Whenever parties enter into negotiations to buy and sell a target company, one of the first points of discussion is the purchase price. In particular, the purchase price discussion often reflects the amount of cash that will be paid by the buyer to the seller at closing, and, in fact, nearly all acquisitions involve cash as all or part of the purchase price consideration. However, a cash payment at closing is not the only type of consideration that is common in acquisition agreements, and other forms of consideration and the timing of their payment to the seller can help parties manage the risks associated with the acquisition and create incentives for continued cooperation between the parties. This blog, Part 1 in a 5-part series, will provide a brief overview of forms of consideration and the timing of their payment common in acquisition agreements.

1. Cash

As noted above, cash is the most prevalent form of consideration present in acquisition agreements. Cash provides for a certain payment at closing and does not require a continued relationship between the parties. If the buyer is concerned about risks related to the target company, the parties could consider a holdback (i.e., the seller retains some portion of the cash consideration for a period of time) or escrow (i.e., a portion of the cash consideration is transferred to a third party, who holds it for a period of time). If the buyer experiences losses that may be indemnified pursuant to the purchase agreement, the holdback or escrow provides a ready source of funds to satisfy the indemnification claims.

2. Promissory Note

Alternatively, the parties could agree that a portion of the purchase price be paid in installments over time pursuant to a promissory note. This will delay the seller’s receipt of the purchase price consideration and can provide an instrument against which setoff is available to indemnify the buyer for certain losses. The parties should also consider whether the seller will receive a security interest in any assets of the target company or buyer to secure the promissory note. In addition, the IRS will impute interest for tax purposes unless the interest rate on the promissory note equals or exceeds the Applicable Federal Rate then in effect, so the parties should consider what interest rate would be appropriate, keeping in mind that a zero interest promissory note will likely have tax implications.

3. Earnouts

Earnouts are future payments that are contingent upon the target company attaining certain milestones in the future, which may include exceeding an annual revenue target or being awarded a lucrative contract. Earnouts are a good way to bridge the buyer and seller’s differing valuations of the target company, permitting the buyer to pay a lower purchase price at closing while simultaneously permitting the seller to benefit from the target company’s success following the closing. Similar to promissory notes, earnouts can provide a source of funds against which setoff is available to indemnify the buyer for certain losses. Earnouts can be the subject of extensive disagreement post-closing, so careful drafting at the outset is necessary to ensure that the milestones and methods of calculation are clear and that there are mechanisms to resolve any disputes.

4. Equity

The purchase price consideration may include equity in the buyer or another entity, often referred to as “rollover equity.” While this will reduce the liquid consideration the seller will receive at closing, rollover equity can help the buyer retain individual sellers who are key employees of the target company and tie their interests to the continued success of the target company and the buyer. Rollover equity can also result in higher cash payments in the future if there is a future sale of the entity in which the seller holds such rollover equity. In evaluating whether offering equity is appropriate, the buyer should consider:
 

  • whether continued investment by the seller is material;
  • whether it is willing to dilute the equity of its current owners and by what percentages; and
  • how the changes in ownership may affect corporate governance arrangements.

If you have questions regarding acquisition agreements, please contact a member of PilieroMazza’s Business & Corporate Group.

 
Francis Massaro, the author of this blog, is a member of the Firm’s Business & Corporate Group.