Purchase Price and Closing

Mini-APA Series: Purchase Price and Closing

Last week, we covered the basics what exactly is an APA; how is it different than equity, the parties to the agreement, what you are selling, what you are not selling.

This week we want to talk about the fun stuff: Purchase Price and Closing

Purchase Price

• Different ways to describe it, one number, one number plus other payments later, a multiple of SDE, etc.
• Get into SDE in a bit
• First want to make sure you confirm the number is correct and when does it get paid
  • Escrow/release of escrow
• Deferred payments
  • Hold back
  • Deferred Payment
  • Stabilization payments
  • Earn Out Payments
• Other deferred payment issues
  • When are deferred payments made?
  • Performance based Earn out payments
    • What is the calculation
    • Are there caps on things like operational overhead?
    • Do you have access to books and records to confirm performance targets
  • Can these be used for set off?

Inventory Payment

• When is this paid
  • All types of options
    • Paid in full
    • % of estimate then true up
    • Consignment
• Inventory estimate/reconciliation process
  • Seller estimates pre closing
  • Buyer determines final post closing
  • Must have ability to object to post closing
  • When is reconciled amount paid
  • Net working capital adjustments

Parting Shot – If you are about to be in a lawsuit, or maybe in a lawsuit, don’t email everyone in the world about it. Those are all discoverable. If a lawsuit is possible, phone calls only. Limit emails to attorneys. Don’t forward your attorney’s emails to other people!

***May It Please The Internet is a podcast brought to you by revisionlegal.com, lawyers who represent businesses who make money online.

John Di Giacomo:

Hey everyone, this is John Di Giacomo of Revision Legal, and you are listening to the May It Please The Internet Podcast. And I’m joined again by my partner, Eric Misterovich. Hello, Eric.

Eric Misterovich:

Hi, John. How are you?

John Di Giacomo:

I am good. And today we are talking about some fun stuff, purchase price and closing in a asset purchase deal. Now, we previously have covered the basics of what is an asset purchase deal? How is that process different than equity? Who are the parties to the agreement? What are you selling? What are you not selling? But this week we want to talk about the purchase pricing and closing Eric, I’ll let you start with price. Tell us what you know and how we get there.

Eric Misterovich:

Yeah, well, it’s the most important term in the entire agreement. If you’re the, probably both sides, how much are you paying? How much are you getting? What are the first things that I look at whenever an APA comes around to my desk to review? And it can surprisingly be complicated. There’s many different ways to slice it depending on who the buyer is and how sophisticated they are, and what’s kind of important to them and how they set it. We’ve certainly seen all of these in one form of the other. But the personal prices, I the seller is going to receive this amount of money in exchange for basically all of the assets related to the underlying business. And the usual ways we see it, right? There’s maybe one upfront payment that is paid at closing, and then oftentimes, there’s deferred payments that are spread out. And we’ll talk a little bit more about that. But I mean, John, we’ve seen purchase price provisions where there’s actually not a number. It goes into this calculation of seller discretionary earnings, or SDE, and some kind of multiple of that, right?

John Di Giacomo:

Yeah, SDE, EBITDA, earnings before interest, taxes, depreciation, and amortization, often 4X multiple of EBITDA. We will pay you 4X of EBITDA or 4X of SDE. So yeah, those are always fun because I deeply enjoy when there is a single purchase price and nothing else. It makes my life so much easier. But we see these all the time and it makes sense. Talk a little bit about SDE. When do you see SDE? Why would somebody want to use SDE?

Eric Misterovich:

Yeah, I see it usually more for deferred payments. If the SDE hits a certain target, then the seller would receive a certain percentage of SDE thereafter, often referred to maybe as a performance payment or something like that. And from buyer and seller side equally, you have to really look at the definition of SDE because it could theoretically give a buyer an opportunity to basically run up some expense and make that number artificially lower. At the same time, you do want the seller to have expenses in terms of advertising expenses and things like that to move the product.

