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Getting Paid - Earn-Outs, Deferred Payments and Vendor Loans - YouTube
Channel: Steele Raymond LLP
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[Music]
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so welcome back nick in our m a d
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constructed series where we are
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unpicking step by step the process of
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selling a company yep
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today's discussion is over something
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that i think is going to be really of
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interest to sellers
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and that is how you get paid
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um
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it's very important in m a speak we use
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a term called consideration
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so most other sellers will think of
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price
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and but the question is how does that
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get delivered in other words when i when
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i sell a business what do i get at the
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end and of course most people think in
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terms of cash
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i simply sell my business for 10 million
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and at the end of the process i signed
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the page at the checker rise i got 10
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million pounds um but of course in
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reality
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it doesn't often go that way there are
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forces at work if you like in the sale
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process that sometimes mean
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that it gets structured in a different
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way so
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um i think if i just briefly talk about
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the cash element that's easy so i'll
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take the easy topic
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so typically a seller will want 100 cash
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on completion um it
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does happen but with the caveat that
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rarely does a deal happen where there is
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not some retention at the end of it
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so i think we talked about in the
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process but if people haven't seen this
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when you sell a business a buy will do
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due diligence they'll look at the
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business forensically usually in
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considerable detail and typically stuff
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comes out
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and
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to guarantee against potential stuff
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that comes out the buyer will often say
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listen we need a certain amount of money
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retained
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held back um because we found some stuff
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there's some tax issues or there might
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be an ip claim or there's some labour
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claim or whatever it might be but it's
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typical that there is a retention and of
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course that the amount that's retained
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is negotiable always yeah it's always
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negotiable if you've got an experienced
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corporate finance lead negotiation for
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you can get it down to a minimum but
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typically there is and there can be
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retentions at the end but it can be the
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deals and we've done deals together
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where you know the large proportion of
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the cash
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um has been delivered
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at completion
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but
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it's in particular i don't know how you
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feel about it since the covet 19
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pandemic
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my view is that there's an increasing
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focus on other types in structuring a
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deal so more of the the money
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comes later and we use terms like an
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earn out
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deferred consideration it could come
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with a vendor loan or vendor take back
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or indeed could have some rollover
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shares both in the existing entity or
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even in another legal entities yeah i
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think let's just talk briefly about
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those sure
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and earn out what's your description and
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how you would you explain an urn out
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okay um
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an earn out is where part of the payment
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of the price payable to the sellers
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is paid out over a period of time
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the sellers
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normally stay involved in the business
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and the amount that is
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paid or payable can vary depending on
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the target's performance if the target
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business does very well
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reaches
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its objectives for the next 12 or 24
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months whatever the earn out period is
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then the sellers can do very well and
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potentially achieve their their maximum
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earn out if the business does less well
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they will receive less
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so quite often earn outs are used by a
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buyer
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as a way of keeping
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sellers involved in a business those
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sellers are the people who know the
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business the best
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and as a way of delivering whatever the
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seller's forecasts or predictions might
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be
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for the future business
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earn outs can be very successful
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there is inevitably some risk and some
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friction on an earn out because
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a seller needs to have the authority to
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run the business
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to make decisions that affect the
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business and which affect the ability to
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achieve the earn out the friction may be
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that the buyer may say well i don't want
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you to run the business like that i want
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you to run it like this
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and so that it's very important that you
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address and capture
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in the spa
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how the earn out period will work there
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will be other things in the earn act
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schedule such as how the earnouts
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calculated and there are many different
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methods um
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typically the earner has to be agreed
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one party the buyer or seller will
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produce their earn out statement the
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other party will say yes we agree or no
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we don't you can have some independent
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referral if necessary
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um so that's how an earn out typically
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works yeah it's interesting because my
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when i go out and speak to potential
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clients and clients there is a universal
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feedback
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when it comes to earn outs and and that
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is that there's a received wisdom
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usually starts anecdotally with my mate
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in the pub that says he sold his company
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or her company and they didn't get their
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earnings and therefore it's a bad thing
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and actually
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what i counsel my clients is it it's not
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necessarily the case because often an
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urn out can be used to bridge a value
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gap
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because you know when you have an sme
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particularly a family-run business might
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be first second third generation um
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the the value that they attribute that
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the exit value they often attribute the
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owners of those businesses is often very
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high higher than the market may
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attribute correct yeah correct and and
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that's where the but the market might
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say the buyer might say well they'd say
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well okay we're going to agree to either
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agree the same value or close to it but
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you need to help me bridge the gap that
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proportion of it will come to you via
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the earn out when you achieve the
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objectives you say that are achievable
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correct and if you say if there's an art
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in this if you like rather than the
