There are thousands of nuances between the sellers and the buyers. Each type of consideration has its strengths, weaknesses, needs and in many respects, it’s own personality. The nature of the consideration can also dictate both long and short-term relationships between buyer and seller.

Everything paid at closing is considered closing consideration, and after that magic date it becomes post-closing consideration. Here are a few choices to consider:

1. Cash: I prefer cash, and my clients prefer cash. Buyers often try to use as little cash as possible. Successful acquirers usually play in the primary cash arena. They either have, or have raised cash and have successful operations. Usually, these firms take the acquisition process very seriously. It is easy to bargain with cash. Cash is taken seriously by all parties. On a chessboard cash is the King.

2. Installment payment: This is similar to a Seller’s Note (see #3) but I include it here because of terminology. In installment transactions a large amount of the purchase price is paid over a period of time. Think less than 50 percent cash down, possibly even zero, and the rest as regular payment towards the purchase price. This could be monthly, quarterly or annually. Different than a note in that it usually does not include interest. The final installment is often a larger balloon payment. For example, in a $10 million acquisition, $2 million down, $500k quarterly payments for two years ($2 +$4=$6), followed by a $4 million balloon payment.

3. Seller’s note: The seller, in essence, is a providing mezzanine financing, although they may be subordinate to a buyer’s lender. It is a loan in the transaction of part of the purchase price back to the buyer by the seller. Buyers often like this as in some sense the seller has some skin in the game and wants the transaction to succeed. Sellers conversely wonder if they will ever be paid back and need to consider the financial background, and reputation on the buyer. The reason I am differentiating the Sellers note from a Installment payment is I see it as “filling in the gap”. The seller will only take $10 million and you only have $9 million, enter a potential $1 million seller’s note. You can imagine a whole range of scenarios; equal payments for x months or years, balloon payments, interest rates and the like. As you would suspect sellers want shorter terms and buyers longer terms.

4. Assumed Liabilities: Assumed liabilities is a financial commitment lifted off the shoulders to the seller and transferred to the Buyer. This does not include, at least for deal valuation purposes, ongoing operational issues such as assumed leases or the postage machine that are necessary to operate the company post-closing. But would include server leases.

In a stock transaction, the buyer is often assuming certain balance sheet liabilities, including payables all of which are detailed in the purchase agreement. Certain items such as long-term debt is typically paid off at close from that cash consideration. However, if there is assumed debt outside of ongoing operational issues that were assumed it is considered part of the overall consideration. In stock transactions expect that there should be enough cash left in the accounts to cover all pre-close operational liabilities.

5. Cash on hand: For some reason in a stock transaction many owners do not realize they have substantial cash in the bank that really should be distributed to current shareholders before the sale leaving enough funds in the account to cover current payables and normal working capital. Keeping your money may not be a consideration but may seem like it if a third-party, like me, brings it to your attention. Buyers that can retain cash on hand more than normal operation expense, pre vs. post closing, may have just sweetened the acquisition in their favor. Looking back this becomes more of a seller issue as we should have addressed this long before the buyer arrived on the scene.

6. Deferred Revenues: In shared hosting transactions this is often the elephant in the room. I am known for my concerns about deferred revenues and have often spoken to this topic at conferences as well as a subject of several of my WHIR blogs. Deferred revenues are those funds paid in advance by a customer for services. As an example, a shared hosting companies lowest plan is $5 a month. However, a client needs to pay three years in advance to purchase this plan, a total of $180. Technically these funds when received should go on the balance sheet as deferred revenue as a cash asset and is offset as a deferred liability. Every month $5 is realized and indicated on the operating statement as income, and correspondingly on the balance sheet both the deferred cash account and deferred liability are reduced appropriately.

In practicality, that hardly is ever the case. The $180 goes into the deposit account for today’s operations, not to fund future operations primarily contracted by the hosting company to its customer. Often a very large portion of the customer revenues pay for affiliate programs may eat up a significant amount of that revenue, often over $100 for each new account gained in this method.

As a consideration item, deferred revenues become a bit of a conundrum. At the end of the first year of a customer’s three-year contract, $120 should be in a depository account. If sold at this period the buyer should receive $120 for the next two years operations and profits attributed to that customer.

In the transaction, deferred revenues cannot be ignored. Why? Because there are customers expecting service.

So how should they be treated in this series on how to buy a hosting company?

Deferred accounts are in essence always assumed by the buyer as it will need to provide to service to that customer. The question is how this is treated in the purchase price of the transaction.

The buyer should be very clear up-front regarding how deferred revenues are handled in the transaction. This becomes a function of phraseology in the letter of intent. Here are two examples that demonstrate the valuation principal:

“I am buying your business for $10 million cash and I am assuming all of your deferred liability.”

or,

“I am buying your business for $12 million cash. Such price will be reduced dollar for dollar for deferred customer liabilities as of the closing date, currently estimated at $2 million.”

