2024 Deal Term Survey

2024 M&A Deal Terms Study

Key findings of deal terms in private-target M&A transactions that closed between 2018–2023

Valuations

  • Deal size trends observed in the 2022 M&A market continued into 2023: lower valuations and a focus on lower middle-market (less than $50 million) deals.
  • The median return on investment for 2023 deals was 2.5x, down from 4x in 2022. The median exit timing for M&A targets continued to rise.
  • There was a 70% increase year over year in the percentage of deals with a management carveout, likely indicative of further pressure on valuations.

Deal Structure

  • Strategic buyers (both U.S. public and private) were more active in 2023, with a corresponding substantial drop by U.S. private buyers backed by private equity (e.g., portcos).
  • While the first part of 2023 saw increased usage of buyer equity as part of the consideration mix similar to 2022, as of the third quarter last year, all-cash deals are slowly on the rise.
  • “GAAP consistent with the target’s past practices” is for the first time no longer the majority practice when establishing the accounting methodology for PPAs; the “worksheet” approach is now used on more than one third of deals.
  • The median size of separate PPA escrows has now reached 1% of transaction value.

Earnouts

  • One third of 2023 deals included an earnout, which is more than a 50% increase year over year (close to one fifth of deals in the previous three years included an earnout).
  • The amount of contingent consideration tied to earnouts also ticked up slightly.

Deal Escrows

  • Use of special escrows (in addition to the general indemnification escrow) is on the rise, with nearly one half of deals with RWI including an escrow for something other than general indemnification or the PPA.
  • The median sizes of indemnification escrows held steady at 10% of transaction value for deals without RWI identified (0.5% for deals with RWI identified).

Indemnification

  • The number of deals with no survival of seller’s general representations and warranties (i.e., walk-away deals) decreased in 2023.
  • The median survival period for seller’s representations and warranties went back down to 12 months, but the average held steady.

Effect of RWI

  • The presence of Representations and Warranties Insurance (RWI) can materially affect certain deal terms, including use of a separate purchase price adjustment escrow, certain seller representations and survival, sandbagging, materiality scrapes, baskets, caps, and escrows.

Why EBITA Multiples Matter: A Key Tool for Business Buyers and Sellers

Why EBITA Multiples Matter: A Key Tool for Business Buyers and Sellers

If you’re involved in M&A or considering buying or selling a business, you’ve probably heard of the term EBITDA multiple. But what exactly is it, and why is it so important?

EBITDA Multiple is a key financial metric used to value a business. It’s calculated by multiplying a company’s EBITDA(Earnings Before Interest, Taxes, Depreciation, and Amortization) by an industry-specific multiple.

Why does this matter?

  • Valuation: Investors and buyers use EBITDA multiples to determine the fair market value of a business. A higher multiple often signals a company with strong growth potential or a competitive edge.
  • Market Comparison: Multiples allow for quick comparisons between companies in the same sector. By analyzing similar businesses, investors can gauge whether a company is overvalued or undervalued.
  • Acquisition Valuation: Buyers use multiples to estimate a reasonable offer price for a business, helping determine if a purchase price aligns with industry standards.
  • Investment Analysis: Investors use multiples to screen potential investments, identifying companies that meet specific financial criteria based on their EBITDA.

Key Considerations When Using Multiples

EBITDA multiples are valuable, but there are several key factors to consider when using them:

  • Industry Differences: Multiples can vary significantly between industries due to differences in growth potential, risk profiles, and capital requirements. Always consider industry-specific benchmarks.
  • Company Size: Smaller companies tend to have lower multiples due to higher perceived risk, while larger companies often receive higher multiples due to their established market presence and financial stability.
  • Market Conditions: Economic trends can influence multiples. During periods of economic growth, multiples tend to expand, while they may contract during downturns. Stay informed about market conditions for accurate valuation.
  • Quality of Earnings: Consider the company’s earnings quality. One-time gains, accounting practices, and revenue recognition can distort EBITDA, leading to misleading valuations.
  • Growth Prospects: A business with strong growth potential may warrant a higher multiple, while a stagnant or declining company may not.
  • Transaction Comparability: Ensure the transactions you’re comparing are truly similar. Differences in business models, geographic locations, or operational scales can affect the relevance of the multiples.
  • Subjectivity: The use of multiples can be influenced by subjective biases or varying interpretations of market conditions, so a balanced approach is key.

While EBITDA multiples are helpful in valuing a company, they are not a hard and fast rule.

