When selling their businesses, sellers often receive payment in the form of cash, equity in the buyer or some combination of the two. Each of these options can have a big impact on the actual value sellers will receive from the sale of their company.
Before diving into the things to consider when evaluating an offer with both cash and equity purchase price, it’s important to take a quick look at the differences between cash and equity sales agreements.
Cash vs. Equity
In a cash only transaction, a seller can expect the following:
1. The sales price is paid for using the acquiring company’s cash reserves or cash acquired through financing. There is no upside if the combined company do well after the closing date.
2. All cash deals are primarily done by private equity funds or cash-rich companies.
3. All cash deals carry less risk than equity-based transactions because the seller gets all the full purchase price at closing.
If equity is part of the deal, a seller can expect the following:
1. The sales price, or a portion of it, is paid for through some form of exchange of stock between the buyer and seller.
2. Sellers have some percentage of ownership in the combined company.
3. Using equity as purchase price is popular with companies who acquire competitors or when the sellers are staying on as employees after the deal closes. In that instance, the buyer wants the sellers to be aligned with the buyer, and this is accomplished, in party, by the sellers owning equity in the combined company.
4. Using equity as part of the purchase price allows the buyer to preserve cash.
5. Equity deals carry more risk for sellers than a cash transaction but may have way more upside if the stock price goes up.
6. It may be hard for the sellers to determine if the equity value they get as purchase price corresponds to the fair market value of the company. Sellers should have their own independent determine of valuation before they take equity in the combined company.
7. Sellers may be uncomfortable owning equity in a company they don’t control.
8. Equity may not have liquidity so sellers might have to hold the equity until the combined company has an exit. A seller’s equity is at risk until the seller has a liquidity event.
9. Taking equity in a publicly traded company may result in the shareholder having additional filing obligations.
When dealing with a transaction that has both a cash and equity component, sellers will also need to consider the exchange ratio. This is the ratio of stock, in addition to cash, that the sellers will get for each share in their company. Take the following example:
Company A offers $50 and 0.75 shares in company A for 1 share in company B. The 0.75 shares is the exchange ratio for this particular transaction. The main thing to consider is whether that ratio will be fixed or floating.
A fixed ratio means that the ratio of stock remains the same regardless of what happens between the announcement and closing date. Going back to our earlier example, if company A’s stock price takes a hit between the time the deal was announced and the closing date then the seller will end up taking a loss on the transaction.
If doing a mixed offering, it’s much better to get a floating exchange ratio. A floating ratio ensures that the ratio of stock can be adjusted to account for any changes in the stock price that may occur before closing. Doing so can protect sellers from losses related to changing market conditions.
Conclusion
Taking all of this into consideration, what should sellers keep in mind when accepting equity as a form of payment? A cash deal is only worth as much as the agreed sales price and there generally won’t be opportunities for additional earnings. On the other hand, equity deals are typically the riskier option. The amount of purchase price received in equity has inherent risk but may have a high return. Picking the right buyer and taking equity allows sellers to have a “second exit” which may provide significant returns for the sellers.
Bottom line: a seller must understand the desired goals for the sale and understand his or her risk tolerance before deciding whether to take equity as all or a portion of the purchase price on the sale of their business.
Regardless of which payment form you decide to go with, having an experienced M&A advisor like Seck Advisor Group can make determining which structure fits your needs best easy. Contact Sheila Seck at sseck@seckadvisor.com.