Eric Misterovich:

So, it’s a little bit of a balance. I think how I typically handle it is you look to install some caps and things that kind of could get out of whack if they were left completely unchecked. So, things like administrative overhead, salaries, legal expenses, things like that where you don’t want there to be an ability to kind of abuse that calculation. Otherwise, the business terms and the business relationship, everyone’s on the same page to make money here. So there’s always some level of trust, but I think it’s always a good idea to cap some of those expenses within SDE.

John Di Giacomo:

Yeah, I agree. So, I want to talk a little bit about what I see as market, meaning what is the common type of term that I see when there’s a non-specific number for a purchase price. And typically, you’ll see SDE where it’s a smaller business, or the business is run by a single owner, and there might be a lot of aggressive use of personal expenses, like the car is on the balance sheet, or the owner has traveled quite a bit. So in those cases, it makes a whole lot of sense to use SDE, and I agree, to add a cap, and also to discuss what is a proper expense to be deducted. And then in larger deals, I’ll see EBITDA in a larger business that’s more sophisticated has better built out processes, whatever it might be.

John Di Giacomo:

It seems that is more market and better tuned for venture capital. For example, venture capitalists want to see EBITDA, they don’t want to see SDE. And as an idea of what I typically see as compensation for a deal, it’s usually some flat amount upfront. So let’s say 10 million upfront, and then a performance payment based on EBITDA 24 months later that is capped at some amount. So if the business reaches 4X EBITDA over a 24-month period, you get up to one million, but never over one million, or something like. That’s usually what we see. And then there’s some backend compensation typically if the seller remains on to help consult or becomes an employee of the acquiring business. Do you see similar things, Eric?

Eric Misterovich:

Yep, that all makes sense, and I think is pretty consistent with what I see there. There’s also sometimes just a straight holdback, just maybe 10% of the purchase price, where it’s held back for maybe six months or a year to cover potential for indemnification. I know everyone’s really on pins and needles for our indemnification episode.

John Di Giacomo:

Yes. Absolutely.

Eric Misterovich:

The APA talk it’s an important one, but it’s not the easiest. It’s normal for a buyer to want to have a pool of money that they can play with if problems come up and they do need to seek indemnification to have some money there. Usually, there’s no trigger other than passage of time to pay them. So, so much time has passed. It is time to pay that money if no claim from identification has been made. And that hold back deferred stabilization performance payments, that’s the terminology we’re seeing a lot of.

John Di Giacomo:

Let me ask you something. I swear that I spend 90% of my effort in deals working on this, working on the deferred payment. What are the parameters of the deferred payment? Do you find that to be the same for you?

Eric Misterovich:

Yeah. I mean, it depends. So from the seller side it really depends who is the buyer. Some buyers I’ve worked with so many times that I understand their agreements very well I think they’re relatively straightforward. Other sellers can really complicate things and I think it goes into… or I’m sorry, other buyers. To me it’s almost a maturity level of doing these deals where I don’t know to me it’s over complicated. When we’re representing buyers we get a little bit more context as to the deal overall.

Eric Misterovich:

And there’s all kinds of outside pressures that kind of go into that, but yeah, it can create a lot of headache because the sellers want to get paid as soon as possible, and they’re going to be fighting and clawing for payments faster than we want to make them. You can’t just have a performance of 24 months and then pay the next day. There’s going to be some time to account for what happened and reconcile things. And especially if you’re dealing with larger buyers they need to line up these payout dates in a way that makes sense administratively. They can’t just have a payment due every other day. They try to line them up so it is easier to kind of handle.

John Di Giacomo:

Yeah. The reason I asked that question too is I swear that the level of anxiety that goes into this process of deferred payments could power the sun, because it’s been my experience, I’ve never seen one of our buyers not make a deferred payment, except for where the assets couldn’t be transferred, or in the case of Amazon, for example, the account was suspended as a result of some action that occurred prior to closing. Have you ever seen somebody not make a deferred payment?