The value of a company not only varies by industry it also varies by numerous other factors including niche, continuation of management, key customers, industries served, and other factors that reflect the unique characteristics of a business. Factors like brand reputation, competitive positioning, and the stability of recurring revenue streams also impact a company’s value beyond the EBITDA multiple.

These nuances mean that while EBITDA multiples provide a quick way to estimate value, they should be considered alongside a more in-depth analysis that captures the full spectrum of what makes a business attractive to potential buyers or investors.

Ultimately, EBITDA multiples serve as one of many tools in the valuation process. A well rounded approach will examine both quantitative metrics and qualitative factors that can lead to a more accurate and realistic assessment. Using a skilled advisor with industry expertise can also add invaluable insights, as they can help interpret these factors and guide strategic decisions in both buying and selling scenarios.

How Long Does an M&A Deal Really Take?

How Long Does an M&A Deal Really Take?

The timeline for completing an M&A deal can vary depending on a range of factors, but one thing is for sure: it takes time. On average, most deals take 12 monthsto close, and there are several stages to expect along the way.

In some cases, sellers face tight timelines to meet their objectives. At Chapman Associates, we’re proud to say that when deadlines are tight, we’ve successfully closed deals in under 60 days from authorization to completion.

Preparation Phase (1-3 months)

The first step in any M&A transaction is preparing your business for sale. This stage is all about getting your financials, legal documents, and operations in order.

Expect to:

  • Conduct a business valuation
  • Clean up financial statements and address any discrepancies
  • Prepare a comprehensive information packet for potential buyers

This phase is critical for ensuring the business is attractive to buyers and is often much more intensive than the seller imagines.

Marketing & Search for Buyers (3-6 months)

Once you’re ready, we start actively marketing the business and searching for the right buyers. This involves:

  • Identifying and targeting potential buyers (strategic, financial, etc.)
  • Creating marketing materials and presenting the opportunity to the right candidates
  • Reaching out to potential buyers through direct outreach or listing on platforms

For most deals, this phase is where the timeline can really stretch, as finding the right buyer may take time, especially if you’re looking for a strategic fit or a higher-value offer.

Buy Side Due Diligence (3-4 months)

After identifying a buyer, the due diligence process begins. This phase often feels like the longest part of the deal, as it involves:

  • Detailed financial review, including historical financials, projections, and tax returns
  • Legal and regulatory checks, including contracts, employee agreements, and any potential liabilities
  • Operational audits, to ensure everything is in place from a business operations standpoint

Buyers will typically ask for several rounds of information, and addressing these requests can take several months. Be prepared for back-and-forth negotiations during this stage.

Negotiation & Final Agreement (1-2 months)

Once due diligence is complete, the negotiations begin. This phase involves:

  • Structuring the deal (e.g., cash vs. stock, earnouts, and contingencies)
  • Finalizing terms and addressing any last-minute concerns
  • Drafting and reviewing the letter of intent (LOI) and purchase agreement

Though it seems straightforward, this phase can still take time as both parties may go through multiple rounds of back-and-forth to reach a final agreement.

Closing & Transition (1-2 months)

The final phase involves the actual closing of the deal, which includes:

  • Finalizing the paperwork and receiving regulatory approvals (if necessary)
  • Transitioning operations to the new ownership, including handling employees, customers, and vendors
  • Post-closing support, where the seller may stay on for a transition period to ensure smooth operations  al is signed, the work isn’t over – transition planning is a key part of ensuring long-term success.

On average, the full M&A process takes about 12 months from start to finish, though larger or more complex deals may extend beyond this timeline. It’s important to note that many of these phases can overlap, with each playing a crucial role in the overall success of the transaction.

If you want to better understand how to prepare for the first step, reach out to us for a checklist outlining what buyers typically look for before making an offer.

The Use of IRC Section 1202 in Mergers and Acquisitions

The Use of IRC Section 1202 in Mergers and Acquisitions

Introduction

Internal Revenue Code (IRC) Section 1202, also known as the Qualified Small Business Stock (QSBS) exclusion, is a valuable provision that offers significant tax benefits to investors in qualified small businesses. This tax incentive, introduced in 1993, aims to encourage investment in small businesses by allowing investors to exclude a substantial portion of their capital gains from taxation when they sell their QSBS. In the context of mergers and acquisitions (M&A), IRC 1202 can play a crucial role in structuring deals, maximizing tax efficiency, and enhancing the attractiveness of potential acquisitions.

