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— A VPA Perspective

Price Adjustments Affecting What a Founder Receives When Selling Their Business

  • Why founders may need to adjust their expectations about what they take home in a transaction
  • Why various price adjustments exist and the effect they have on purchase price

A common oversight on the part of founders is not realizing that what a founder receives in cash at the close of a transaction is not the same as Valuation (Enterprise Value) x Ownership %.

In reality, the purchase price undergoes several adjustments (most of them downward) before arriving at the closing cash payment to founders.

Why do founders need to understand these adjustments?

First and foremost, so founders can adjust their expectations. If a founder doesn’t anticipate these adjustments, they’ll experience a rude awakening as they begin to contemplate a close and see the purchase price significantly adjusted downward.

A second important reason to understand these adjustments is because, while the majority of the adjustments won’t be negotiable, some are open for interpretation with differing points of view on the buy-side vs. the sell-side. As such, founders are better off if they’re in a position of leverage to address negotiable issues.

To give you a sense of what to expect, take a look at a basic example below of how adjustments to the purchase price influence what a founder takes home.

Calculating Closing Cash Payment Amount

Purchase Price (Enterprise Value) $50M
(+) Cash $1M
(-) Debt $(2M)
(+/-) Working Capital Adjustment $(1M)
(-) Escrow/Holdback $(1M)
(-) Transaction Expenses $(2M)
(-) Rollover Equity $(15M)
Closing Cash Payment Amount $30M

In the above example, the company was valued at $50M but founders only took home $30M in cash. What happened? Let’s walk through it.

Adjustments for Cash and Debt (Net Debt)

Buyers and investors acquire companies on a cash-free/debt-free basis, meaning that the shareholders are entitled to any excess cash in the business but are also responsible for paying off any debt they used to finance the business. The adjustments for cash and debt are often represented together as Net Debt (Debt - Cash).

Why are transactions conducted as cash-free/debt-free? Like in the sale of a home, the owner only has title to their equity in the asset, not the portion financed by debt. To arrive at the equity value, you have to subtract Net Debt from the enterprise value.

To create a cash-free/debt-free transaction, cash is treated as an upward adjustment to the purchase price, and debt a downward adjustment. These adjustments come at the end of the transaction because, to determine what is cash and what is debt, a buyer/investor has to fully diligence the business.

The debt adjustment will almost certainly include more than just the debt on your balance sheet. During diligence, buyers will look at other liabilities your company faces that you may or may not be aware of. For example, unpaid taxes such as sales and use taxes, taxes from an unknown tax nexus, or taxes resulting from misclassification of employees, would go under the debt adjustment. Accrued expenses could also go into the adjustment for debt.

Working Capital Adjustment

Your business requires a certain amount of working capital to keep operations running without liquidity issues. The working capital adjustment protects buyers by ensuring that enough working capital (i.e. cash and near term cash equivalents like accounts receivable) remains within the business when it changes hands so that operations continue to run smoothly.

The way your working capital adjustment is calculated is relative to a target or "peg" amount that you will negotiate with your buyer beforehand. This peg represents what you and your buyer agree to be a reasonable amount of working capital required to run the business.

When the deal closes, if working capital is above the peg, that will create a positive price adjustment. If below, a negative adjustment.

Learn more about the working capital adjustment

Adjustment for Escrow/Holdback

Escrows and holdbacks are for unknown issues that may come up after the deal closes. The balance is held for a predetermined period of time then released to the founder given no issues surface.

Historically, escrows/holdbacks were calculated as a percentage of the purchase price, but in the last few years, a new insurance product called representation and warranty insurance has resulted in very small balances in escrow.

Transaction Expenses

Transaction expenses are costs of selling your business, including but not limited to:

  • Banker fees
  • Accountant fees
  • Legal fees
  • Other fees for outside consulting services
  • Deal bonuses for employees

Rollover Equity

When you hear about a company being sold for both cash and stock, the stock portion is equity that the founder chose to "roll over" to maintain a stake in the business and participate in future upside. The founder won’t take this money home in cash at the time of the sale, but they will in a future exit or exits after the equity has had a chance to appreciate.

From the perspective of a buyer or investor, having a founder roll over equity can serve as a way to keep them motivated if they remain involved in the business. Buyers/investors vary as to how much or little equity they want founders to roll over. When considering buyers, you’ll want to have this conversation early in the relationship and ensure you’re aligned with the spectrum of outcomes on the stock side.

Special note about rollover equity

Something founders should pay attention to is the security structure of any equity they roll over in the business. While rolled equity’s security structure won’t affect the payout founders receive in the current exit, it will significantly affect payouts in subsequent exits.

In other words, if the structure of your rolled over equity is unfavorable, your percentage of equity ownership may not accurately reflect your economic payout in subsequent exits. If you’re unfamiliar with the nuances of structuring securities or unable to negotiate, then buyers may introduce terms like participation and liquidation preferences that significantly favor the buyer over the founder.

What’s the Takeaway?

The above transaction example is contrived and the magnitude of each adjustment relative to the purchase price can vary considerably. But what founders need to be keenly aware of is that, if a founder isn’t careful and prepared with leverage to negotiate, buyers can considerably reduce the purchase price by offering their own interpretation of certain balance sheet items. For example, some gray areas that can come into play include questions like:

What constitutes debt?

During diligence, buyers will suggest that certain liabilities should be included in the calculation for the debt adjustment. While in some cases doing so is appropriate (such as with an unpaid tax liability), in other cases it is not.

For example, buyers may suggest that a company's deferred revenue (which could be in the realm of millions of dollars) represents a liability and therefore should be treated as debt.

But except in rare circumstances, deferred revenue should never be treated as debt. Still, if as a founder you're not in a position to negotiate on this point, then this misclassification of deferred revenue could represent a significant reduction in purchase price.

What should the working capital peg be?

The higher the working capital peg, the more cash the founder will have to leave in the business to fund operations. As such, buyers will try to negotiate a higher peg, sometimes coloring their arguments with language about "supporting future business operations," which could mean a significantly higher working capital level than historically.

These are just a couple examples of areas where, without lowering valuation, a buyer can materially reduce what they pay for an asset. So what to do as a founder? The key is to create leverage in your transaction and be informed about the ins and outs of the various terms. An investment bank can help you in this regard.

Hire Experts to Sit on Your Side of the Table

There are many subtleties of running a transaction that you as a founder can’t expect yourself to know but that can have a strong effect on your expectations and outcome. Hiring a bank will give you the expertise and bandwidth you need to run a smooth process and realize a good outcome.

Learn more about why you should hire an investment bank.

Modified on Feb 01, 2022