Acquisition terms you may see when considering an offer.

Over the life of our business Pagely  we’ve seen a few term sheets from potential acquirers (None that we’ve accepted). There are few things I’ve seen in all of them that as a founder stuck out to me.

Cash is not really Cash until it is in your hand.

We’ll use some made up number’s here that make for easy math. 

You are minding your business and someone comes along and ask’s to buy your company. You choose to entertain them and see what they are offering. You got a number in mind, let’s see how how it all shakes out.

The term sheet has this nice big number acquisition price that get’s your attention: $30 million. Hey $30million, that’s a lot of cheddar and in line with what you were thinking is a good price for your company. Okay, so you keep reading and the terms go on to spell out something like this.

  • $8m cash at closing
  • $2m at milestone 1
  • $5m at milestone 2
  • $5m at milestone 3
  • 500,000 stock options

You think to yourself, hey that looks like only $20m, WTF? You keep reading and more details emerge.

  • $8m cash at closing
    • $3m of which will be held in escrow for 24 months
    • $1m of which is written in as a clawback you repay if you or any important staff leaves prior to 24 months
  • $2m at milestone 1
    • This is a simple time-based milestone, after 24months it’s yours.
  • $5m at milestone 2
    • This is a performance milestone, you only get it if your business unit they just acquired and integrated achieves some revenue goal
  • $5m at milestone 3
    • This is another performance milestone like above, but with a higher threshold
  • 500,000 stock options
    • 250k are granted at closing of deal, but on a 4year vesting schedule
    • 250k are actually part of the employment package for your team, but for some reason included in the total consideration of $30m they put in front of you. They don’t include the salary of your team, just the stock allocation. Odd right. And it’s on a 4year vesting schedule. So this doesn’t count as part of the acquisition price.
    • Option strike price is unknown, but for the math to work they assign an illustrative value of $20 per option. 500k * $20 = $10m.

Okay, so you have a better idea now of what you are looking at. Roughly $20m in cash, and $5m in stock options. Hey’s it’s still $25million right, and employement packages for your team. Well…

  • Of the $8m at closing, $3m is locked up in an escrow account you can’t touch for 24 months. This is essentially insurance for the buyer as if any legal trouble or anything pop’s up you did not disclose, they have easy recourse to just deduct what they want from the escrow account.
    • Of the $5m in cash you actually get in your hand at closing, you have to keep $1m of it liquid for the clawback provision in case you or a key team member quits early and you have to pay some of it back.
  • The $2m on the first milestone is essentially yours if you stick it out in 24 months. Cool.
  • The $10m tied up in milestone’s 2 and 3 are only yours if you hit those milestones, this is typically called an earn-out. Now more than likely the term sheet says something along the lines of “buyer will not intentionally make it hard for you to achieve these milestones, but will not put any covenant’s or assurances in writing to such effect”. What this means is that $10m is open to the whims of the acquirer; what if they decide to change tact and pull your team off your business unit to go work on another project for 9 months making it impossible to hit that milestone. Or the acquirer was acquired themselves and the new owner just decides to drop the business unit all together making your milestones not even feasible. So let’s say you only have a 50/50 chance of ever seeing a dime of this $10m.
  • The 250k stock options that are part of the business acquisition are on a 4 year vest. The acquirer is doing well from what you can see so these may be worth something in the future. Is it $1 or $100/share? Who knows. Most likely the default contract language will see you forfeiting any non-vested options if you leave the company prior to 4 years.

So after all that, you figure on the DAY you close this $30million deal (remember it’s really only $20m in cash, and 250k options they are telling you should be worth $20/share someday), you get.

  • $5m in cash, in your hand.
  • 250k stock options (not really yours yet as they have to vest over 4years).

Say it all goes well and a year later you get:

  • 1/4 of your 250k options are vested. It’s a private company, and there is no secondary market demand for these shares, so no realized value.

It’s still going well, and so at the 2 year mark you get:

  • $3m back from the escrow account
  • $2m for hitting milestone 1
  • 1/2 of your 250k options are now vested, still cant sell them as there is no secondary market.
  • You made it this far, so the clawback is void.. so you are not at risk of having to pay back the $1m (of the $5m you actually got at closing)

Yes! It’s now around the end of Year 3, things are still going good and you hit milestone 2. You get:

  • $5m sweet cold hard cash
  • 3/4 of your stock is now vested

Sometime later around the end of your fourth year you hit milestone 3 and you get the last chunk of change.

