In business, what is a purchase consideration?
How is the purchase consideration structured and what methods are used to calculate them?
In this article, we will discuss what is purchase consideration in detail.
We’ll go over calculation methods like the net payment method and payment structures like cash and non-cash purchase considerations.
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Let’s get started!!
What is purchase consideration
In the context of an acquisition or the purchase and sale transaction, the purchase consideration is the total payment made by the buyer to the seller.
You can think of the purchase consideration in the following purchase and sale scenarios:
- Acquisition or sale of a business
- Acquisition or sale of a property
In a business amalgamation, consolidation, take-over, merger or acquisition, the purchase consideration can be in the form of cash, shares, assets, securities, financial instruments or other assets the parties agree upon.
This is referred to as the cash and non-cash considerations.
For example, a purchasing company can offer to purchase a vendor company for a total amount of $10,000,000 in cash and by the issuance of 100,000 shares worth $100 per share giving a total purchase consideration of $20,000,000.
Half of the purchase consideration is in cash and the other half is in shares.
Methods of purchase consideration
Purchase considerations can be evaluated using several methods:
- Net asset method
- Net payment method
- Lump-sum method
- Intrinsic value method
Let’s look at each of these purchase consideration methods.
Net asset method
The net asset method for evaluating purchase consideration is pretty straightforward.
The buyer will take the seller’s total assets, excluding any fictitious assets, and deduct all liabilities from the assets to come up with a value.
The formula looks like this:
- Seller’s total assets – Seller’s total liabilities = Seller’s net assets
- Seller’s net assets / Seller’s total outstanding shares = Seller’s net assets per share
The net result will reflect the purchasing consideration the buyer will be prepared to pay to purchase the seller’s business.
Net payment method
The net payment method or net proceeds will look primarily at the value of the total consideration or payment the buyer is willing to make to the seller.
The formula for the net payment method is simple:
- Total cash + value of shares + debentures + other assets = Total net payment
If a business is acquired using cash, securities, debentures and other assets, then the net payment method will require that you add up the value of the cash, the value of the securities and the other assets to come up with the total net payment.
Lump-sum payment method
The lump-sum method, as the name suggests, is one payment to acquire the business or asset.
The buyer and the seller agree on a one lump sum payment to conclude the transaction.
Since the parties will not be making payment using securities or other assets that may require evaluation, the transaction will be consumed in a much faster way without the need for a formal valuation of assets and liabilities.
Intrinsic value method or share exchange method
The intrinsic value method is the value of the company’s stock.
The intrinsic value can be calculated as follows:
- Seller’s net asset value / Buyer’s price per share = Seller asset value per share
- Seller asset value per share / Seller’s total outstanding shares = Intrinsic value ratio
This method uses the seller’s net assets value on a per-share basis to derive the intrinsic value.
Acquisition consideration in merger and consolidation
Depending on the nature of the business transaction, the acquisition consideration will be paid by the buyer and received by the seller in different ways.
Let’s look at the acquisition consideration in the context of a consolidation and a merger.
Purchasing consideration in a merger
A merger is when two businesses merge whereby the seller merges into the buyer’s business and is subsequently dissolved.
For example, Company A and Company B merge.
Company A, the surviving company, will take over all the assets and liabilities of Company B and Company B will cease to exist.
When Company A pays Company B, Company B will pay the purchase consideration it received to its shareholders during its dissolution.
Purchasing consideration in a consolidation
A consolidation is when a buyer and a seller combine into one larger organization.
For example, Company A and Company B consolidate to become a new business called Company C.
Company C is the successor company.
Similar to a merger, if Company A and B are dissolved, the purchase consideration can be paid to company shareholders in the form of cash or shares in the new successor company.
Contingent payment consideration
A payment consideration can either be payable upon the conclusion of the transaction or it can be contingent on some conditions or future parameters.
For example, if a buyer agrees to purchase a seller contingent on the business performing as it was represented or contingent on the fact that key personnel of the seller work full-time post-closing for the buyer for at least two years, these conditions represent contingent factors impacting the purchase consideration.
Another example is if a company agrees to buy another company for $2,000,000, they may decide to pay $1,000,000 today and leave $1,000,000 to be paid in the future contingent on the realization of the conditions they’ve mutually agreed upon.
