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The entrepreneurial journey is full of innumerable risks: Your largest customers can leave at any time, and for any reason. The market may change faster than your company’s ability to adapt. Your largest supplier may decide to cut you out of the value chain and simply build your product themselves. And so on.
These (and countless others) are just some of the worries that keep entrepreneurs and CEOs up at night. They certainly did for me. The accumulated weight of these risks eventually grows to become quite heavy for many entrepreneurs, particularly for those who have the majority of their net-worth tied up in their companies, which tend to be illiquid private assets for which there is no readily accessible market.
Some entrepreneurs find the strength to endure these sleepless nights by telling themselves that once they sell their companies, they will be able to take all of that risk off of the table for good. They think that selling their companies will be the singular event that will finally lift a lifetime of weight off of their shoulders.
But these entrepreneurs would, in all likelihood, be wrong.
Though selling your company certainly does possess the potential to eliminate some or most of the risk that an entrepreneur bears, it rarely eliminates it entirely. In fact, in my experience:
The single biggest myth about selling a company is that the seller bears no further risk after the sale of his or her company is completed.
In most cases, this is simply not true. Indeed, the negotiation process between buyer and seller can be loosely thought of as two parties mutually deciding which risks will be borne by whom, and whether any given party will bear an asymmetric burden of any given risk.
To better illustrate why this is a myth, what follows is a list of some of the more common ways in which sellers may still bear some risk (in some cases, material risk) even after the consummation of the sale transaction. Though this list isn’t an exhaustive one, you should expect to encounter at least some of these sources of risk when the time comes time for you to sell your own business, so it’s worth educating yourself on them from now.
Acquisition Financing as a Source of Risk
You may be familiar with the idea that an acquiror can use either equity, debt, or cash on hand (or some combination thereof) to finance any given acquisition. In practice however, it is considerably more nuanced. Here are three very common financing tools that acquirors regularly use, each of which transfers some risk back onto the selling entrepreneur:
- An Earn-Out: An earn out can be thought of as a portion of the purchase price that a seller will receive contingent on certain things happening (or not happening). For example, consider an acquiror that has offered to buy your company at a $20M valuation. Instead of paying you $20M in cash however, your acquirer has proposed an $11M cash payment and a $9M “earn-out”. The terms of that earn-out say (for example) that you’ll receive a $3M payment after year 1 if sales grow by at least 5% YoY, a $3M payment after year 2 if sales grow by at least 6% YoY, and a $3M payment after year 3 if sales grow by at least 7% YoY (for a $9M total earn-out). Obviously, that $9M is now fully at risk. To make matters worse, in many cases (at least with respect to majority buyouts), once the sale closes, the selling entrepreneur is no longer in control of hitting those targets, as that is now officially the domain of the buyer, who may be brand new to your business or industry. I happened to use revenue as an example here, but note that earn-outs can be based on EBITDA, cash flow, gross margin targets, or any number of other variables.
- A Seller Note: If an earn-out can be considered a form of equity, then a seller note (also known as a vendor-take-back note, or “VTB”) can be considered a form of debt. You as the seller become the lender, and the purchaser becomes the borrower. Extending the example above: Using the same $20M valuation, the acquiror can propose an $11M cash payment and a $9M seller note, at a 5% interest rate, maturing in 4 years. In this situation, the selling entrepreneur receives only $11M in cash today. They would then “lend” the acquiror the remaining $9M (by way of not taking immediate payment of it), and they’d charge the acquiror 5% annual interest, with payment due at the end of 4 years (note that there could be interim payments, for example, annually).
For sellers, this is safer than (and is often preferred to) an earn out, because as a “lender” to the business, you are senior in the capital structure to the equity holders (which is what you’d be had you accepted the earn-out). “Senior in the capital structure” means that lenders have to be paid in full before equity holders see a penny, should the company ever dissolve or be sold. Some selling entrepreneurs don’t mind accepting VTBs, as they’re less risky than earn-outs, and, in this example, would still provide for a 5% annual return on $9M of capital (assuming that it gets paid back in full), which may be superior to the seller’s other investment alternatives at the time.
Among other reasons for proposing VTBs, buyers often use them as a cheap form of financing: In our example above, it’s possible that the acquiror can borrow $9M from the selling shareholder at a cheaper rate than they’d otherwise get if they asked for the same amount of money from a bank, particularly if the seller isn’t aware of prevailing rates in capital markets, which they often are not. In this way, buyers can benefit from a sort of “interest rate arbitrage”.
