if the entity sold is a C-corporation, the seller faces double taxation. The corporation is first taxed upon selling the assets to the buyer. The corporation’s owners are then taxed again when the proceeds transfer outside the corporation.

Understand Debt Free, Cash Free

Most acquisitions are structured as acquisitions of stock or assets on a cash-free, debt free basis. In other words, the buyer acquires a business that typically has no financial debt and limited or no cash in the operating account. Buyers often require that a minimal amount of cash be left in the business so that short term needs can be met without drawing on an interest-bearing revolving facility or potentially delaying vendor payments or payroll. Net working capital (“NWC”) is working capital less excess cash.

Negotiate Working Capital

The working capital issue can surprise a lot of sellers and cost them millions of dollars. Many business owners assume the purchase price for their business will be based on a multiple of some financial metric (e.g. revenue or EBITDA). This is generally true, but a buyer may also require a specific or minimum amount of “working capital” on the balance sheet when they buy it to ensure there are no immediate liquidity issues.

Peg or Working Capital Target

The working capital target (also known as a “peg” or “true-up”) is an important part of an acquisition where millions of dollars are at stake, is poorly understand by many, and is typically left until later stages of the deal. Very often, sellers leave significant amounts of money on the table (to the benefit of the buyer) as a result of not understanding and addressing the working capital issue earlier in the acquisition process. In fact, sellers would be best suited to understand the impact of working capital well before they begin the process of selling their company.

The most common method for determining a peg is a 12-month historical average. If a business has been growing very rapidly, then taking a simple average of the latest twelve months may understate the amount of working capital needed to run the business. In that case, it may make sense to use a 12-month weighted average, or an average based on the latest 6 month period, or even latest 3 month period.

To the extent that the actual net working capital exceeds the target, then the seller is owed the difference in a cash payment. If the business shows a deficit relative to the target, then the seller owes the buyer the difference. Due to unpredictable nature of sales, billing, and collections, there is always a payment one way or another, also known as the post-closing “true-up”.

Minimize Holdbacks for Indemnification Pool

Buyers in mergers and acquisitions often negotiate purchase price escrows and holdbacks to secure post-closing obligations of sellers. Escrows (where a third party holds funds) and holdbacks (where the buyer retains funds) defer payment of a portion of the purchase price to sellers and provide a pool of funds to the buyer to offset indemnification claims or other post-closing obligations. Although specified dates are common triggers for release of these funds, release can also be triggered by the achievement of milestones or the satisfaction of post-closing conditions. My LinkedIn article on “How to Accelerate Closing a Transaction” is a helpful guide on what is market for terms and conditions such as holdbacks.

Negotiate Transaction Fees

Last but not least, make sure you negotiate transaction fees with your advisors upfront.

Experienced Attorney

Make sure you hire an attorney with extensive M&A experience. M&A is a complex topic and hiring an inexperienced attorney can be very expensive in the end. Condider asking for a fixed fee for the transaction as opposed to an hourly rate.

Seasoned Investment Banker

Hire an investment banker to guide you through the process, to reach out to potential acquirers to create competition and to negotiate the best terms and conditions. Fees vary widely so contact a few bankers and ask for their proposals. Make sure they have experience in your specific sector so they understand the true value of your company and have senior level connections with buyers.

Brand Name Accountant

A brand name accountant should be hired since the potential acquirers need confidence in the financials. Make sure you ask the potential buyer if they require audited numbers versus just reviewed, since reviewed can be much less expensive.

Private Wealth Advisor

Finally, hire a private wealth advisor early in the process to save on taxes for intergenerational transfers and charitable giving, as stated earlier in the is article.

Conclusion

At the end of the day, the $16 million you keep at the closing can be considerably more if you prepare well for the process, hire experienced advisors, and aggressively negotiate the right terms and conditions of a transaction. In the example at the beginning of this article, by decreasing taxes, negotiating working capital and the holdback, the net amount at close is $22 million, a savings of $6 million.