Eric Misterovich:

I have, but it’s been in pretty rare circumstances where it was really the fund it’s was going under. They still made it, but it took a long time and there was some negotiation to get some money. But I agree with you in that, the level of distrust is not proportional to reality. Everyone thinks there’s all of these bad things are going to happen. And of course we have to account for those and put in guardrails to make sure someone can’t just go crazy, but the business part of this just kind of prevails. If they really try to intentionally not make money, how does that help the buyer? It doesn’t make sense.

John Di Giacomo:

Yeah. I mean, contractual language is like a gun, right? It’s leverage, but ultimately, lawsuits are mutually-assured destruction. So, both parties if somebody doesn’t get paid are at risk. And making the language better or more onerous doesn’t change to that level of risk. You’re still going to get sued. If you’re a buyer, and you don’t pay your earn out, and it’s justifiably owed, at the end of the day the language is the language and it doesn’t really have that large of an effect on the outcome because you’re still going to get sued. So it’s just interesting to me that there’s so much wheel spinning and times spent just on these few terms when the reality is from a litigation perspective they’re not as important, I think, as we give them the effort for.

Eric Misterovich:

Yeah, I agree. And I mean, you can really get hung up on it and feel like you’re being treated unfairly because maybe for a seller you think the payment is taking too long or something, but there’s just so much that goes into it as a buyer that they need to have some wiggle room. They also don’t want you to turn around and sue them if they needed a couple more days to make a payment. So of course they’re going to ask for, and probably demand, probably more time than they need to do it. If I’m the buyer, I’m 100% making those terms the way I want them within reason, but I think the buyer is going to control for the seller. It needs to be market.

Eric Misterovich:

They need to be paying, I don’t know, 30, 45 days after the payment, the kind of calculation period has expired. It’s probably reasonable. And you should have access to the books and records. Not full access, but limited access to confirm their calculations. And there maybe should be a procedure to handle disagreements, but nine times out of 10 that procedure says, “We’re going to try to figure it out ourselves first, and then we’re going to have this super complicated thing if we can’t figure it out.” Nobody wants to go down that road.

John Di Giacomo:

No, they really don’t. A good example is I’m working on a deal now and there was a lawsuit involving this seller. And the seller was going through a dispute with this partner, and our client, the buyer they asked if we would look at it to make sure there was no effect on the ability to purchase the assets. And I look back at the docket and it’s five years of litigation. They probably spent a million dollars on it. And ultimately, very little money exchanged hands. And it’s interesting that there seems to be a disconnect between M&A attorneys and litigation, where stuff that doesn’t matter seems to matter a lot in an M&A deal, and stuff that does matter it doesn’t. And it’s a very interesting world. It helps to have litigation in negotiating these things, and I think it informs the way that we negotiate the important parts of the purchase price, but-

Eric Misterovich:

Yeah, I’m dealing with that from the opposite end right now, where we are about to start litigation over an APA, and I’m dealing with the transactional APA attorney, and they’re telling me things, their position, and then I just keep responding and I say, “I do not understand your legal position based on the language of the agreement.” I understand what you’re complaining about, but I don’t understand how that is a viable claim under the language? I mean, those are two very different things. And we are well beyond these kind of general complaints, or something that I’m phrasing them as general complaints, and I’ve asked many times for a legal explanation. I’m still yet to get one. So, we will see.

John Di Giacomo:

Yeah, that’s a great point. I think the point was implicit that though I’m saying some of this language doesn’t matter, it does in a lot of ways, because it needs to be clear, it needs to be enforceable. And the language in the agreement is all the language between the parties. It is not, “Well, he said this during due diligence, and he said this prior to the letter of intent being signed.” None of that matters. At the end of the day, that document it’s the document that controls the relationship between the parties, and what it says goes. So, I don’t want to give short shift to the language of the agreement. It is very important.

