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 Tags: M&A

When faced with a potential acquisition opportunity, we often receive calls from buyers asking for the “typical” deal structure. While there really isn’t a typical deal in this space, there are some guidelines that can serve as a good starting point.

Purchase Price

The first thing to remember, is that the offered purchase price doesn’t need to be the same as the valuation amount. Any valuation serves as a baseline; a starting point from which you can apply further risk or stability premiums to best reflect the opportunity and meet your objectives. Perhaps an acquisition helps you to accomplish one of your strategic objectives (such as expanding into a new geographic footprint) – you may want to offer a purchase price higher than the valuation amount. Conversely, you may feel that the transition of the clients will be trickier than normally expected. For this, you may decide to apply an additional discount to arrive at the appropriate purchase price.

Next, keep in mind that purchase price and deal structure are separate items – yet they work together. If your seller would like to receive 100% cash at close, you’ll likely lower the purchase price to properly reflect the additional risk you’re assuming in the deal. On the flip side, if the seller is willing to hold a 7+ year (seller) note, you may want to bump up your offer price a bit. And remember too, that for the seller, it’s what they net from the deal – not what they gross. Tax allocations play an important role in deal structure (more on that later).

Deal Components

Generally speaking, there are 3 potential components to deal structure:

  • down payment
  • promissory note
  • earn out

The down payment component is pretty self-explanatory. This is the cash amount a seller receives at closing. In this industry, we generally see a down payment amount of 20-40% of the purchase price. We have, however, seen transactions with no down payment. Rarely do we ever see a down payment amount of greater than 50% though.

For the balance of the purchase price, there are two available options. We’re all familiar with the promissory note where it’s paid over time with interest. Typical note length is 3-7 years. We’ve seen as long as 15 years, but these are usually in family transition situations. As for the typical interest rate, for seller-held notes the rate is usually 4-6% interest (most lenders in the space are currently at a rate of 7-7.5%).

Earn-outs get a little tricky. An earn-out allows a seller to participate in any upside potential to a transaction. In other words, if the buyer is able to substantially grow the business after the sale (for a specified period of time), the seller gets to share in the additional profits. An earn-out period is typically three years, but could be as long as five. Some buyers will cap the upside potential, but most will not penalize the seller should they have flat or negative growth. In this instance, the seller will just receive the principal amount – the “risk” is that they’re giving up potential interest in exchange for keeping some skin in the game. Note of caution: if the seller is affiliated with a broker dealer, use care to make sure that an earn-out is a viable option.

When a buyer doesn’t know where to start, we’ll often suggest 1/3 to each component, and adjust and negotiate from there.

Lookback

One final thing that’s a component of all deals – the lookback provision. Buyers usually don’t want to pay for assets/revenue that don’t transition. To solve for this, a lookback (or clawback) provision allows added security for the buyer. One year after the deal, most buyers will “look back” to determine how much revenue has transitioned. If that amount is lower than a pre-determined threshold, the buyer will make an adjustment to the purchase price, which is made up in the promissory note. We generally see an 85-90% revenue transition threshold on deals.

Tax Allocations

As mentioned, tax allocations are important to deal structure. Deal components will fall under either capital gains or ordinary income.

Capital gains has a 20% tax rate to the seller and includes any down money, escrow amounts, principle on the promissory note, and the earn-out. Ordinary income yields a 40% tax rate to the seller and is tax deductible to the buyer as a pre-tax expense. Ordinary income items include interest on the promissory note, any non-compete compensation, and any part of the payment that is classified as salary.

For obvious reasons, most sellers want as much of the deal classified as capital gains, and most buyers want ordinary income. This can often become an important negotiating point in many deals.

It’s also crucial to remember that most deals will primarily be classified as goodwill (usually upward of 80%). Finally, deals amortize over 15 years with no depreciation. As such, it becomes imperative for both parties to work with a qualified accountant when contemplating a transaction.

Conclusion

Navigating deal structure can be confusing if you’re not sure where to start. Make certain to work with professionals who are well-versed in transactions and the associated tax implications. From there, everything falls under the art of negotiation as the parties work toward a deal that is amenable to all.

Disclaimer

The above article is meant for information purposes only and is not intended in any way to provide legal or other advice for any specific situation.  Readers always should consult their own tax, accounting and legal advisors before taking any action related to the above article or subject matter.

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