Welcome back to the Deal Influencers Series, are you ready to make a deal? Our first two articles have discussed EBITDA Considerations and Its Impact on Deal Value and The Structure of Your Deal: Asset vs. Stock. The third and final article of our series will discuss two elements of your deal which not only influence its ultimate value but also directly impact the amount of cash you’ll walk away with: 1) earnout provisions and 2) working capital calculations. We will also explore the importance of clearly defining the terms of the purchase and sale agreement in order to properly establish the very foundation of your deal.
In an earnout, part of the purchase price will be paid to the seller after the deal closes based on the company’s future performance. As such, earnout provisions directly impact cash in the seller’s pocket now versus later.
From the seller’s perspective: An earnout ties the seller to the company after the sale. In some cases, the seller may be obligated to remain part of the organization in some capacity. A seller should carefully consider the provisions of an earnout to ensure that they are attainable. Any calculations in the earnout should be clearly defined and consistently applied. For example, if the earnout provision is based on revenues, the revenue recognition accounting policy should be consistently applied throughout negotiations and post-deal.
From the buyer’s perspective: For the buyer, an earnout typically removes some level of uncertainty from the deal. Why would a buyer consider an earnout? If a company is forecasting growth that has not historically been achieved and there is no valid basis for that forecast, the buyer may be inclined to add earnout provisions in the deal. Similar to the seller, if considering an earnout, the buyer should make sure that any calculations in the earnout provisions are clearly defined and consistently applied.
Working Capital Calculation
Working capital is an important financial metric during a transaction as the buyer needs to secure working capital to operate the company post-deal without injecting additional capital. Typically defined during the Letter of Intent (LOI) stage of the deal and then documented in the purchase and sale agreement, the number calculated for working capital cannot be altered post-sale. The buyer typically wants the seller to deliver more working capital and the seller wants to drive the number down. Deals often have an agreed-upon target working capital of which both parties have agreed to.
Why is this important? Any differences from delivered working capital to target working capital could affect deal value. For example, if the target working capital in a deal was $100,000 and the seller delivered $50,000, the seller would be required to give back $50,000 in sales proceeds. Like the earnout provision, the working capital calculation should be clearly defined and both the buyer and the seller should ensure that the agreed upon terms are consistently applied during post-deal calculations.
From the seller’s perspective: For the seller, the most important consideration is to have an understanding of what the minimum working capital requirements of the company are. These requirements should be based on the company’s historic financial information and should be soundly documented and supported.
From the buyer’s perspective: Buyers should be aware that the working capital calculation is subject to due diligence. The due diligence procedures should be applied and buyers should consult an expert to ensure that the numbers and methodology applied are reasonable.
The Purchase and Sale Agreement
A purchase and sale agreement is what binds your deal together. However, the terms of a purchase and sale agreement can often be written ambiguously and not clearly defined. Make sure that you understand the terms and that qualified professionals who are well-versed in terminology for U.S. Generally Accepted Accounting Principles (GAAP) and merger and acquisition (M&A) transactions are taking part in the draft, review and finalization of the document. For example, if a purchase and sale agreement contains an earnout calculation based on a percentage of an adjusted EBITDA and the adjusted EBITDA was not clearly defined, this could result in inconsistent calculations by the buyer and seller. These inconsistent calculations can result in potential future conflict upon settlement of the earnout. Read more about how EBITDA can impact your deal value in our first article, here.
Closing the Deal
This Deal Influencers Series has been based upon the day-to-day transactions that we encounter in the professional accounting field. There are certainly a myriad of other elements that can influence deal value that we did not touch upon such as representation and warranties, nexus studies and expansion on deal value in general. What “deal influencers” have you experienced? Share your observations with us in the comment box below or reach out directly if you would like to further explore any of the ideas that we have presented in this series.