Just because you’re a lender to the business however, that doesn’t mean that you’re holding a risk-free investment: What if your acquiror is unsuccessful at operating your business, and can no longer generate the cash flow required to service your debt? What happens if the acquiror also borrows money from a bank, and the bank has first priority over all of the company’s cash flow before you’re able to see a cent? Are you comfortable with not being able to use the full $9M until 4 years from now, after having presumably run your business (and dealt with the illiquidity of its value) for decades?
- An Equity “Roll”: Keeping our example above: The acquiror has offered you $11M in cash today, and has proposed that you “roll forward” the remaining $9M of your equity. This is akin to receiving your $9M today, and immediately investing it back into the “new” company that’s created once your business is combined with the acquiring entity. Buyers often frame this as a rare opportunity for the selling entrepreneur to get a “second bite of the apple”: Take some chips off of the table now ($11M), but stay invested in the business and potentially turn that $9M into something much larger now that the company has access to the buyer’s expertise, personnel, and access to capital. Like everything that we’ve discussed thus far, sometimes these arrangements work well, and sometimes they don’t. Naturally the seller would be taking a large bet on the business, and specifically the new ownership group’s ability to grow the value of that business.
Even if the new ownership group is successful during their ownership tenure however, there is room in the fine print for the entrepreneur to have a downside surprise: Will you hold the same class of shares as the acquiror? Do the acquiror’s shares have to get paid out in full (plus a stipulated annual percentage return) before your shares have any value? Do you have a Board seat to guide the company’s major decisions? Even if you do have a Board seat, you will likely be in the minority, meaning you may not have any de facto control around the decisions that will govern the success or failure of your $9M investment. Will you have anti-dilution provisions to prevent the new owner from issuing new shares and diluting down your ownership interest? And so on.
All three of these financing tools represent ways in which savvy buyers finance acquisitions to stage or mitigate their own risk. As mentioned above, any risk that is not borne by the buyer by definition becomes borne by the seller.
Before you tell me that you’d never accept a deal that contained any of these forms of compensation, know that the majority of acquisitions in the SMB universe feature at least one of these financing tools, and many include more than one. In some instances, accepting one of these as a form of payment can be the difference between getting a deal done or doing no deal at all.
Also remember that in selling your company, price and deal structure can’t be negotiated in isolation: If, say, you’re absolutely adamant that you must be paid in cash on day 1, then be prepared to accept a materially lower price in return, as a lower price is simply another way to mitigate a buyer’s risk if they’re not able to mitigate that risk via the deal structure. In an M&A negotiation, whenever one lever is pulled, be it related to price or structure, all of the other levers must also move to compensate and maintain balance.
Form of Sale Proceeds as a Source of Risk
Even if sellers do get paid upfront for the sale of their business, that payment isn’t always in cash, as we’ve seen above. Another possible form of sale proceeds includes the receipt of stock. If your acquiror is a private entity, it may take the form of an equity roll as described above. If your acquiror is a publicly traded company, some of that compensation may come by way of the acquiring company’s stock. When selling entrepreneurs receive stock as a form of compensation, there are often “lock up” periods that prevent them from selling that stock for a considerable period of time. Of course, the value of those shares could go up, but similarly could go down. I don’t necessarily know this to be true, but I can imagine a world where Blockbuster, Barnes & Noble, Kodak, Enron, and Lehman Brothers used their stock as a form of compensation for plenty of companies that they acquired. Of course, catastrophic stories like these don’t tend to represent the norm, but $1 in stock today doesn’t always equal $1 in cash tomorrow.
Deal Terms as a Source of Risk
The various risk mechanisms described thus far tend to be quite “visible” to sellers, and as a result, many selling entrepreneurs easily understand how much of their deal proceeds may be at risk when evaluating any given mechanism. Slightly less visible, but equally impactful, are the specific terms of the negotiated transaction that are contained within the endlessly long and over-lawyered purchase agreement. These “fine print” mechanisms have the potential to impact sale proceeds as much as anything listed above, so the selling entrepreneur would do well to take due care in negotiating these terms alongside their legal advisors. Some of the more common ones to keep an eye out for include:
- Reps, Warranties, and Escrow: Representations and Warranties (usually referred to as “Reps & Warranties”) can be thought of as legally binding promises that the seller makes to the buyer that certain things are true (buyers also make reps & warranties to sellers, but there are usually far fewer of these). For example, the seller usually has to represent (aka promise) that she didn’t intentionally misrepresent any material facts to the buyer, nor did she omit any material facts to the buyer that might have reasonably impacted their investment decision. Typically, sellers make a very large number of reps & warranties to buyers, and buyers can theoretically request anything in a negotiated transaction.
