I recently appeared on an episode of the Private Equity FunCast: “The Art (and Science?) of the LOI” to talk deal terms with private equity masters Devin Mathews and Jim Milbery. This well-spent hour got me thinking about how confusing some of the deal terms in a Letter of Intent (LOI) must be for first time sellers. As a result, we are launching a series of blog posts that will deconstruct the LOI into easily understandable parts. In this series, we will be covering the following topics:
- The purchase price and how it is calculated;
- The structure of the transaction;
- Key tax issues;
- Key deal terms, including working capital, representations and warranties, and indemnification/escrow arrangements; and
- The legal “mumbo-jumbo.”
We covered much of this during the FunCast, but will take a deeper dive here with a more intense focus.
The Purchase Price and how it is Calculated
For most business sellers the purchase price is the purpose of the deal – cashing in on years of sweat and hard work. At the beginning of every LOI, the buyer sets the price (sometimes called the “enterprise value”), which is a top line number meant to entice the seller. Keep reading. Much of the rest of the LOI contains terms that over time may reduce the price. So, let’s start with how the price is actually calculated, which in a typical buyout is composed of a few standard parts:
- Enterprise valuation (every buyer has a different philosophy on how the enterprise is valued but it is often based on a multiple of EBITDA);
- Reduction of enterprise valuation for debt and other identified liabilities;
- Increase of enterprise valuation for cash of the business (taken together, parts two and three are sometimes referred to as doing the deal on a “debt-free, cash-free basis”);
- Reduction of enterprise valuation for the seller’s costs of selling the business (e.g., transaction bonuses to employees, certain taxes payable by the company and the fees of lawyers, accountants and investment bankers hired by the sellers to help sell the company);
- Increase or decrease of enterprise valuation based on the variation in working capital at closing from a working capital target, which is generally set to approximate a normalized (i.e., average) level of working capital for the company (we will spend some time in a later blog post discussing the working capital adjustment in much more detail).
A numerical example of the purchase price calculation described above would be helpful. The example below is based on a business with $10 million of EBITDA being valued at a 10x multiple:
Enterprise Valuation: $100 million; less
Debt: $20 million (assuming here that the business has a $20 million credit facility with a third party lender); plus
Cash: $1 million; less
Transaction Expenses: $2 million; less
Working Capital Adjustment: Reduction of $3 million (assuming here that at closing the business fails to achieve the required working capital target)
Net Proceeds at Closing: $76 million
But wait, don’t celebrate yet, there’s more: In most transactions there is a holdback or a third party escrow of a portion of the price to satisfy post-closing claims by the buyer against the seller, usually for 12 to 24 months. In this example, let’s call it 10 percent of the enterprise valuation, which may or may not ultimately get paid to the seller. In our example, this reduces the proceeds payable to the seller at closing by an additional $10 million.
Net Proceeds at Closing: $66 million
And more: In some transactions, there is a requirement that the seller either rollover a portion of the proceeds into new equity of the buyer (rollover equity) or provide some seller financing for the buyer to close the transaction (i.e., a “seller note”). The rollover equity usually only gets paid when the buyer ultimately sells the business. The seller note should, at the latest, get paid when the buyer sells the business, but will often have a set term to it (e.g., two to five years). If there is rollover equity or a seller note this could account for another 20-50 percent of the proceeds. In our example, let’s assume a 20 percent rollover or $20 million.
Net Proceeds at Closing: $46,000,000 (which you will note, is not $100,000,000).
In our example, however, the seller would still own 20 percent of the company on a go-forward basis due to the rollover of 20 percent, which, depending on the seller’s objectives and views of the company’s future prospects, can be a positive thing. Moreover, the value attributable to the rollover is usually not taxable at such time – but that is a whole other subject…
The moral of the story is that when selling a business, don’t just focus on the topline number. Read the fine print!
Stay tuned for future installments as we continue to deconstruct the LOI.