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Is Cash King: The Merits of Taking "Paper" as Consideration for the Sale of Your Business

29/06/2010


Is cash king? The answer is almost always a resounding yes, especially when it comes to selling your business. The reason is that taking cash mitigates the risk that you won’t recover full value in the future. BUT these days 100% cash deals are rare and there are always exceptions to rules. Here are three situations where it may be better to take some form of “paper” (deferred or non-cash compensation).

  1. Shares: Exchanging the shares of your business for the shares of the acquiring business can have significant benefits if there is expected “upside” in the combined business. If the acquiring company is public versus private, the seller gains liquidity (though usually there is some minimum hold period). The risks are that the combined business’ shares reduce in value, there is limited trading volume, or there is a long vesting period, making it impossible to sell your shares when you want.

    Example: I recently witnessed an example in which the selling shareholders of an oilfield service company took the shares of the acquirer as total compensation, in large part because the business plan of the acquirer was so compelling. The shareholders wanted to sell because some of the company’s management were shifting their focus on other unrelated ventures, which the selling shareholders did not want to pursue, so selling to another management team provided them with the best upside for their existing shares. The shareholders also had competing interests, some wanted to grow the business, whereas others just wanted their money back. This was a win/win for all parties.
  2. Earn Out: Earn outs are a deferred compensation for the purchase of a business, and there is typically some action on the part of the vendor to earn the additional consideration. Earn outs are most favourable when the existing shareholder has better information about a perceived risk voiced by the acquirer. If the existing shareholder thinks the risk is outweighed by the possibility of a much better result than anticipated, it may be worth taking the earn out. It also helps, if owner is going to remain working within the business for some period of time, to ensure control over the results. Earn outs are only favourable (over cash) if there is some “upside” potential of the earn out. This often comes down to adequate forethought and structuring.

    Example: We assisted a paving and aggregate business that owned a gravel resource. The buyer had an engineering firm analyse the proven and probable metric tons of gravel available in the pit. The buyer was only willing to pay for proven reserves, but the owner had so much familiarity with the resource that he knew that the probable reserves were there too. So instead of an all cash transaction, the vendor took some cash and then a royalty on the gravel resource. He earned an additional $2m over the initial offer as a result.
  3. Vendor Take Back: A VTB is effectively a loan from the seller to the buyer. It often helps in situations where capital to finance a transaction is tight. This is especially true of management or employee buyouts. Often times these groups don’t have access to the necessary equity or debt capital to finance a transaction. The VTB will bridge the gap between the available capital and the purchase price. We are seeing a growing number of instances in which owners are taking a partial VTB, even when the buyer is a strategic or financial. This is being spurred on by the continued tightness of credit in the banking industry. A VTB should always include defined payment and interest terms and most importantly security such as a charge on the assets sold.

Remember, vendors should always be compensated for taking paper. This comes down to negotiation and proper transaction structuring. There can be a number of pitfalls to watch out for and this is where expert advisors can help.

For more information please feel free to contact myself, Peter Kinkaide, CFA, Corporate Finance, or your local MNP advisor.