Let’s assume you are selling the family business. In order to get the best terms and price, you may not be able to negotiate the full purchase price in cash up front. More likely, some portion of the purchase price will be placed in escrow for a period of time to secure any potential post-closing claims a buyer might have. Also, some of the purchase price might be paid through an earnout, in which the buyer agrees to pay some portion of the purchase price based on the performance of the business after closing. Sometimes part of the purchase price can even come in the form of equity in the buyer or loans from the buyer.
Generally speaking, none of these arrangements is as good as cash up front. Each one of the possibilities mentioned above runs some kind of risk of never being paid. Money that is put in escrow might be used up to pay claims brought by the buyer; an earnout might never be paid if the business does not perform as expected after the closing; and equity or debt from the buyer depends on the viability and success of the buyer after closing. But a seller may be able to sell the business for a better overall price if they are willing to accept some of these non-cash forms of purchase price and get a deal done where a deal only for cash would not have been possible.
Ordinarily, where the purchase price is broken up into these different forms, all the owners of the business share pro rata in each form. In other words, if ten percent of the purchase price is put into escrow, each of the owners reduces the cash he or she would receive at closing by ten percent and then collects that share of the ten percent (or less!) when it is released from escrow. This way, everyone shares in the risk of the contingent forms of purchase price.
Sometimes, in a family business context, it does not make sense for all the family members to share equally in this risk. Perhaps certain family members are less involved in the business and in the sale transaction and so it seems unreasonable for them to share in the risk on a pro rata basis. Sometime, the older generation has made sure the younger generation has a certain ownership interest in the business for estate planning purposes and want to make sure the value on that is delivered in whole, without the risks that come with contingent forms of payment. And sometimes, as is the way with family businesses, ordinary business rules just do not apply, and the family has decided for personal reasons that it wants to allocate the risks a little differently.
One solution to this dilemma is to make an internal reallocation of the purchase price among the selling family members. This way everyone still gets the same proportional value, but some family members can receive their share entirely in cash and others receive more of the contingent forms of purchase price. This can be a handy solution in that it does not have to involve the buyer or interfere with the sale transaction. But it presents a challenge in that it requires the family to value these different forms of consideration.
For all the risks associated with each of the various forms of consideration discussed above, there is some discount that the market would apply in valuing them. In other words, $100 in cash is worth more than $100 in potential earnout payment, partially because of the delay in receiving the money through the earnout and partially because of the risk that the recipient will never receive the money. But most families are ill-equipped to determine the appropriate discounts and valuations, particularly when the transaction involves multiple forms of purchase price.
What many do not know is that there are firms whose entire purpose is to value businesses and all sorts of contingencies relating to businesses that can assist with precisely this task. These firms can review the business, the transaction and the proposed forms of purchase price and actually provide the family with the dollar amounts at which to value all the pieces of consideration.
Valuation advice is important for at least two reasons. First, despite the fact that everyone in the family agrees on the principle of the thing, no one wants this reallocation of risk to somehow deprive any family member of value to which they are entitled. In other words, no family member wants to receive cash instead of contingent forms of purchase price if they perceive that they are receiving so little cash that they are obviously losing out on their fair share of value. To ensure that this cash and contingent allocations are fair to all family members and that bad feelings (or worse, disputes) do not result, it is valuable to have a qualified third party professional help the family determine how much cash each contingent piece is worth. Second, a reallocation like this, if it is not a true value-for-value exchange, could trigger tax consequences. A family member who receives more value than he or she exchanged would be imputed income that would create an unintended tax obligation. Moreover, if the older generation were to provide more value to the younger generation than it received in return, this could be characterized as a veiled gift, which could impact various tax regulations relating to gifts and estate planning and could create tax obligations for everyone involved.
Questions of cash vs. contingent purchase price might seem rare, but they come up more frequently than you may imagine. Buyers favor contingent earnouts in order to ensure that they do not overpay for speculative or unpredictable business results. When a family sells its business and receives some combination of cash and contingent purchase price, there will automatically be considerations regarding who in the family should bear the risk of non-payment on the contingent portion. Valuation professionals can work with your legal counsel to provide useful and objective documentation of cash vs. contingent value.
Drew Steen is an attorney in the Family Business Practice Group at Davis Wright Tremaine.