Understanding IRC Section 1202

IRC Section 1202 provides an exclusion from federal capital gains tax on the sale of QSBS, subject to certain conditions. To qualify for the exclusion, the following criteria must be met:

  1. Qualified Small Business Stock (QSBS): The stock must be issued by a domestic C corporation with gross assets not exceeding $50 million at the time of issuance and immediately thereafter. The corporation must actively conduct a qualified trade or business, excluding certain industries such as professional services, banking, and real estate.
  2. Holding Period: Investors must hold the QSBS for more than five years to be eligible for the exclusion.
  3. Original Issuance: The stock must be acquired at original issuance directly from the company, not from a secondary market.
  4. Exclusion Limits: The exclusion percentage depends on when the stock was acquired. For QSBS acquired after September 27, 2010, 100% of the gain is excluded, up to the greater of $10 million or ten times the taxpayer’s basis in the stock.

IRC Section 1202 in Mergers and Acquisitions

In M&A transactions, IRC Section 1202 can be a strategic tool for both sellers and buyers. The provision can influence deal structure, negotiation dynamics, and overall transaction value.

  1. Tax-Advantaged Exits for Founders and Investors: For founders and early investors in qualified small businesses, IRC 1202 offers a tax-efficient exit strategy. By excluding a substantial portion or all of their capital gains, sellers can significantly increase their after-tax proceeds. This tax savings can be a strong selling point during negotiations, particularly when dealing with buyers who might be looking to acquire a business with tax-advantaged growth potential.
  2. Increased Attractiveness of Target Companies: Companies structured to issue QSBS can become more attractive targets for acquisition. The potential tax benefits for shareholders can enhance the perceived value of the company, making it a more appealing investment for buyers. Additionally, the presence of QSBS can provide leverage for sellers in negotiating a higher purchase price.
  3. Deal Structuring Considerations: In some M&A transactions, the buyer may prefer a stock purchase to take advantage of IRC 1202. By structuring the deal as a stock acquisition rather than an asset acquisition, the buyer can retain the QSBS status of the acquired shares, provided the necessary conditions are met. This strategy allows the buyer to preserve the potential future tax benefits of IRC 1202 for subsequent sales.
  4. Strategic Tax Planning: Sellers and buyers can engage in strategic tax planning around IRC 1202 to optimize the transaction. For example, sellers may consider timing the sale to ensure they meet the five-year holding period requirement or to align with other tax planning objectives. Buyers, on the other hand, may evaluate the potential tax savings associated with acquiring QSBS and factor this into their valuation and deal structure.

Challenges and Limitations

While IRC 1202 offers significant benefits, there are also challenges and limitations to consider:

  1. Qualification Requirements: Not all companies and investors will qualify for IRC 1202. Companies must carefully assess their eligibility, and investors must ensure that they meet the original issuance and holding period requirements.
  2. Industry Restrictions: Certain industries are excluded from qualifying for QSBS status, which can limit the applicability of IRC 1202 in M&A transactions involving businesses in those sectors.
  3. Complexity in Deal Structuring: Structuring M&A transactions to maximize IRC 1202 benefits can be complex. Legal and tax advisors play a critical role in navigating these complexities and ensuring compliance with the requirements.

Conclusion

IRC Section 1202 provides a powerful incentive for investment in small businesses, offering substantial tax benefits to investors in qualifying stock. In the realm of mergers and acquisitions, this provision can enhance the attractiveness of target companies, facilitate tax-efficient exits for founders and investors, and influence deal structuring. However, careful planning and expert guidance are essential to navigate the qualification requirements and fully leverage the benefits of IRC 1202 in M&A transactions. As the landscape of business and tax regulation evolves, IRC 1202 will continue to be a valuable tool in the M&A strategy toolkit.

 

The Impact of Sellers’ Debt

The Impact of the Seller’s Debt in M&A Transactions

In mergers and acquisitions (M&A), understanding the financial landscape of both the buyer and the seller is crucial for structuring a successful deal. One of the key factors that can significantly influence the transaction is the seller’s existing debt. The debt profile of the target company not only affects the valuation and negotiation process but also plays a critical role in post-acquisition integration and financial stability. This article explores the impact of the seller’s debt in M&A transactions, the challenges it poses, and strategies to mitigate associated risks.

Understanding the Seller’s Debt in M&A

The seller’s debt refers to the outstanding obligations of the target company at the time of the acquisition. These can include:

  1. Secured and Unsecured Loans: Borrowings that are either backed by collateral (secured) or not backed by any specific assets (unsecured).
  2. Bonds and Debentures: Long-term debt instruments that can be traded on public markets.
  3. Revolving Credit Lines: Flexible lines of credit that the company can draw on as needed.
  4. Vendor Financing: Debt that may be owed to the seller’s suppliers or customers.
  5. Convertible Debt: Debt that can be converted into equity at the discretion of the lender.

