Bridging the Gap on Price: Contingent Payments

Most negotiations end up like the one depicted above - buyer and seller just canít agree on the price.

While there is nothing wrong with this in and of itself, it does beg the question - is it really as far as each side can go? Have all alternatives been explored? Are there not some creative ways each side can discuss as a means to reach an agreement?

If the parties have truly reached their limits in a negotiation based on a fixed price, a common way the gap gets closed is via contingent payments of some sort.

In the article that follows, we will explore this subject in more detail.


Bridging the Gap on Price: Contingent Payments

For every deal that gets negotiated, there are scores of other negotiations that have taken place where the buyer and seller could not reach an agreement. In many of these situations, the main reason for the impasse is price. The buyer and the seller simply can not agree on how much the business is worth. As mentioned earlier, there is nothing wrong with this. In fact, it is completely normal. The question that comes up however, is this: Have the parties considered all alternatives? Is there any way both sides can get a good deal that hasnít been discussed?

If an impasse is reached on what the fixed price should be, it is always worth considering some form of contingent consideration as a means of bridging the gap between buyer and seller. Contingent payment negotiations are not zero-sum games centered on a single number. They are aimed at coming up with a solution that is a win-win for both sides.

Contingent payments can take many forms. For example, an earnout which provides for payments to be made at a future date based on achieving a certain financial target (such as sales, gross margin, operating income, cash flow, etc.) is not unusual. Having substantial payments made after a closing tied to an employment contract with a key selling shareholder can also provide the win-win that satisfies both parties. Another way to structure contingent payments in the situation where the seller is closely-held is to have a selling shareholder retain some equity in the company going forward, with a formula to buy out the shares at a later date that rewards improvement in the business and penalizes stagnation.

A CONTINGMENT PAYMENT DEAL CAN TAKE A VARIETY OF FORMS, BIT WHAT IS IT IN THE FIRST PLACE THAT LEADS TO AN IMPASSE ON PRICE THAT CAN BE BRIDGED WITH A CONTINGENT PAYMENT STRUCTIRE?

When key people on the sellerís side are needed by the buyer. Seller wants cash on closing. Buyer needs one or more shareholders or employees to help run the business after closing, or at a minimum, to stay on for a transition period. Buyer is concerned that cashing out the owners might cause them to lose interest, go golfing, or otherwise neglect the business. Solution: If the key people want to remain with the business, have part of the price tied to their continued employment.

When there is a concern that projected earnings may not be achieved. Seller sees a bright future and wants to get paid for it. Buyer is not sure the sellerís projections are realistic, but if they are, a higher price is justified. Solution: Have a fixed price based on the value of the business today and additional payments based on the increased value in the future.

When shareholders of a closely-held seller have differing interests. Some shareholders want to cash out and retire, some want to keep their shares. Solution: A fixed price for the shareholders who want cash and a continuing equity interest for those who want to remain with the business.

When the seller and/or the buyer have unrealistic price expectations. Seller wants too much for the business. Or buyer is looking for a steal. Or both. Solution: A two-tiered pricing structure, with the second tier paid in the future based on some contingency (which could be very easy or very difficult to achieve). This could allow seller to say it got a high price (based on the sum of both tiers) and/or the buyer to say it paid very little (based on the first tier only). While this can be a transparent solution, the psychology of a negotiation is something that should never be ignored.

When taxes can be minimized. The tax treatment of payments made in an acquisition (for both buyer and seller) can vary depending on what the payments are for. Capital gains vs. ordinary income, goodwill, payment for stock vs. payment for employment, etc. are a few of the issues that are important tax-wise. Solution: In some cases, structuring a deal with contingent payments can be a win-win to the bottom line of both the seller and buyer, with Uncle Sam on the short end.

Negotiating a fixed price for a deal is not complicated or time consuming. It takes one sentence in a purchase agreement.

Negotiating a contingent payment deal is complicated and time-consuming. It can take up pages and pages of an agreement. With contingent payments, the seller will typically be concerned with having some of the price being determined at a future date when someone else controls the business. Buyer will be concerned with setting up a structure that ties in to its objectives. Nevertheless, there are many situations when a fixed price deal is not achievable. When that happens, it pays to consider a contingent price structure as a means to bridge the gap.