When you sell your company, a certain percentage of the transaction value will likely be put into an escrow account (a separate account that neither buyer nor seller controls) for a specific period of time. The purpose of escrow is to essentially act as a form of insurance for the buyer in case any of your legally binding promises to them turn out to be untrue. Using our example above, say that your deal featured a 20% escrow for 2 years. This means that as the seller, $4M (= 20% * $20M) of your sale proceeds are unavailable to you for 2 years, and remain at risk. Let’s further assume that you didn’t tell the acquiror of rumors of a competitor suing your company for patent infringement, because the rumors were unsubstantiated at the time, and that particular competitor had a long history of making threats. If that competitor ends up suing the company, even 1 year, 11 months, and 29 days after your deal closes, the buyer can (if they so choose) make a claim on the funds held in escrow due to your breach of a rep/warranty. In this case, they may use the $4M to fund their legal defense, which is an expense that they were not contemplating having to incur when they decided to acquire your business. Though this is an extreme example (as sellers would be wise to disclose something this material to buyers well in advance of a transaction closing), buyers can ask you to represent a conceivably infinite number of things, all of which put a percentage of your deal proceeds, held in escrow, at risk.
- The Working Capital Adjustment: This is an important one, and one of the deal terms that tends to trip up sellers most frequently: In our example, a buyer has ascribed a $20M valuation to your business. What many sellers don’t realize however is that the $20M valuation is contingent upon the business having a “normal” balance of working capital (current assets minus current liabilities) on the day of closing. On the closing day, if the business is delivered to the buyer with “more than normal” working capital, then that positive variance gets added to the purchase price, and paid to the seller. If the business has a “less than normal” balance of working capital at closing, then that variance gets subtracted from the purchase price, and gets paid to the buyer. During the course of negotiating the transaction, buyers and sellers will negotiate something called a working capital “peg” (aka a target) that they mutually agree represents a “normal” level of working capital in the business. Approximately 30 – 120 days after closing, the actual amount of working capital on the closing date is compared to the peg. If there is any variance relative to the peg, then either buyer or seller is paid based on the logic above, usually via the funds held in escrow.
Because the working capital adjustment tends to be fraught with so much uncertainty, I’ve decided to dedicate a separate blog post to discuss the many ways in which buyers may attempt to use this mechanism as a way to get you to shoulder an asymmetric share of the risk. For more on this specific issue, please see my blog post “The Working Capital Adjustment”
- Indemnities: To indemnify somebody essentially means to “hold them harmless” for that same thing. For example, you may be asked to indemnify your acquiror against any and all losses stemming from your breach of reps and/or warranties. Said another way, if you breach a rep or warranty, and some financial obligation is thrust upon the buyer as a result of that breach, the buyer will be “held harmless” for that financial obligation, and you as the seller must fund any necessary costs or losses. Again, in a negotiated agreement, buyers could request indemnification for any number of things. The more things you indemnify the purchaser against, the more risk that you will personally bear. You could be asked to indemnify the buyer against breaches of reps/warranties, product defects that existed prior to the closing date, legal actions that resulted from decisions that took place prior to the closing date, breach of contract for any customer contracts signed prior to the closing date, and many others.
Shareholder Class as a Source of Risk
If you have other investors in your business besides yourself, it’s important to realize that not all shareholders are necessarily treated equally in exit transactions. Most frequently, the ownership interests of the owner/CEO (or the individual who otherwise occupies an important operational role within the company) are treated differently than the ownership interests of other, more passive shareholders. This is a reality that isn’t discussed terribly frequently, in spite of how common it is. As a result, it tends to catch many owner/managers by surprise.
Though I was the CEO and largest shareholder of my own company, I also had about a dozen individual investors who occupied passive, non-operational roles. Of the 13 bids that I received for my company when I first attempted to sell it in 2018, over 70% of them proposed to treat my ownership interests in a manner different to those of every other investor. Specifically, in order to get a deal done, these acquirors required that I personally assumed more risk than any other investors via:
- Rolling 50% (or more) of my sale proceeds back into the business; AND/OR
- Required me to remain with the business as an employee for 2 or more years after the sale’s closing date
Some offers required that I do one or the other, and some offers required that I do both. Theoretically, all other investors should be indifferent to either (or both) option(s), yet both were highly unappealing for me personally, as they required me to bear an asymmetric burden of risk. These are not easy decisions to wrestle with, and they are far more common than you may think.
