In the Canadian middle market, many businesses are sold for consideration other than just cash. Other consideration such as vendor notes, contingent consideration or vendor notes are commonly referred to as “structure”. Transaction structure can be very useful for getting transactions completed: optimizing value for a seller and reducing risk for buyers. A purchase agreement can be very creative in the types of features it includes. The three most common forms of structure are vendor notes, contingent consideration, and retained equity.
What are vendor notes, contingent consideration and retained equity?
While they share similarities, there are key differences between the three concepts:
1) Contingent Consideration:
Nature: Contingent consideration is a payment or series of payments that are contingent upon the occurrence of specified future events or the achievement of certain performance metrics.
Basis for Payment: The payments are typically tied to the financial performance of the acquired business, specific milestones, or other predetermined criteria.
Purpose: Contingent consideration is often used to bridge valuation gaps between the buyer and the seller, align the interests of both parties, and provide a mechanism for sharing risk when uncertainties exist regarding the future performance of the acquired business.
Examples: Earnouts, milestone payments, royalty payments, contingent value rights (CVRs), and equity-based contingent consideration are all examples of contingent consideration.
2) Vendor Note:
Nature: A vendor note is a form of financing where the seller agrees to provide financing to the buyer as part of the purchase price. The seller essentially acts as a lender to the buyer.
Basis for Payment: Payments are structured as promissory notes or loan agreements, outlining the terms of repayment, interest rates, and any collateral or security interests.
Purpose: Vendor notes are often used when the buyer may face challenges obtaining traditional financing, or when the seller has confidence in the future success of the business and is willing to defer a portion of the purchase price.
Examples: Promissory notes, loans, or other debt instruments issued by the buyer to the seller as part of the transaction.
3) Retained equity:
Nature: Retained equity is when the seller keeps a minority equity position in the business or obtains minority shares of the acquiring company as part of the purchase consideration.
Basis for Payment: Typically, there is no defined payment for the retained equity. The retained equity participates in dividends at the same pro-rata rate as the acquirers’ equity. This includes participation in a future sale or IPO. As part of a transaction the parties can negotiate put and call options that define the liquidity rights of the shares.
Purpose: Retained equity can be used to ensure there is alignment between the vendor and the purchaser post close to oversee the continued success of the business. It can also be used to bridge a financing shortfall if the purchaser does not have capital to purchase 100% of the business. Lastly, sellers may see value in the future combined businesses and believe participation in a future exit such as an IPO is the greatest value proposition.
Examples: Common shares or preferred shares.
Summary of Differences
|Basis for Payment
|Based on future profit paid through dividends and/or future sale
|Based on future events or performance of defined terms
|Defined payment terms based on negotiated interest rate and principal amortization
|Future Risk and Reward between Seller and Buyer
|Fully shares the future risk and rewards of the business
|Based on risk of specific future performance
|Limited to credit risk only (i.e. bankruptcy)
|Timing of Payment
|Limited definition. The terms can include call and put options that define liquidity rights of the shares with defined timelines
|Timing can depend on external events occurring and will typically have an expiry period
|Prescribed repayment schedule
Optimizing seller value
Retained equity – Ensuring the shares are parri passu with the acquirors shares, or have preferential status. This could include the negotiation of a preferred cumulative dividend. When selling to a private business, considering future liquidity clauses such as call and put options provides a path to an ultimate exit at pre-negotiated terms and time frame.
Contingent Consideration – The level of customization of contingent consideration means there are lots of factors in optimizing value and the breadth of the subject is beyond the scope of this article. At a high level, the more definitive the basis of the earnout the more valuable it is. For example, an earnout out based on revenue has less ability for a purchaser’s to manipulate than profit. Additionally, an earnout that is paid as a percentage of every dollar (revenue or profit) is more assured value than one that is paid only when exceeding a defined threshold.
Vendor note – Negotiating higher interest rates, shorter maturity terms, pledge of shares and corporate or personal guarantees increase the value of the loan and likelihood of repayment.
These instruments can be powerful tools to achieve the desired objectives of both buyers and sellers. CCC has strong experience negotiating advantageous deal structures for our clients. We bring deep accounting and legal expertise to ensure the negotiated terms optimize value and minimize negative exposure. Further, our deep knowledge of other transaction structures is useful in guiding deal terms toward market norms. To explore this subject or other topics on the sale of the business reach out to Josh Ellis or a CCC professional.
Josh Ellis, CPA, CA, CBV
Vice President, Toronto
Josh advises clients on complex divestiture and corporate finance processes across a broad range of industries including consumer package goods, industrial manufacturing, business services, oil and gas services, and more. As a lead member of CCC’s valuation practice, Josh takes a practical approach to valuations which is focused on the user’s needs, while adhering to CICBV standards.