Eric Misterovich:

Yeah, but I think what you’re going to add as is, “Listen, the payment’s due and there’s a calculation.” If the buyer and the seller without the attorneys can read that and understand what it means, then you probably not going to be super far off a year or 24 months later. Indemnification, and inventory things, and third party lawsuits, those can be complicated, but in earn out, well, there’s a calculation, we all know what it is, and this is the time period. There’s not a whole lot to argue about, and then you either hit it or you don’t. And most of the time you do. But I get it that, yes, this language is the only thing that matters, but I don’t know why we have to fight so much about these deferred payments. I think they should be relatively straightforward.

John Di Giacomo:

Yeah, I agree entirely. Let’s talk about inventory and making inventory payments. So, typically we’re going to see this in a asset purchase agreement involving an e-commerce company, potentially an Amazon FBA seller, for example. When do inventory repayments occur? And how does that process work?

Eric Misterovich:

Yeah. I mean, we’re going to do a little brief review here of how we see inventory and APA’s inventory and dealing with it all. And legally, it could probably be a whole podcast on its own. But what we usually see is there’s either all the inventory is paid up front, right? You estimate how much there is at closing, the buyer pays that amount to the seller at closing, and then you go back later and true it up within 40, 60 days as to any fluctuations. That’s normal. Now you can go anywhere from there. You can say, “Well, I’ll pay you a 50% of the inventory payment,” or, “75% and then I’ll pay the rest later.” There’s a ton of variables. You can also do straight consignment, where you’re not really paying anything, you’re just going to pay the seller the inventory landed cost as it sells maybe every quarter, or six months, or something, where you’re not going out of pocket up front. I think more common that I see is really the estimate of the entire amount in paying if not the total amount, most of the amount at closing.

John Di Giacomo:

Yeah, I agree with you. And I think the caveats to that are stuff on containers. What do we do with that stuff that hasn’t yet to arrive, damaged inventory that might be discovered during handover? Those types of things. I also want to just put a note here, because it’s something that I’ve seen lately. Going through this APA process, make sure you’re talking to suppliers. If you’re a buyer, you need to understand what’s going on with the supplier because… We’ve discussed this before, and getting your contracts in order and all that stuff, but as you’re doing these inventory calculations and determining the purchase price and figuring out what you’re going to pay for the inventory, if there’s not a written agreement that can be assigned, they’re going to jack up that price.

John Di Giacomo:

And the other one that we see frequently now is the supplier comes out of nowhere and says they have a patent that the product that wasn’t disclosed during due diligence. So getting your head around these types of issues and understanding what’s being shipped? When is it being shipped? Where is it at? What does it cost? How are we going to true up or do this reconciliation is very, very important in this process.

Eric Misterovich:

Yeah, I mean the nuts and bolts pay this at closing and then reconcile later. That part isn’t that complicated. The complicated part is if you’re buyer, you’re buying a business for an incredible amount of money that may not have a single contract in existence, and you are not entirely positive those terms that the current seller is getting with that supplier are going to continue. So you usually contract around that and include a representation and warranty that they’re not aware or anything. The seller’s not aware that there’s going to be any changes. You usually want to be able to place an order, or in the very least, have an introduction to the supplier during what we defined as the migration process, where you’ve closed, but the payment of the money has not been released out to the seller yet.

Eric Misterovich:

Introductions to suppliers and confirming pricing terms is usually a requirement to happen during that period of time. Whether or not you’re going to do it before is kind of discretionary. Some buyers want to do it, others don’t. Some sellers invite that, some don’t. That’s one where it takes probably a little bit more or feel than experience in running these kinds of businesses to figure out the right path. When you talk about talk to your suppliers though, I’ve also had the other way around where a seller day before closing talks to his supplier and is kind of joking around with them, and then they say, “Oh, by the away we’re going to be raising prices.”