Impact of the Seller’s Debt on M&A Transactions

  1. Valuation Adjustments:
    • The existing debt of the seller directly impacts the valuation of the company. In a typical acquisition, the enterprise value (EV) of the target is calculated by adding the market value of equity and the net debt (total debt minus cash) of the company.
    • High levels of debt increase the enterprise value, which can make the acquisition more expensive. However, the buyer often adjusts the purchase price downward to account for the assumption of this debt, effectively reducing the equity value paid to the seller.
  2. Deal Structure and Financing:
    • The presence of significant seller debt can influence the structure of the deal. Buyers may prefer to purchase assets rather than the entire company (stock purchase) to avoid assuming the liabilities associated with the seller’s debt.
    • In some cases, the buyer may negotiate to refinance or pay off the existing debt at closing. This requires careful planning to ensure sufficient financing is available to cover both the purchase price and the debt payoff.
  3. Impact on Cash Flow and Financial Stability:
    • Post-acquisition, the combined entity’s cash flow will be impacted by the need to service the existing debt of the seller. High levels of debt can strain the cash flow, reducing the funds available for operations, capital investments, or further strategic initiatives.
    • This situation is particularly challenging if the target’s existing debt carries high interest rates or restrictive covenants that limit the financial flexibility of the combined entity.
  4. Covenant and Restriction Considerations:
    • Debt covenants associated with the seller’s existing loans can impose restrictions on the target company’s operations, such as limitations on additional borrowings, dividend payments, or certain capital expenditures.
    • These covenants may conflict with the acquirer’s strategic plans, necessitating renegotiations with lenders to modify or remove such restrictions as part of the transaction.
  5. Due Diligence and Risk Assessment:
    • Thorough due diligence is essential to understand the full scope of the seller’s debt, including hidden liabilities, contingent obligations, or off-balance-sheet financing.
    • The buyer must assess the target’s ability to generate sufficient cash flows to service the debt and identify any risks that could impair the repayment capacity, such as declining revenues, adverse market conditions, or legal liabilities.

Strategies to Mitigate the Impact of Seller’s Debt

  1. Debt Refinancing:
    • One approach to managing the impact of the seller’s debt is refinancing. This involves renegotiating the terms of the existing debt or replacing it with new debt at more favorable terms, such as lower interest rates or extended maturities.
    • Refinancing can improve the cash flow position of the combined entity and provide greater financial flexibility.
  2. Purchase Price Adjustments:
    • Buyers can negotiate purchase price adjustments based on the amount of debt assumed. This ensures that the acquirer is not overpaying for the equity of the target, given the liabilities that will be inherited.
    • A thorough understanding of the net debt position helps in negotiating fair terms that reflect the true value of the target.
  3. Alternative Deal Structures:
    • In scenarios where the seller’s debt is particularly burdensome, buyers might opt for alternative deal structures, such as asset purchases. In an asset purchase, the buyer can selectively acquire desirable assets while leaving behind unwanted liabilities.
    • This approach can mitigate the risk associated with taking on excessive debt but may require complex negotiations to transfer specific assets and liabilities.
  4. Escrow Arrangements and Contingency Plans:
    • Buyers can also establish escrow arrangements to cover potential liabilities associated with the seller’s debt. These funds can be used to address any unexpected issues that arise from the seller’s obligations post-acquisition.
    • Additionally, contingency plans should be in place to manage any debt-related challenges that may affect the integration process or the financial health of the combined entity.

Conclusion

The seller’s debt plays a significant role in shaping M&A transactions, influencing everything from valuation to deal structure and post-acquisition financial stability. While high levels of debt can complicate the acquisition process, strategic planning, thorough due diligence, and effective negotiation can help mitigate the associated risks. By understanding and proactively managing the impact of the seller’s debt, acquirers can better position themselves for successful M&A outcomes, ensuring that the transaction aligns with their financial and strategic goals.

 

101 Questions You Must Ask Before Buying a Manufacturing Company

As an M & A professional selling within the manufacturing sectors, I’ve compiled a list of questions every buyer should ask before acquiring a manufacturing company.

On The Company History

  • How and why did the company start?
  • What were the major milestones?
  • How much has it grown from inception until now?
  • Who are the shareholders?
  • Are they all on board with the sale?