These types of requests are very common when selling SMBs because there is often a large asymmetry of information between buyer and seller (in favor of the seller), and the buyer understandably wants and needs the help of the existing CEO and management team to facilitate a smooth transition. Moreover, as a way to get more comfortable with the risk that they’d be assuming in acquiring your company, many acquirors want owner/managers to retain “skin in the game” (aka an ongoing ownership interest in the company) to signal that they still fundamentally believe in the future prospects of the business. Indeed, buyers often interpret an unwillingness of the existing CEO to retain an equity ownership interest in the company as a potential sign of trouble on the horizon for the company that hasn’t yet been disclosed to them.
Form of Sale as a Source of Risk
When one sells their company, what exactly are they selling? To the uninitiated, this may sound like a strange question to ask, but the specific form of the sale in question can have a very real impact on the risk(s) that the seller will continue to bear, even after the acquisition is completed.
More specifically, there are broadly two “types” of transactions: Share sales and asset sales. When one sells the shares of their company, the buyer essentially purchases the entirety of the business in question, including all of its assets and liabilities (for the sake of simplicity, we are ignoring the cash-free-debt-free nature of most transactions). When one sells the assets of their company however, buyers effectively pick and choose the assets that they wish to purchase, and can exclude any liabilities that they do not wish to assume. Thus, in an asset sale, unless a liability is specifically included as part of the purchase, then the seller will still effectively bear any risk associated with the liability in question.
This reason alone might compel a business owner to prefer a share sale to an asset sale, but it’s important to note that the form of the sale is also likely to impact several other parts of the deal, most notably the relevant tax treatment for both buyer and seller. Though the tax implications of each go well beyond the scope of this blog, for our purposes it is likely sufficient to reiterate that the risk that sellers bear, even after the sale of their companies, can still be material in asset sales.
Select Risk Mitigation Tools
Though things like reps & warranties or indemnities are a necessary part of almost any transaction, there are a few ways in which sellers can reduce their risks, including the following:
- Starting with the obvious: What you agree to indemnify the purchaser against, and what you don’t. Or, what you choose to formally represent (aka promise) and what you don’t.
- “Caps”: With respect to indemnities, a “cap” is a date in the future after which the seller is no longer financially responsible for the risk in question. For example, you can indemnify your purchaser against any losses stemming from breach of customer contracts for up to 3 years after the closing of the transaction (in this case, 3 years is the “cap”).
- “Baskets”: With respect to indemnities, a “basket” is a maximum amount of money that a seller is responsible for funding. Any financial obligation over and above this maximum would be the responsibility of the buyer. For example, you can indemnify your purchaser against any losses stemming from breach of customer contracts for up to 3 years after the closing of the transaction, up to a maximum of $500,000 (in this case, $500,000 is the “basket”)
- Rep & Warranty Insurance: A new niche form of insurance has evolved that provides insurance against the risk of a rep or warranty claim. In such instances, buyers and sellers often negotiate who will bear the burden of paying for the insurance premium(s), but should a rep or warranty ever be broken (and a financial claim made against it), it is the insurance company who would fund the amount owing to the buyer, not the seller. From the perspective of the seller, this type of insurance can be expensive, but does possess a certain “sleep at night” factor, especially for risks that are more nebulous in nature. What’s more, good rep & warranty insurance can help expedite (or at least remove some friction from) the negotiation process between buyer & seller, as the Reps & Warranties section tends to be one of the most time-intensive components when negotiating most purchase agreements.
Though selling your company certainly possesses the potential to eliminate some or most of the risk that an entrepreneur bears, it rarely eliminates it entirely. Indeed, most entrepreneurs don’t fully appreciate how the “typical” transaction features multiple mechanisms that have the potential to create (or at least maintain) financial or legal risk for them even after the sale is completed.
Almost all transactions will include at least some of these risk-sharing mechanisms, and the entrepreneur would be wise to educate herself on these before she begins negotiating them. Most importantly, she should realize that, when it comes to selling a business, no single term is ever negotiated in insolation: When one lever is pulled, all other levers move to compensate. Though of course she wants the acquiror to assume all of the risk after the date of closing, she must realize that such a desire is virtually impossible in reality. If she ever wishes to successfully sell her business, she must be prepared to continue to assume some risk, even after the closing date.
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