It is probably a good idea to make sure that you understand the “fine print” affecting the bottom line, being how much you and your fellow founders or stockholders are ultimately going to get to put in your pockets.
Here are my top five “fine print” pitfall items, in a nutshell. I would recommend that you skim this list on your way to your big meeting in the Valley with potential buyers.
1. Currency: How are you being paid? Obviously there is a huge difference between payment in cash and payment in shares (for example, you can’t buy your groceries with shares). And if you do get paid in shares, the distinction as to whether the purchasing company is a private company or is listed on a respectable stock exchange is no less crucial. Beyond tax considerations, payment in shares assumes attributing a certain valuation to the purchasing company, and there is no guarantee that you will be able to sell your shares at that price. You have probably heard of some of the famous cases where the value of shares that sellers received in their exit plummeted before the date on which those shares could be on-sold by the sellers.
2. Earn Out: If part of the consideration is defined as an “Earn Out”, that means that it is conditioned on the achievement of certain technological or commercial milestones following closing of the transaction. So, for example, a $50M price tag might include a $15M payment at signing and a $35M payment that is conditioned on achieving a certain pre-agreed sales target. Obviously, if the sales target is not met, the $35M (or part of it) will not become payable, so the price ends up being $15M instead of $50M. It is wise to keep in mind that sometimes a bird in the hand is worth two in the bush.
3. Escrow: This means that, at Closing, a certain portion of the sale price is not paid to the sellers, but is instead transferred to an escrow agent. This sum will remain in escrow, often for several years, as a security for the buyer guaranteeing the sellers’ obligation to compensate the buyer for any breach of contractual undertakings or inaccurate representations made to the buyer in the transaction. Typically, this sum will be around 10% to 15% of the sale price. So, taking a $100M transaction as an example, a sum of $15M might not be paid to the sellers at Closing. Sellers will instead need to wait several years after Closing to receive the sum, or rather whatever remains of it if claims for compensation were brought by buyer during the intervening period.
4. Holdback: A holdback means that a portion of the consideration that the founders were supposed to receive for their shares will not be paid at the Closing. Instead, it will be paid a few years after closing, on condition that they have continued to work for the company during that period. If founders had committed to working for the company but ended up leaving before the relevant date, the holdback sum won’t be paid to them and their total consideration in the transaction will diminish accordingly.
5. Taxes, Taxes, Taxes: You need to remember that the tax authorities are a silent partner to any transaction. The structure of the transaction will play a critical role in determining the tax rate that will ultimately apply to the sellers. For example, if an acquisition is structured as an “Asset Purchase”, this may result in the sellers paying nearly twice as much tax as they would have to pay were it instead structured as a “Share Purchase”. Similarly, a transaction which includes a holdback (described in 4 above) might result in the founders being subject to a much higher tax rate if the holdback arrangement is not carefully constructed to meet certain conditions. A transaction where the consideration is paid in the form of buyer shares might also lead to unnecessarily high taxes for the sellers, unless they make sure to get the necessary approvals from the tax authorities.
The above is really just the tip of the iceberg for each of the points. There are creative solutions that can be considered and many complex factors that may be involved. I recommend that you consult professionals with expertise in the field in order to try and negotiate and formulate an informed position concerning the “real” value of a proposed transaction. The bottom line is, before rushing to sign with the buyer who quoted the highest price, first make sure you understand the “fine print”.
Though the other deal may make racier newspaper headlines, less $$$ in cash often beats more $$$ in shares, especially if the higher price comes with a significant indemnification escrow or holdback, and a less efficient tax structure which may impose a higher tax rate on sellers.