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science the artist in the negotiation
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the corporate finance lead the m a lead
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that is negotiating that on the seller's
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behalf because of course the key thing
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that the real
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interesting part of what you say is how
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that earn out is calculated and of
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course is that there's ways that buyers
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can manipulate it to their advantage and
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there's a way a seller can manipulate it
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to their advantage and the key thing is
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to have a very experienced negotiated
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lead to negotiate it but my viewers earn
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ants are not necessarily a bad thing
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they don't have to be a bad thing i mean
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i think there is a natural nervousness
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on the part of any seller when they hear
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or learn about an urn out
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i think the key thing to remember is
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that actually
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the buyer and the seller do have a
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mutual interest for the target business
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to do well the buyer wants it to do well
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because it's the business they've bought
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and they want to see it succeed the
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seller wants it to do well so they can
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maximize their earn now so actually if
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you can capture in the earn out schedule
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that
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the parties will work in such a way
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which enables the seller to make the
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decisions they think need to be made
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which protects the buyer's investment in
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the company
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which enables the parties to work
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towards the maximum earn out you know
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most buyers if they have to pay at the
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maximum earn out are probably quite
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happy because it means the underlying
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value of the asset they've bought is
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higher than what they paid for it at
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completion and you know the earn out
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cash will be funded by the target
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business so it's i mean it's an
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opportunity as you say to bridge that
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gap to engineer a bit more value out of
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the deal
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so i think that people should have an
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eyes wide open approach to it not
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necessarily close their ear straight
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away so i'm just simply not going to do
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an err now i think explore it look at
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the detail so the opposite not the
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opposite sort of uh
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value would be deferred consideration
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deferred means
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that the payment comes later in other
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words after the deal is completed the
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deferred payments are part of the
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consideration part the price comes later
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and it can be conditional or
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unconditional
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those payments um but of course the
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difference between a deferred
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consideration and an earn out is the
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deferred if it's unconditional means
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you're going to get the money yeah
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that's right there's just a scheduled
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payment for
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i don't know you've got a 10 million
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pound deal 9 million is paid on
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completion you get 500k
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six months after and another 500k 12
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months after it's not conditional on
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hitting
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targets it's not subject to performance
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it's just that money is paid to you and
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the buyer might want to engineer the
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deal like that for a number of reasons
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one might be cash flow
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the second might be and this is a point
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you alluded to earlier is
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retention in other words that means that
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if the buyer that you know brings the
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claim against the seller uh and they
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reach some sort of agreement rather than
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having to try to get the cash out of the
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sellers to settle that claim the bar can
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say well we'll just net that off your
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your deferred consideration so i think
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that's the risk to the to the sellers is
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that the buyer has control of the cash
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at that point unless it's put in some
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sort of joint escrow or something else
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which we do see from time to time um
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a key point about deferred consideration
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of that type which is unconditional is
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what's the risk for the seller and the
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risk is that you don't get that money
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for whatever reason
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if the business becomes insolvent if
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there is some other problem
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um then how are you going to recover
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that money
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and what you should be looking at is
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what security can you have for it and
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that means
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what can the buying company or the
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buying
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individuals offer you
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and it might be that you could ask for a
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charge of shares
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you could ask for a charge over some
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company assets you could ask for a
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personal guarantee from some individuals
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it's quite often quite hard to
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securitize those deferred payments
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because most businesses are funded by
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banks or financial institutions which
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means that most of their assets are
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normally charged to the bank
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therefore you can't say well why don't
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we have a charge over that lovely piece
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of machinery or
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that property because the bank are
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already there so those are some of the
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things you've got to think about when
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looking at deferred consideration yeah
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and that can make sellers a little bit
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nervous in terms of you know how do i
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secure my earn out how do i make sure
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you know in a lot of the deals that we
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do the buyer is a large legal entity
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yeah it's a successful well-capitalized
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entity and very rarely in my experience
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will they give those pgs as personal
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guarantees
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the directors of a company with a market
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cap of 100 million plus are unlikely to
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roll over and saying yes you can take a
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mortgage over my house that's fine
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you have the form of you at that point
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don't you now i think you're looking at
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balance sheet strength i think you're
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looking at
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how long that business has been around
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you're looking at their trading
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prospects and at the end of the day you
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have to form a view you have to evaluate
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the risk and you have to decide what you
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know you're comfortable with what you're
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not comfortable with there will be or
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not be certain things on offer
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and you need to decide with advice
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what's the best route for you so let's
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talk briefly about vendor loans vendor
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take back vendor loans um is something
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that actually in deals that i've done
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we've done um i rarely see but they do
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exist and it's the notion of a vendor
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loan effectively is a loan it's part of
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the consideration that is a loan from
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the seller to the buyer yeah um for part
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of the money and and the
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i suppose if you like the foundation of
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it is
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that the business
