A Case Study in Transaction Structuring
Many times the dynamics of an actual transaction can provide more relevant information about the sale of mid-size companies than articles about transactions in general. Here is an example:
THE BACKGROUND
A consumer products importer/distributor decides to sell the company because its 50 - year-old CEO and part-owner is "burnt out."
The company has flat sales of $10 million, primarily to the mass merchants with heavy customer concentration. The company is extraordinarily profitable with $2 million of EBIT after the CEO's compensation of $300 thousand per year. The owners plan to dividend out excess $2 million in cash and sell the business for four times EBIT of $2 million, or $8 million, cash at closing. Reconstructed book value without the excess cash is $2 million.
The current CEO is a critical part of the business. He not only designs the products, but is also responsible for sourcing them in the Far East. Once the business is sold, he is willing to remain as CEO for one year, and for the next four years maintain a consulting agreement for new designs and sourcing to suppliers. Assuming all the customers stay in intact going forward, the $8 million proposed purchase is reasonable except that such an acquisition, as stated, would create $6 million of "goodwill," which would require the next 15 years!
Dynamics of the Transaction
A prospective financial buyer is interested but cannot justify the full cash price of $8 million. All potential strategic buyers have fallen by the wayside. In order to meet the selling company's $8 million price, the buyer suggests the following structure.
The Buyer's Offer
$3 million cash paid to seller for 50% ownership interest
The remaining 50% interest is purchased with a $5 million non-contingent, interest-bearing 5-year note, subordinate to bank debt and guaranteed by the importer/distributor.
The conditions of the above offer are unique.
The purchased 50% ownership interest is to be held in escrow as security.
The remaining 50% ownership interest is to be transferred only upon full payment of the note.
A corporate governance agreement is to be drawn (a) restricting certain asset sells or other management actions without the agreement of all parties; (b) an ongoing officer/board member role for the "outgoing" CEO; (c) and providing the right for the "outgoing" CEO to take over complete management control in the event of default on the loan. Default is defined as non-payment and/or noncompliance with the covenants for senior bank debt or the subordinated note.
Buyer/Seller Benefits
Since the seller "dividends out" the $2 million cash and receives $3 million cash at closing, the seller starts with $5 million cash on day one of the transaction, less the tax impact. As an importer/distributor with heavy customer concentration, the seller is receiving a "full price" at 4 times EBIT, particularly since there is $6 million of goodwill left for the new owner to carry on the balance sheet. While the seller has downside risk because the remaining $5 million purchase price is not fully guaranteed, the ownership interests are phased in after certain milestones and only after the seller has secured strong debt covenants and a protective governance/management agreement.
On the other hand, the buyer acquires a business with a long history of continual profitability, excellent market position, and reliable cash flow. The buyer pays $3 million cash at closing for a company that has a clean balance sheet with $2 million book value and a $2 million EBIT. Furthermore, the previous owner remains as part of the management for the next five years to help ensure the ongoing success of the business. Since the previous owner has a vested interest in the new ownership, he will be motivated to ensure the ongoing business is successful.
The above structure is not perfect for either the buyer or seller. However, it enables the seller to receive a full price with reasonable assurances of being paid off in full. The buyer, who plans to use the inventory and receivables to borrow from the bank, will be able to acquire a very strong business with a minimum of his own cash and without personally guaranteeing the note.