3 Reasons Why Selling Price isn’t Necessarily a Cash-Equivalent Value

The saying “a bird in the hand is worth two in the bush” rings true when evaluating the time value of money. That is, depending on an investment’s risk and payout period, $1 paid out today could be worth more than $2 promised to be paid far in the future.

How does this concept relate to business valuation? When the value of a business is based on the sales of comparable companies under the guideline merger and acquisition (M&A) method, it’s important to understand the cash-equivalent value of comparables. Creative deal terms can make a deal more (or less) valuable than it appears on the surface. Here are three common reasons why selling price can be a misleading metric and may require an adjustment to arrive at a cash-equivalent value.

  1. Installment contracts

In some situations, the buyer may pay the seller a lump sum up front and then make ongoing installment payments over a period of time (usually, three to five years). These deals sometimes require interest payments, as if the seller is providing financing for the buyer. Other times, the interest rate is wrapped up in the installment payments and can be imputed based on market rates.

Installment contracts are particularly common among small businesses when a shareholder is settling his or her divorce — or when a controlling shareholder is buying out a minority shareholder. Typically, installment sales are used to finance deals when the buyer has limited cash and access to bank loans, possibly due to weak credit, high leverage or insufficient personal assets to guarantee a loan. Here, the seller bears additional risk, because there’s a chance that the buyer may be unable to make timely installment payments.

  1. Earnouts

Likewise, a buyer who’s skeptical of management’s estimates of future earnings may hedge its risk with “earnout” payments. With an earnout, the buyer pays a lump sum down payment, and then the remainder is contingent on the company’s future performance.

The seller may receive the rest of the selling price if certain benchmarks are reached. These benchmarks could include future revenues, market share or cost synergies. Or the seller may opt to receive a set percentage of, say, the company’s gross receipts or net cash flow for a certain number of years.

These provisions can get complicated, so it’s important to define financial terms, payout limits and timing issues upfront. The use of an outside accounting firm can help ensure unbiased financial reporting under U.S. Generally Accepted Accounting Principles (GAAP).

  1. Contractual agreements with sellers

Buyers and sellers may enter into a variety of contractual agreements, including noncompetes, consulting agreements and employment contracts. These may, for example, protect the buyer from competition by the seller (for a specific number of years) or ease the transition from the seller’s management style to the buyer’s style.

Sometimes, these contracts are excluded from the selling prices that are reported in transaction databases. But in other cases, pieces of a deal are bundled together, and the valuation professional must allocate value to each component of the selling price in order to achieve apples-to-apples comparisons. In some industries, however, a noncompete agreement may be standard, and can’t realistically be separated from the selling price.

A need for adjustment

The guideline M&A method has intuitive appeal, because it’s based on real-life transactions. But experienced valuation professionals know better than to blindly accept comparable deals from transaction databases at face value. It’s critical to understand each deal that’s being used as a comparable. Often, “selling price” includes creative deal structures that may require adjustments. For help understanding how this method works, contact a credentialed valuation expert.

 

Sidebar: Bridging the gap

Creative deal structures — such as installment payments, earnouts and contractual provisions — often come in handy when there’s a big difference between the seller’s asking price and the buyer’s offer price. For example, suppose a seller is asking for $10 million, but a buyer thinks the business is worth only $8.5 million. Can the parties work out their 15% difference of opinion?

This hypothetical scenario was worked out with some creative planning. First, the buyer’s valuation expert suggested that the parties could structure the transaction as a stock deal, which worked to the seller’s advantage from a tax perspective, because the seller’s proceeds are generally taxed at the lower long-term capital gains rate.

Then, the seller’s valuation professional recommended an earnout provision to help reduce the risk that the company wouldn’t reach its cash flow projections. If the buyer would pay 65% of the selling price upfront ($6.5 million), the seller would accept the remainder ($3.5 million) over five years. Moreover, the remainder would only be paid on a sliding scale based on whether the company met predetermined revenue benchmarks over the earnout period. No interest would be paid during the earnout period, and the seller agreed to sign a seven-year noncompete agreement.

As a result of these bilateral concessions, the buyer and seller were able to break their deadlock. And they agreed on a creative deal that served the needs of both parties.

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