  • $5M in sweet cold hard cash
  • All 250k options are vested and maybe there is a secondary market or the company when public and you can actually sell these now for profit. WIN! (don’t forget to pay the taxes from your profit)
  • During your employment you likely got a nice 6 figure salary and some additional option’s along the way. Not a bad life really.

But wait, there’s more.

So it all went perfect, no hiccups, everyone is happy.

Let’s assume you have a fairly clean cap table when you sold your company. You own’d 80% of the shares of your business, and 20% is allocated to your employees, and for the sake of argument the 20% is fully vested.

So every  number up there you only get 80% of. 20% of the cash and 20% of the stock is spread around your former employees who had vested shares.

And DO NOT forget taxes at around 30% (of your 80%).

So your net, as the founder looks something more like this.

  • $2.8m at closing, of which $800k still needs to be liquid for for 12mos as your pro-rata share of the clawback
  • $1.6m from escrow at 24 months
  • $1.1m for milestone 1 at 24 months
  • $2.8m for milestone 2 at ~30 months
  • $2.8m for milestone 3 at ~40 months
  • 200k (80% of 250k) stock options
  • – deduct 1-2% in legal fees
  • – deduct whatever debt your company carried when purchased as this is cleared by funds at closing

Best Case:

Your $30million deal netted you ~$11m cash after taxes and dilution and 200k stock options that may be worth a little, or a lot. Not a bad deal at all really.

But, and this is a big but.

Every single acquaintance, advisor, attorney, entrepreneur, financial planner, and even private equity/VC friend I’ve ever talked to about an acquisition deal says the same thing: “You can’t count on ever seeing a dime after closing as hitting those milestones are out of your hands, so you need to be okay with the fact the cash at closing may be all the value you ever realize.” Sure you can negotiate a few things like double-triggers on the options, or reduced escrow amounts, or whatever have you. These changes around the edges of the deal structure can help but may not have an impact on the above statement.

Worst Case:

You go into it with good intentions, ready to work hard, but hit a cultural wall and offer your resignation after 6 months, your $30million deal nets you something around $2.2m after taxes, dilution, and clawbacks.

Average case:

For whatever reason (the acquiring company up and decides to change direction putting the other milestones out of reach, or you become disenfranchised and decided to go start a new project) you walk after 2 years, your $30m deal netted you around $5.5m and some stock (hopefully may be worth something).

Conclusion

So assume your company was generating $10m a year in revenue, you sold it for 3x topline or $30m in cash and stock. In the average scenario above you work hard at your new company, and decide after 2 years to move on. You net $5.5m cash + 2yrs of salary, and some stock. Would you still sell it?

Maybe you rode it a little longer, maybe you didn’t. The moral of the story here is between dilution, taxes, and the whims of the acquirer, you may do better off just continuing to grow the company and optimize it a bit more for profit and pay yourself a fatter dividend. Over time you may, or may not, pocket well over the $5.5m, and still own the asset that was valued at $30m a couple years prior (Maybe it’s worth $35m or $45m now).

So in order to net more cash in a deal like this:

  • Get a higher sales price (get competing offers/build your revenues)
  • Negotiate hard for better structured earn-outs, or no earns-out at all. (Maybe the total deal is only $18m+ stock, but $16m upfront)
  • Negotiate every other part of the deal to your advantage

The buyer is looking to reduce their risk, it’s a large sum of money they are agreeing to hand over to you and your team and they want to make sure they get an ROI on the investment. These deal terms are not bad or evil, they are just the acquirer’s way of reducing their risk.

As a founder it is your job to reduce your risk as well, it’s your company you are giving up. You are able to reduce some risk by selling (realizing some gains on your asset), but if the deal terms are not in your favor you are taking on even more risk that you’ll never see the full value you earned.

As a final note: I’m no expert in any of this. These are just my thoughts and point of view I’ve built over the years going through the motion’s a few times. In the end we have chosen to keep betting on ourselves and our company. This is not legal advice, consult your attorney.. blah blah blah.

 

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Strebel

I write here on this blog. Kinda cool huh.

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