You are very interested in acquiring the company and would be more than willing to pay the $5M in goodwill if the current owners forecasts actually come true. In this case the best way to structure a formal Letter of Intent to purchase the corporation would be to utilize the benefits of an “earn-out agreement” for the seller.
An earn-out agreement bases all or part of the purchase price of the business on its performance in the future. As an example, in the aforementioned scenario you could submit a Letter of Intent of $1M cash on closing (four times last year’s earnings of $250K) and provide an earn-out agreement whereby the seller receives X% of the net profits over the next five years. The X% would be based on the seller’s forecasts of future profitability and if they are in deed correct the seller would receive an additional $4M in goodwill payments. However, the earn-out agreement also protects you. If the current owner’s forecasts turn out to be incorrect you will not have paid out the $5M in goodwill.
Earn-out agreements can be based on any parameters that you feel are valid within the context of the business you are acquiring. You can use gross margin, profit, sales, cost of goods sold, specific targets and or ratios or a combination of some or all of them. In all cases attempt to keep the earn-out agreement as simple as possible. I have seen some earn-out agreements that are so complicated that they wind up backfiring because no one can figure out exactly what they are supposed to accomplish and how it will affect their payout. You also have to ensure that the earn-out and its resulting pressure for short-term results do not discourage the original owner from doing things like spending money on research and development, diversifying, or investing corporate funds in other ways that would only produce results over the long-term.
You also must be somewhat warry about earn-out agreements possibly producing the wrong kind of results for you, depending on the type of company you're purchasing and your own financial goals. If it's a fast-growing business, you may want or need to put all the cash back into growth and may not actually be overly concerned about short-term performance. In such cases, it makes better sense to simply negotiate a purchase price that satisfies all parties.
Generally, earn-out agreements are only structured in deals where the original owner is staying with the company and hence will have an impact on its future performance.
Tangible Assets:
Tangible assets such as capital equipment are usually sold at their book value. You may feel that this is a reasonable way of determining their value. However, it is important to remember that book value is an accounting term that is based on the original cost of the item less an allowed yearly depreciation of its value. The tax man and reality are not necessarily the same thing. One area which always stands out in my mind is the purchase of computer hardware and software. It is possible, from a tax stand point, to depreciate computer hardware and software over a 5 year period. In my opinion computer hardware and software should be depreciated to zero value within 12 to 24 months maximum.
If you are looking at acquiring a specific business it is important to look at depreciation schedules as part of your due diligence exercise. If you find schedules that are not rational, adjust your purchase price accordingly. For instance, if I was to find that all of the computer equipment and software are more than 12 months old and the current owner is depreciating it over a period of 5 years I would not be prepared to pay anything for those specific assets.
It is also important to verify that any specific tangible asset actually has the value that is currently on the books. You should investigate tangible assets such as production machinery, rolling stock and vehicles. The book value is based on the purchase price of the asset, a vehicle that is only one year old may have a high book value, but it is really not worth much if the engine is blown. If the business relies on a substantial amount of complex production machinery it may well be worth paying for a service company to inspect and provide you with a written report as to its current functionality and its estimated life prior to making an offer to acquire the business.
When purchasing inventory one must consider “good” inventory versus stale or obsolete inventory. Depending on the business good inventory is usually inventory that has been acquired within the last 90 days. However, in the case of a fashion retailer good inventory might be defined as inventory that has been purchased in the last 30 days. In any case look for inventory obsolescence relative to the industry norm for the company that you are considering acquiring. Look at overstock. Is it a seasonal business? A hardware store may have 20 wheel barrows in stock, but its winter time and there is snow on the ground, as soon as spring arrives those wheel barrows will sell, you may want to offer a 30% discount on inventory older than 90 days in the case of a hardware store. If however, you are buying a toy store that relies on the “in” toys for its primary profitability, you may want to consider defining current inventory as anything purchased within the last 30 days and discounting older inventory by 50% or more. If you are acquiring a manufacturer of electronic equipment good inventory may be any inventory that is currently used in the production of their products without reference to the date it was purchased. There is no rule or law that states that you have to pay the “book value” or “replacement value” of any item that you are acquiring.
Many businesses have a very high change in inventory levels from one month to another. Inventory is made up of raw materials, goods purchased for resale and in finished goods, which could carry an amount of overhead and labor. It is important that you understand what items are included in the inventory numbers you are supplied. It is very common situation to find that inventory has sales tax, labor, overhead, and freight included in their book values.