Eric Misterovich:

And if he just would not have been having that conversation, there would never have been an opportunity to be told that, but now it was told to him, now he does have notice, it is “We are closing in 12 hours.” And now we have to disclose it. I mean, for me, it was not a close call. You have to disclose that. It’s going to come out. If the price goes up it is coming out, and then you are going to look real bad that you are lying to someone that you’re in an agreement with them for the next two or three years. To receive these deferred payments you should not be starting out lying to them. We were able to resolve it, and nothing changed except the closing date, but if you’re selling, keep those conversations to a minimum with the suppliers.

John Di Giacomo:

Yeah, and if you’re buying price in the risk into the purchase price. So don’t overpay for an asset where the market rate for the supplied product is so vastly different from what is currently being received from the current supplier of the seller that you can’t switch. It just is such a basic thing, but a lot of people don’t do it. And the other side of that too is make sure that if you use a hold back amount, that the hold back amount is sufficient to cover the difference between what the supplier is currently selling the product to you for and what a third party would sell that product to you for so that you offset that loss if this occurs after closing.

Eric Misterovich:

Yep. Very important.

John Di Giacomo:

Well, you’ve got a parting shot for today, Eric? What do you want to say?

Eric Misterovich:

Yeah, I do. It’s about if you are starting a lawsuit, or about to be in a lawsuit, or already in a lawsuit, do not email people or text people about your lawsuit. Do not do it, ever. Nothing good is going to come from telling your high school buddy and sending them a detailed email about what is going on in a lawsuit, how you’re getting screwed, or how you did this, or they’re saying that. Do not put this stuff off in writing. It is all discoverable in litigation, meaning you’re going to have to turn it over to the other side. And the conversations you have with friends or family about litigation they don’t have to be bad to damage your case. You don’t want to give the other side an inch, ever.

Eric Misterovich:

You don’t want to give them anything that they can use, and if they have these casual conversations between you and your friends and family you could give them something that ends up working against you. And people don’t ever think about this. I know when we do this oftentimes it comes up with a client says, “Oh, well, maybe they’ll forward us an email from someone.” And you’re like, “Oh, my God, why are you emailing them?” And by the way, don’t forward my emails to them either. Our emails are private, they’re confidential, let’s keep it all between us. If you want to talk about it, go ahead, call them. Pick up the phone and talk. Do not put the stuff in writing ever. They will never ever help your case.

John Di Giacomo:

I agree entirely. The one that I see recently is I’m on a number of e-commerce forums on the internet and we have clients there, or third parties will ask questions about legal stuff and they’ll give specifics. And I just want to say, “What are you doing? You can’t do this. You can’t talk about this potential legal issue that you have in public because this is all discoverable.” And any strategic decisions that you think you’re making are not strategic at all because they are discoverable and your strategies are discoverable, because they’re not protected by attorney-client privilege.

John Di Giacomo:

The funny one that I always like is we settle a case and a client immediately goes on an internet forum and then talks about the settlement and what they settled for. And of course the settlement agreement has nondisclosure clause, And you’re just like. “What are you doing? You’re completely in violation of settlement agreement.” So yeah, I agree entirely. Also, good advice, apps like Signal or WhatsApp are still discoverable. Even when you have the destroy feature on, if you’re in litigation, that’s spoilation of evidence. You have to keep your communications if you’re in active litigation or under the threat of litigation. So it’s not enough to just use one of those apps and text your friends and say, “Hey, this is going to be destroyed, do that,” because if somebody finds out about it, you’re looking at sanctions that I have seen attorneys get sanctioned for it before.

Eric Misterovich:

Yep. I mean, there’s a reason why everyone says no comment when they’re talking about lawsuits, and this is why, there’s just no benefit can come from it. There’s none, zero. It’s never going to help, so just do not do it.

John Di Giacomo:

Nope, I agree entirely. Well, thank you, Eric, as usual. This again has been the Revision Legal Podcast May IT Please The Internet, and we will see you next time.