On Strategy & Market Potential

  • What are the key risks to this business?
  • What are the major impediments to corporate growth?
  • Are you aware of any new technology that will disrupt the industry?
  • What markets exist for your products and services that you’re not going after?
  • What is the one strategy that, if implemented, would be a game changer for the company?
  • What are the best opportunities for growth?
  • When was the last time you increased prices?
  • Do you feel there is room in your current pricing for an increase without losing customers?

On Your Competition

  • Who are your three main competitors?
  • How do you differentiate yourself from them?
  • What is the most common reason you lose an order to a competitor?
  • Thinking of your closest competitor in size, what do they do better than you?
  • Who are the most dominant industry players? What are their strengths and weaknesses?
  • How can you better position yourself against the competition?

On Marketing

  • Describe any company marketing and advertising campaigns.
  • What is your annual marketing budget?
  • What trade associations do you belong to?
  • What is your level of participation in your trade associations?
  • Do you market to existing customers to obtain more work?
  • When was your website last updated?
  • Do you utilize social media? What venues?
  • Do you promote your business through Google AdWords?
  • Who handles social media for your company?

On Sales

  • Describe the typical sales process from order to delivery and installation.
  • Describe who on staff is dealing with the customer at every stage of the sale cycle.
  • Describe how a quote is generated.
  • Is your quoting system computerized?
  • How far back in history do you have quoting records?
  • Is there a minimum profit margin added to quotes?
  • Do you have a standard shop rate? What is it?
  • Do you track the actual time of a project in comparison to the time quoted?
  • Do you have an inside sales force?
  • Do you have outside sales reps?
  • How is the sales force compensated?
  • How critical is the owner to the sales process?
  • Who besides the owner are the customers accustomed to speaking with?

On Operations

  • What industry certifications does the company hold?
  • Are there other certifications that, if obtained, would help the company grow?
  • What are the main production bottlenecks right now? What is the cost to remedy?
  • Any known or suspected deferred maintenance?
  • As to equipment, if money were no object, I’d do _____. Why?
  • How many shifts do you currently run, and what hours?
  • What is the remaining % capacity of the existing shifts?
  • What is the remaining % capacity of the current building and staff?
  • What would have to change to double sales?
  • Describe safety programs and training.

Human Resources

  • Do you use a professional payroll service? Who interacts with the payroll company?
  • Are there any union contracts? Any suspected union organizing activity?
  • Are there any employees ready to retire in the next few years?
  • Do you have a plant manager? Describe their level of
  • Describe any training programs in the last three
  • Describe all employee benefits.
  • Do you have a bonus or profit-sharing program?
  • Do employees receive annual raises?
  • Are any employees receiving an above market pay rate?

Facility

  • Do you own or rent?
  • If owned, do you prefer to lease or sell, and under what terms?
  • What are you paying if you rent, and when does the current lease expire?
  • Are there renewal options?
  • Describe the relationship with the landlord.
  • Any known or deferred maintenance?
  • Describe the top 5 facility needs.

Information Technology (IT)

  • What software systems are currently used in the business?
  • What are the top 5 tech needs for the company?
  • What software, if installed, would be most helpful to the business?
  • Does your current staff welcome technology improvements and changes?

Suppliers

  • Describe your supplier sourcing procedures. Who performs this function?
  • Are there any sole suppliers of products or services?
  • Are there any quality or dependability issues with suppliers?
  • What are your supplier payment terms?

Financial

  • What accounting software does the company use?
  • When was the software last updated?
  • What are your payment terms with customers?
  • Do you offer a discount for early payment? How many, if any, take advantage of the discount?
  • What is your average A/R aging?
  • How much bad debt have you written off in the last five years?
  • How much capital is needed to run the company for 30 days?
  • What is your average A/P aging?
  • Are you on COD with any of your suppliers?
  • How much of your income comes from your top customer?
  • How much of your income comes from your top 10 customers?
  • How much of your income comes from the top industry served?

Legal

  • Have there been any lawsuits in the last three years?
  • Any workplace accidents in the last three years?
  • Any EEOC issues in the last three years?
  • Are there any OSHA issues in the last three years?
  • What warranties does your company provide on its products?
  • Are there any warranty claims in the last three years?
  • Are there any known or suspected legal, regulatory, or government issues?

Personal

  • Why do you want to sell the company?
  • How long will you remain for training and transition?
  • Would you consider a consulting arrangement on an as-needed basis after the transition?
  • Will you be moving away from the area?
  • If you were younger and money was not an obstacle, how would you grow this business?
  • What do you most want to see in a buyer?
  • What are your primary concerns about the sale of the company?