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will be allowed sufficient time to
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generate the cash
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in order to pay
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the seller
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what is due on that balancing payment
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yeah um
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what's your take on vendor loans sure i
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think vendor loan and vendor loans is
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sort of a new piece of terminology which
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is um you know we're seeing more of it's
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not a million miles apart from deferred
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consideration which is not conditional
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in reality
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if you're going to be paid a sum of
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money to sell your business but you
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allow the buyer to pay you some of that
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money later that's a vendor loan how
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it's captured and recorded in the docs
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is up to you
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if you're going to say it's not deferred
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consideration to vend alone you want
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some interest on it you want some
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security on it whatever else the risks
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are the same it's money you're not
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getting at completion you need to work
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out what the risks are whether you're
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going to to get it
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vendor loans are of course distinct from
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low notes
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which are
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a more formal um
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form of consideration which have
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different tax consequences which i won't
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go into today um something you know
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someone more qualified than me and tax
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can can pick up on but low notes um will
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issue
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certificates to sellers often in a
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holding company
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often with a coupon attached to them
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meaning that you get some interest on a
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period low notes can be over a short or
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long term
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and
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it might be something that a very large
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business is using to help them fund
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multiple transactions um
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it's something people can look at the
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risks are similar again
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the other risk with low notes is that
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quite often they are expressed as being
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subordinated which means that they are
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subject to the buyers or the bio groups
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other financial commitments and those
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other financial commitments may say that
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they cannot repay other borrowing low
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notes unless the company has hit its
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covenants or
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has sufficient headroom in the business
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in terms of profit and other things so
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there's quite a lot to look at and quite
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a lot to understand in respect of
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those
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but again they are options that are on
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the table for for how deals can be
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funded talking briefly one last part
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which is very occasional and that's roll
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over shares yeah and that is instead of
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receiving cash or getting your money via
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an earn out a deferred is this the last
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component would be taking shares in
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either the same business or a new
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business or a holding company
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how many transactions do you come across
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that have a rollover share we do yeah we
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do see those deals they i wouldn't say
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that they are particularly common i can
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think of we've done a few in recent
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years we've got one at the moment
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there are a number of points in respect
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to rollover or consideration shares as
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they're often known you need to
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understand what shares you're getting
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and we've done deals where the
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consideration shares have been in
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foreign entities which is another
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another layer of complexity and the key
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things you're looking at are
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what is the value of the issuing entity
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of those shares and what proportion of
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the shares are you getting so are the
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shares at least at completion of
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equivalent value to the cash you would
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otherwise be getting so that's point one
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the second point is how do you turn
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those shares into cash how can you
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liquidate them you know
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are the shares restricted quite often um
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in smes there's a limited pool of buyers
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if you're a minority shareholder you
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can't just go and sell your shares to
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whoever down the road there may be
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restrictions that say they've got to be
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offered to the other shareholders pro
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rata they've got to be valued in
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accordance with the way the company
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wants to value them they may apply
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discount to a minority holding etcetera
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etcetera
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so i think that there is a lot to look
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at
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they can work
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and we sometimes see it in in private
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equity models which who are going for a
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sort of
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you know buy and build strategy where
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they're bringing lots of businesses
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together to enable them to fund doing
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that they'll give you some rollover
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shares in their holding company
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in that sort of scenario the private
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equity buyer is probably trying to get
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to a critical mass point and then
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they're going to sell the whole uh
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entity so
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if that's the plan you need to
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understand what the plan is what the
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time frames are what the eventual future
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values might be some of those scenarios
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can work well you get a second byte of
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the cherry you get a second return of
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value
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but it's it's like many things in m a
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it's just understanding the detail
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looking at the key points
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making sure when you sign up on the
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dotted line you're clear in your mind
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what you can and can't do with your your
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rollover shares and i think that's in
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terms of however the consideration is
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structured having a strong commercial
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guide to negotiating a negotiating the
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best possible deal but b also modelling
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out potential returns of those because
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of course it can be attractive to get
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for example a certain proportion of
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shares in a holding company a top code
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that's a very big plc that's going to do
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extremely well it aligns people's
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interests
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so it can potentially deliver more value
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if the sums all add up but some sellers
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don't want all cash they might have got
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enough cash or whatever and actually uh
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having some rollover shares means that
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if there is a later disposal it'll be in
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another tax year
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it's another opportunity down the line
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there may be some dividend or income
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stream off those shares in the interim
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period so it is an opportunity it will
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depend on the seller's circumstances
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yeah look at the detail so i think
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that's we've covered that the headlines
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always more to discuss i think that's a
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great one nick thank you pleasure talk
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again
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[Music]
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you
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