As a buyer, you will decide the value and how to treat this. It should not become a surprise. I could go on for hours outlining the debate between a buyer and a seller regarding the treatment of deferred revenue.

7. Seller’s carried interest: The buyer offers the seller to stay in as a part owner. This can assist in the financing, lower leverage or even provide a level of confidence to your funding sources. A major question you should ask yourself is how long do you want to be involved with the seller.

8. Conditional Consideration: This is not a legal term but a description of the scenario in which you agree with your seller that a certain sum will be payable upon a particular event occurring.

To give an example, a worldwide data center has a contract with a Fortune 500 firm that represents 20 percent its annual revenue. The contract is up for a three-year renewal six months after the close. The acquisition valuation was based on this contract, revenue stream, and profits. If the contract were to be lost, the business would be worth considerably less. A conditional payment crafted around this contract is where this is heading. For a buyer, in this case, it can act as a deferred payment and is underwriting the-the transaction at closing. Consider a kicker to the seller if the contract exceeds expectations.

9. Earn-Out: Earn-outs are more often used in smaller transactions. At one seminar I listened for 20 minutes while the buyer outlined how he structured a $50k annual revenue shared hosting transaction. Often these transactions are simply zero dollars down transactions, and the buyer pays a percentage of revenues collected from the purchase of the accounts for a specified period or until a total dollar amount is paid.

10. Earn-Out as in Performance: This covers the scenario in which part of the purchase price is linked to the future performance of the business. It is frequently linked to profits as in EBITDA but could also be linked to other financial measures such as general revenue growth, successful migration from one data-centers to another. It may involve the seller working for the business after the transfer date, normally for the specific purpose. If the business performs over and above the agreed minimums, the seller may have an upside or bonus.

This sounds like a clause to benefit sellers, but there is a benefit to buyers in that it may allow then to pay a lower price for the business at the outset and, if the business does not perform as well as the seller promises, it could lower your total purchase price.

10. Holdback for representations and warranties: This is a cash payment deferred from the cash at closing but paid at a later date. For the buyer it is in effect an insurance, and is paid, or released to the seller at a date beyond the closing date, anywhere from ninety days to two years, however, one year is the norm. The amount can range from as low as 5 percent to as high as 20 percent of the total purchase price. It could, but for some reason usually doesn’t have an interest component. An example off a representation claim is where the seller failed to tell the buyer that of data center rent increase notice prior to close. This would cause a breach of representations and warranties and would reduce that payment.

The one issue regarding representations and warranties hold back is when, and if, funded. For the seller, an unfunded R/M payment at closing is akin to an interest-free loan. The seller would prefer it funded to an interest bearing escrow account.

11. Employment Agreement: The buyer can enter into an employment agreement with the seller. Until the buyer came along the owner never pulled $50K a month out of the business. This can provide the seller with an excellent salary and possible company benefits for a set period. The seller will expense this over the term rather that putting this portion of the purchase price on the balance sheet and depreciating such over the long term. The real employment conditions may be hard-lined, as in show up by 8 AM Monday through Friday to very loose, as in “ Do they have FaceTime in Fiji?”

12. Consulting Agreements: Similar to employment agreements financially but do not include company benefits.

13. Non-Compete Agreements: Typically non-compete agreements are limited to three years. They can be geographic and sector specific and should always restrict the seller from poaching customers. The non-compete agreement should always contain a cash component. As with an employment agreement, the buyer can make annual non-compete payments and expense this item.

14. You Can Keep That: Part of the consideration is goodwill, in this case not the subscriber list, but the relationship between the owner and buyer build during the transaction. For example, the seller, as in company, own’s a BMW that the owner would prefer to keep. There can be a lot of deal capital in how it is treated and can move some change around the table. If handled correctly, someone may also save a few thousand dollars in taxes. You may be surprised at how important something like this can be in a transaction. You will know it when you see it. Sorry, I have to go here, but I once purchased a cable TV company throwing in the condition it would include the vintage Predicta TV in the shelf in the back room.

15. Board Seat: The buyer may offer the seller a seat on the board of the acquiring company. This can be a voting or non-voting capacity depending on the ongoing relationship and the overall nature of the transaction. People like to be on boards.

16. Defer Taxes. In a year where taxes on capital gains or income tax may have some significant changes look closely at the closing date. As a buyer, you may work a slightly better deal if you can close on December 31 vs. sometime early next year. Again this provides the seller with the opportunity to move funds into years with lower tax rates.

17. Another goodwill item: baseball tickets or use of a private jet. When I merged 40 cable television companies to start Charter Cable, I quickly understood the value of my Cincinnati Reds tickets or the promise to fly the buyer to the closing in my partner’s jet.

18. Offer to pay the seller’s broker fees: Of course, you will reduce your top line offer to cover that expense, but the seller will feel as if it no longer counts. Again, you have moved an expense from the balance sheet to the operating statement which can have some current tax advantages.

Source: TheWHIR