Mergers & Acquisitions Process Overview

Mergers & Acquisitions Process Overview

From the Sell Side

Succession planning is an essential consideration for sellers. In many instances, no one from the next generation is able or willing to take the business mantle and assure the owner or owners of payment commensurate with the value of the enterprise and adequate for their retirement needs. Although the primary next-generation candidates are family members, children often leave and establish their careers. Key unrelated personnel who have demonstrated leadership often do not have the financial wherewithal or financial backing to allow owners to transition comfortably over a long period in and through retirement. Owners should plan for this as they discuss estate planning and retirement goals and objectives with their advisors.

The best-laid plans, as the saying goes, oft go awry. Agreements between and among owners try to anticipate events that may trigger the purchase and sale of the owners’ interests. Sometimes, the agreements are not updated to reflect the current economic reality. Whatever the circumstance, the owners may have a situation in which a sale to a third party is in their mutual best interest instead of a cross-purchase between or among themselves.

Whatever the trigger event or circumstance for the owners, they have created a business that has been at the center of the owners’ and their families’ lives and has become vital to the community and their employees. There is a legacy associated with the business that they want to preserve, and there are employees and customers they want to protect. There are many emotions involved on the sell side.

From the Buy Side

A buyer’s motivation may be strategic growth to acquire a new product line or market. It may be to expand existing business to take advantage of economies of scale. An acquisition may enable a buyer to expand geographically. There may be non-owner key employees the Buyer will want to engage to deepen its bench strength at the Seller’s location and across the Buyer’s enterprise.

Where Do the Interests of Buyers and Sellers Overlap?

Owners have managed their businesses to generate sustainable profit. Buyers want to capture that and repay the purchase investment as rapidly as possible. Aggregating overhead expenses [e.g., accounting, insurance] may create cost savings that enhance the Seller’s earnings. The reduction of owner compensation may also enhance projected seller earnings. Seller earnings, maintained or increased through cost reductions and synergistic growth, are desirable for the Buyer and may serve to increase the purchase price or result in earn-out opportunities.

The legacy of the Seller can be maintained through the reputation and resources of the Buyer. The Seller will become part of a larger, more sustainable enterprise. Client and customer services may be expanded. Key employees may have greater opportunities for advancement, and all employees have the security of knowing the answer to the question, “What happens to me if something happens to the owner?”

How Do the Buyer and Seller Connect?

Sometimes, it’s the old-fashioned way. They talk to each other. It may be at a convention, trade association meeting, or educational presentation where one person will say, “Have you ever considered…(selling/buying)…?” The rest is history.

More often, the owner will want to maintain the privacy of the intention to sell and engage an investment banker who will work with the owner and the owner’s professional advisors to position the Seller to be acquired.

Investment bankers enhance the value of the Seller and smooth the transaction process. Yes, they are compensated as a percentage of the deal, but that means they have every incentive to maximize the return for the owner. The investment banker will confidentially prepare information regarding a potential seller and solicit interest from buyer candidates. Once candidates complete a non-disclosure agreement, specific information regarding the Seller is distributed to the candidates. The investment banker can screen buyer candidates and arrange face-to-face meetings for the mutual exchange of information regarding the business and the respective cultural fit of the Seller and prospective buyers.

After the preliminary financial disclosures and discussions, acceptable candidates are invited to submit letters of intent outlining the terms upon which the Buyer would acquire the Seller. The owner will review the proposed terms and, in consultation with the investment banker and professional advisors, select the buyer candidate that best matches the owner’s deal objectives.

Letters of intent, term sheets, or memorandums of understanding come with various names. Still, whatever it happens to be called in your transaction, it should generally include the following:

  • Parties. The Seller and Buyer should be identified, and owners included.
  • Binding or Non-Binding sets forth the parties’ understanding of whether the letter of intent will contractually bind the parties to proceed with the intended transaction based on the outline in the letter of intent. In general, because the parties do not yet have a complete understanding or appreciation of each other, non-binding is preferred. Either party may discover something about the other that may make one or the other want to call the whole thing off.
  • Deal Structure provides the framework of the transaction: asset purchase, stock or equity purchase, merger, other transaction, and any tax elections associated with a given transaction and perhaps any specific assets or divisions or affiliates to be excluded.
  • Purchase Price and Payment sets forth the cash or equity consideration, payment at closing, earn-out payments, and conditions to trigger the deferred payments.
  • Employment of Owners
  • Employment of Key Personnel
  • Restrictive Covenants (non-compete or non-solicitation) and Duration
  • Conditions Precedent. These may include buyer financing conditions, requirements for seller subordination to Buyer’s lender(s), and divestiture of excluded assets or affiliated entities.
  • Target Close Date and General Conditions to Closing. Typical conditions are approvals from parties’ shareholders or directors undertaking by Seller to cooperate with Buyer’s representatives in conducting a due diligence review of Seller.
  • Exclusivity. The Buyer will typically require the Seller to stop shopping for a sale while the Buyer completes its due diligence and works toward closing. This provision prevents the Seller from using the Buyer’s terms to shop for a better deal and usually comes with a break-up fee if the Seller engages in such activity.
  • Confidentiality. Although there should be a non-disclosure agreement in place before the Buyer receives any specific information as to the Seller, each of the Buyer and Seller will want to maintain the confidentiality of the transaction until they are each prepared to announce it at the time and manner that will be most advantageous and no one wants to announce a deal that for some reason does not later close.
  • Expenses. Generally, the LOI clarifies that each party will be responsible for its transaction fees, costs, and expenses.
  • Special Circumstances. Items that relate to the transaction deserve a specific statement as to the parties’ expectation of treatment [e.g., payment of transfer taxes; requirement for extended reporting insurance (tail coverage)].
  • Definitive Agreements. Typically, the LOI provides that the Buyer will prepare the purchase agreements.
  • Seller’s Conduct Pending Closing. The LOI will require the Seller to conduct its business in the usual and customary manner through the closing. The Seller does not want to make any dramatic changes to its business model if the sale doesn’t close, and the Buyer doesn’t want any changes that could negatively impact the economic model upon which it determined the purchase price and transaction terms.
  • Governing Law. The Buyer and Seller may be headquartered in different states, and the LOI will generally provide which law will govern the LOI and the transaction.

Once the terms of the LOI have been agreed upon and the parties execute it, the Buyer will proceed with its due diligence review of the Seller’s business.

Due diligence is intended to prevent the Buyer from acquiring a pig in a poke. Over time, the process and undertaking have become very sophisticated. The advent of digital data sites and artificial intelligence reviews have facilitated the expansion of the lists of documents available for examination by buyer advisors.

Examples of due diligence request lists are published on the internet. References to “bulletproof” due diligence and Excel spreadsheet lists with columns beyond the alphabet give owners heartburn. Some buyers have taken a one-size-fits-all approach to due diligence and assume that the broadest, most all-encompassing request list is the best approach to examining the target seller. Other buyers utilize a more measured approach that aligns the scope of the review to the cost and risks associated with the transaction.

Regardless of the Buyer’s approach to due diligence, the general focus of the documents that will be requested for review deals with the following aspects of the Seller’s business:

  • Financial
  • Operational
  • Legal
  • Tax matters

You will see many subsets of these categories. For example, the operational category will include employee benefits and licensing/permitting matters. There will be an overlap with legal regarding vendor, customer, and employment contracts. Financial will overlap with legal regarding loan and lien matters.

Before generating long lists and asking for documents and reports that don’t exist or in a format that the Seller’s system cannot develop, good practice is for the Buyer to have a preliminary discussion with the Seller to:

  • Understand the Seller’s system and capacity to generate reports;
  • Identify a seller representative who has sufficient knowledge of the Seller’s business to provide the requested information without breaching the confidence that a potential transaction is underway and
  • Identify the representatives from the Buyer’s team who will be working with the owner or designated seller representative to respond to requests for information.

The operational, legal, financial, and tax review by the Buyer should be coordinated to avoid siloed, uncoordinated reviews. It is unproductive for the Seller to receive multiple requests for the same document or report, and it is equally unproductive for the Buyer to have different teams of reviewers making the same request.

Some buyers make the mistake of using due diligence review solely to discover issues or liabilities that must be resolved before closing. Without minimizing the importance of that function, well-coordinated operational, financial, and legal due diligence will enhance the post-closing transition of the Seller’s business and employees into the Buyer’s fold.

For example, the owner will want to assure the seller employees that health and welfare benefits will continue and, preferably, continue at levels comparable to the benefit provided by the Seller. Changes by the Buyer may necessitate modification of employment or compensation to avoid employee unrest. In this example, regarding employee benefits, coordinated due diligence would allow the Buyer and Seller to present a comprehensive benefit/employment rollout to seller employees.

It can be daunting, but sellers who plan, organize, and designate a responsible person will work through the due diligence process with minimal disruption to the business.