A contingent payment consideration bridges the gap between the difference in the knowledge of the buyer and the seller about the seller’s business during the negotiations.
Purchase considerations: cash and non-cash considerations
In a typical merger or acquisition, a buyer will offer the selling company cash and non-cash considerations to represent its total purchase price or value.
This is how most purchase considerations are structured.
It’s not expected for a buyer to pay the seller the full purchase price all in cash.
You’ll typically see non-cash considerations in the mix.
Cash consideration is pretty self-explanatory.
It’s the amount of cash a buyer will pay the seller in the context of a purchasing deal.
A non-cash consideration can represent different payment methods.
The most common non-cash considerations in the financing of M&A transactions are:
- Stock payment
- Escrow deposit
- Earnout
- Equity hold
- Seller’s note
Let’s look at each of these non-cash purchase considerations.
Stock payment
Stock payment is when the buying company will issue shares to the stockholders of the target company based on an agreed-upon ratio.
Buyers will opt for issuing shares and securities to purchase a target company when their company is overvalued.
That makes it worth using non-cash consideration such as the issuance of equity to acquire another business.
Escrow deposit
An escrow deposit is more of a protective mechanism helping the buyer and the seller bridge the gap in their real knowledge of the business being bought out.
The buyer and seller can agree to deposit a percentage of the total purchase consideration in escrow to guarantee the seller’s representations and warranties.
If the seller’s representations and warranties turn out to be true in the future, then the escrow deposit will be released to the seller.
If the representations and warranties do not materialize, the buyer will deduct the value of losses or damages it suffered from the escrow deposit.
Earnout
An earnout is a method used to bridge a valuation gap between the buyer and the seller.
Earnout provisions relate to mutually agreed future earning targets.
Often, earnout provisions are strict.
A buyer can impose strict earnout requirements as a means to avoid paying full price to the seller.
Sellers must be careful in setting up an earnout provision to ensure that the obligations and milestones are clear.
Depending on the success or failure to hit the earnout marks, the buyer will pay or be discharged from paying a certain amount initially agreed as total purchase consideration.
Equity hold
An equity hold is a time period that the buyer must hold on to the seller’s shares following the purchase transaction.
In the context of a buyout investment, an equity hold can range between five to seven years.
Equity hold is used by private equity firms to manage the value of their acquired business portfolio.
Seller’s note
A seller’s note is a financing method to bridge the gap between the purchase price and the financeable assets in the transaction.
When there are not enough assets to allow financing, buyers will issue the seller a note bearing interest and payment terms.
Essentially, the seller is self-financing all or part of the deal by agreeing to a seller’s note.
Purchase consideration debentures
In some cases, a company may purchase another business by issuing debentures as consideration.
This type of purchase consideration is called the issue of debenture as a consideration.
A debenture is an unsecured loan certificate issued by a company.
The difference between a debenture and a bond is that a debenture is not backed by the assets of the company, it’s issued based on the company’s credit.
The debenture as a purchase consideration can be paid in the context of any type of acquisition transaction.
You can issue debentures in the context of an acquisition, a merger, consolidation or amalgamation.
Takeaways
The purchase consideration is what a buyer is prepared to pay a seller in the context of purchase or sale transaction.
In business, the purchase consideration is relevant when companies are conducting mergers, acquisitions, consolidations, amalgamations or any other business purchase and sale operations.
The purchase consideration can be calculated using different methods such as the net payment method, lump-sum method, intrinsic value method or net asset method.
Each purchase consideration calculation method allows a buyer to establish the value it is prepared to pay to buy the seller’s assets or business.
Once a purchase consideration is defined, then the buyer and seller will need to consider the proportion of cash and non-cash payments.
Cash payment is the payment of hard cash to make the purchase.
Non-cash considerations can be in the form of equity, stocks, bonds, debentures, escrow deposits, earn outs, promissory notes, seller’s note and so on.
The most common ones are stock issuance, debentures, escrow and notes.
We hope this article helped you better understand purchase considerations in business, the methods used to calculate it and how the purchase considerations are paid.
Have you been involved in calculating purchase considerations using one of the methods we mentioned?
Perhaps you’ve been part of an M&A deal where you structured a cash and non-cash purchase consideration.
If so, we would love to hear from you.
Drop us a comment!
