When you think of selling your company, do you picture a friendly handshake, a pile of cash pushed across the table and a pretty sunset to sail off into? Perhaps, but this is seldom the reality in WA for sellers of private companies.
Buyers (Buyers) of privately held companies (Companies) have in the last few years leaned strongly towards insisting that sellers (Sellers) remain involved to some degree following completion of a sale of shares (Completion) in a Companyusually for a period ofbetween one and three years following Completion (Transition Period) – both from a management and financial perspective.
In terms of management, this means remaining involved in the business of the Company for a specified period of time following Completion.
Financially, this means a portion of the consideration which would otherwise be payable at Completion becomes payable at a later date, commonly known as “deferred consideration”, either because:
- the Buyer acquires only a portion of the shares at Completion and acquires (and pays for) the balance at a later, specified date; or
- buys all of the shares, but pays for some of them at a later date.
Deferred consideration has become so prevalent that the Australian Government Board of Taxation has issued a special paper (Review of the income tax treatment of certain forms of deferred consideration (tspace.gov.au)) on the tax treatment of deferred consideration.
For Sellers, involvement (both managerial and financial) following Completion is usually an unattractive prospect. Here are the top reasons why.
- Length of Transition Period
Buyers often ask Sellers to remain involved in the business of the Company for up to three years post Completion, that is an inordinately long period of time if you’ve already mentally committed to that trip around the world (or, during COVID, around WA).
- Penalties for leaving during Transition Period
To ensure continued (and proper) Seller involvement, Buyers often attempt to install deterrents against an early departure of the Seller. An example is a Seller losing value if they leave the business as a “bad leaver” during the Transition Period (usually voluntary resignation).
Quite often “good leaver” provisions can be included so that Sellers are not penalised on their death, sickness, sickness of relatives, if the Buyer breaches the terms of the transaction documents, etc. However there is a residual risk. If the Seller leaves employment with the Company and the Buyer and Seller cannot agree on whether the Seller is a good leaver or bad leaver this can result in litigation, a very poor outcome for both parties.
- Risk of non-payment
Would you sell your car, hand it over, and happily allow a stranger to promise to pay you some of the amount due at a later date? If you sell all the shares in your company and the Buyer is allowed to pay a portion of the consideration later then this is in effect what you are agreeing to. In those circumstances I tell clients: “be happy with what they pay you on Completion – you might not receive any additional funds for a variety of reasons, some of which may be out of the control of the Buyer”.
Sellers can seek security for the payment of the balance, such as by taking security over Buyer assets, a bank guarantee, a parent company guarantee, setting of funds to pay the deferred consideration into an escrow account, taking out an insurance policy, etc. However, other than a parent company guarantee these risk mitigating protections tend to be fiercely resisted by Buyers due to the potential impact on their balance sheet.
- Risk of underperformance can transfer to Seller
In some cases, Buyers will only buy or pay for a percentage of the shares in a Company (often 70-80%) at Completion, with the payment of the balance being dependent on the performance of the Company (commonly called earn outs, or deferred consideration) during the Transition Period. In other words, if the Company performs well during the Transition Period then the Buyer pays more, and if it doesn’t…well sometimes this results in a Buyer paying nothing more than the initial payment made at Completion. As a result, the risk of the Company performance shifts to the Seller – one might think “no worries” but bear in mind…the risk of Company performance (which drives whether and how much additional consideration is paid) is on the Seller whilst at that same time the Buyer owns the majority of, and controls, the Company. Whilst some Seller protections can be negotiated in (such as control levers on the Company in favour of the Seller during the Transition Period), the performance risk largely remains with the Seller.
- Seller finance
Given the Buyer is in effect deferring part of the payment which would otherwise be required to be paid to the Seller on Completion, some argue that this is a form of Seller finance. Naturally whether this is the case turns on the fact of the transaction, but undeniably there is a financial benefit to a Buyer in delaying payment as it reduces the need to immediately pay cash to the Seller, funds which can then be used to organically grow the Buyer’s group or remain free to pursue a larger acquisition strategy. Conversely this means the Seller does not have the benefit of those funds to pursue its own interests… that boat you were eyeballing is now more likely to be the tender attached to that boat, at least for now.
- Credit risk on Buyer
If a Buyer requiresa portion of the consideration to be deferred, the Seller takes a credit risk on the Buyer for the balance to be paid. In practical terms, if the Buyer becomesinsolvent, then the Seller may not get paid (or not get paid all outstanding amounts due), irrespective of the performance of the Company. Some mitigating mechanisms may be negotiated in (see risk of non-payment above), though again, these tend to be resisted, especially by larger Buyers.
- Security for claims
If the Buyer owes deferred consideration, the amounts due to the Seller become a bucket of cash for the Buyer to claim against. This may mean that the Buyer is more likely to make warranty or indemnity claims, or find a technical breach to launch a claim (no matter how minor), as it is relatively easy to negotiate a settlement if you owe the other party monies. This means the Buyer pays less for your Company. The old saying “possession is 9/10ths of the law” is by no means a legal position but it certainly holds sway in negotiations, especially if there is a disparity in the balance of power between the Buyer (e.g. it is a global entity, deep pockets) and the Seller (individual(s) who will want to preserve value and not suffer the headache of litigation).
So…what does this all mean? Should a Seller agree to continued involvement and deferred consideration?
As a Seller, do you simply reject the notion of management and financial involvement following Completion? Maybe, but if you do then you are unlikely to have a Completion, in the current market. Having said that, Mergers and Acquisitions tend to be trendy (see what I did there?) and what is popular with today may change tomorrow.
Finishing off with an interesting reality check…almost universally my clients who are Sellers have reported thoroughly enjoying working with their Buyer during the Transition Period, helping nuture the Company they built into a wider group who are truly interested in seeing their Company reach its full potential. Oh, and to mention a critical point – so far they’ve all been paid in full.
