How to sell a company - Part 4: The Consideration

This is the fourth part in a series of seven blogs that outline the process of the sale of a company – before, during and after the negotiation and signing of the share sale and purchase agreement.

In this Part 4 of the series, we focus on the structure of the consideration to be paid for the shares. That is, what the price is, how the price is to be paid (ie the form of the consideration) and when the price is to be paid – all of which should be reflected within the terms of the share purchase agreement. Follow the links to read Part 3: The SPA and Ancillary Documents and Part 5: Warranties and Indemnities.

1. Calculation of the consideration

The price may be calculated by the buyer using the last set of annual accounts of the target company but may be based on several factors depending on the nature of the relevant business and there are many different valuation methods which can be used. The price will be negotiated and agreed by the parties according to their respective priorities and bargaining power.

2. Form of consideration

Once the parties have agreed the price for the shares in the target company they have to consider how that price is to be paid. The consideration can take various forms the most common of which include:

• Cash: this may be the payment of a specified cash sum, or a sum to be calculated based on a formula, on completion or in stage payments. If a set sum is payable at completion, for both parties that provides certainty as to the value being paid and received for the target company. For the buyer, cash also allows for a "clean break" so that it can manage the company as it sees fit from the date of completion. For the seller, cash provides some liquidity.

• Shares: this involves the seller being issued with shares in the buyer's own company (or one of its group companies). For the buyer, provided it's articles of association do not prohibit the issue of shares for the purchase, this can be an attractive option if it does not have access to cash funds although there would be additional negotiation around the arrangements with the seller going forward. For the seller, although there may be some uncertainty as to whether the value the target company and the value of the consideration shares reflect each other, this form of consideration provides an opportunity to retain an interest in the company (or perhaps even a larger buyer group) going forward.

• Loan notes: this involves the issue of debt instruments by the buyer to the seller, allowing for deferred payments with interest. There will often be negotiations around the interest rate payable on the loan notes, the redemption (or repayment) date and whether the seller requires any security for the buyer's payment obligations. It can be an attractive option for a buyer as it does not require to have immediate access to cash funds. For the seller, loan notes may be preferable to shares as consideration as they are likely to offer greater security for payment (particularly if secured).

The above outlines some of the advantages and disadvantages of the most common forms of consideration. Ultimately, the purchase price may be paid in one or more forms of consideration depending on the nature and value of the transaction and the negotiating strength of the parties.

3. Payment of consideration

The purchase price may be fixed by the parties in advance of completion of the transaction or the share purchase agreement may provide for a price adjustment mechanism to help ensure that the price paid for the target company reflects its true value.

Fixed consideration

• Cash: an agreed cash price paid on completion provides certainty for both buyer and seller.

• Locked box: a locked box mechanism involves the parties fixing the consideration at an agreed 'locked box date' prior to completion of the sale and purchase, based on a recent balance sheet of the target company. Whilst there is no post-completion price adjustment in locked box transactions, the buyer will, for a period of time post completion, benefit from "leakage" protections, ensuring it will have recourse against the seller for any value extracted from the target company between the 'locked box date' and completion e.g. by the payment of dividends, transfer of assets or non-ordinary course management fees.

Adjusted consideration

• Completion accounts: completion accounts are prepared and negotiated by the parties post-completion to calculate the final purchase price. The accounts are usually based either on the target company's net asset value or its cash, debt and working capital position as at the completion date. Once the accounts are agreed, the purchase price is adjusted to account for any difference between the estimated value of the target company used to complete the transaction and the actual value of the company as at completion as shown in the completion accounts.

• Earn-outs: an earn-out is where the buyer makes payment of part of the purchase price on completion and the remainder of the price is paid in one or more instalments over an agreed period of time based on the achievement of specified financial or other targets. Earnouts can be useful where the buyer wishes the seller to remain involved with the target company to help ensure its success and the seller wishes to have influence over the company to protect and maximise any additional purchase price payments that may be due under the earnout. Earn-outs can help to bridge valuation gaps and encourage a collaborative approach between the parties.

Deferred consideration

• Deferred consideration is where the consideration (or part of it) is paid after completion. Similar to an earn-out, it usually involves the buyer paying some of the consideration on completion, with the remainder being paid on a specified payment date (or dates) after completion. This can benefit a buyer where (i) they wish to pay in cash but are not in a financial position to fund the whole purchase price upfront; or (ii) they are seeking security around a seller's ability to pay for any post-completion claims by negotiating a right to set off such claims from the deferred consideration. A seller may, however, have concern around the buyer's ability to fund the deferred consideration any may request some protections. For example, a security over the buyer's assets or relevant guarantee provisions to help ensure that all of the deferred consideration is settled. In some cases an element of the consideration can be retained on an escrow arrangement pending settlement (which does mean the buyer needs to also have those funds available at completion).

Key takeaways

The structure of the consideration for a share acquisition can be tailored in different ways to suit the nature of the transaction and the respective financial status and bargaining power of the parties. Any consideration structure will have advantages and disadvantages for both buyer and seller and careful consideration should be given by both to ensure the requirements and obligations of their particular consideration mechanism can be met before being entered into.

How Brodies can help

If you would like to discuss anything raised in this blog in more detail, please get in touch with a member of Brodies Corporate Team listed below or your usual Brodies contact.

View our downloadable guide, "Taking the blinkers off when selling your business", by Neil Ritchie, Director of Personal Tax, on what to watch out for from a personal perspective when selling your business.