The Seller will need to conduct due diligence on the Buyer, particularly if part of the purchase consideration is deferred or if part of the purchase consideration consists of equity in the Buyer. In addition to the financial aspect, is the owner comfortable with the cultural fit of the Seller and the Buyer? The owner has to be satisfied with both the objective economics and the subjective feel of the transaction.

Description of What Is Being Acquired

Suppose the transaction is structured as an asset purchase. In that case, there will be a comprehensive description of the purchased assets and typically identification of those assets being expressly excluded (usually non-operating assets, vehicles, or, perhaps, real estate). The agreement will describe the class and number of shares or other equity interest being acquired in a stock transaction. Most commonly, the Buyer will not assume any seller liabilities and will expressly exclude these or require that they be satisfied or otherwise accounted for at closing [e.g., working capital calculations that will either add to or be subtracted from the closing payment].

Purchase Price and Payment Terms

This provision will set forth the cash or securities being paid at closing, any deferred or contingent purchase price, and the conditions for and timing of the deferred payment(s). If the agreement includes an escrow, the amount and timing for distribution from escrow will be included. There will typically be a separate escrow agreement with a third-party custodian if there is an escrow.

Seller’s Representations and Warranties

Notwithstanding the Buyer having conducted due diligence to satisfy itself regarding the Seller’s business, the Seller and owners will be required to attest to and provide schedules of information regarding, at a minimum:

  • Organizational structure, ownership, and authority to proceed with the transaction;
  • Accuracy of financial statements and tax returns and timely and current filing of all tax returns;
  • Current assets may be separately scheduled with Seller attesting as to the condition and the sufficiency of the assets to carry on its business;
  • Retirement and welfare benefit plans [ERISA] and absence of liabilities;
  • Cyber security and absence of any data breach;
  • Absence, or schedule, of any pending or threatened litigation;
  • Absence, or identification, of any material changes in the Seller’s business;
  • Absence, or identification, of any liens or encumbrances;
  • Schedule of the Seller’s employees, compensation, and employment terms or agreements;
  • Identification of any broker or finder;
  • Schedule of the Seller’s insurance; and
  • Catch-all provisions that the Seller has not excluded any material items from its disclosure schedule responses and that all such responses are complete and accurate.

Buyer’s Representations and Warranties

These are generally minimal and related to the authority to proceed with the transaction. If equity is involved, there should be a separate subscription agreement addressing the details of the buyer equity being issued.

Conditions Precedent to Closing

  • Regulatory compliance, if any
  • Satisfaction of liens or encumbrances
  • Absence of any material changes in the business and no new or threatened litigation

Covenants Before Closing

These covenants require the Seller to conduct its business in the ordinary and usual course before closing.

Restrictive Covenants for the Owners and Seller

These prohibit competition with the Buyer and prohibit the solicitation of the Seller and Buyer’s customers and employees.

Indemnification

Indemnification allocates the risk [cost of the risk] between and among the Seller and its owners on the one hand and the Buyer on the other, associated with the business acquired not meeting the Buyer’s expectations based on the Seller’s representations and warranties. Parties endeavor to limit/allocate the risk with:

  • Baskets [no seller liability until the basket or threshold indemnified claim amount is reached, and once reached, this basket either acts as a deductible and Seller is responsible for claims over that amount; or once reached, Seller is responsible for claims back to dollar one];
  • Caps set the limit on the maximum seller liability [usually with exceptions for tax, litigation, ERISA, or other known or specific liabilities];
  • Indication as to when or whether the “materiality” of a claim will apply to determine whether a breach has incurred or whether materiality will be excluded in crediting claims toward the basket;
  • Limitation on the time for claims to be made; and
  • Offsetting liability by the amount of any insurance covering a given claim.

Negotiating the acquisition agreement may be a good context for the expression: “Don’t let perfect be the enemy of good.”

Seller and Buyer have a mutually agreeable deal summarized in the letter of intent. They are memorializing the deal in the acquisition agreement. As each party progresses through the acquisition document, the thinking shifts from “good deal” to “perfect deal.”

From the Buyer’s side, the perfect may be: “I’m paying you $x for this business, and I expect $x of value with no diminution.” From the Seller’s side, perfect may be: “You have looked at every document, email, text, agreement, financial statements, and tax return that the business has ever generated, so you know the business better than I do, and I should not have any liability because something arises after closing.”

Fortunately, the baskets, caps, and carve-outs for certain liabilities allow each party to return to a middle ground so that each party has no more than an acceptable risk. In many instances where the business has a risk, the risk can be addressed with insurance, which benefits both parties.

For example, in insurance agency/brokerage transactions, it is common for the Seller to obtain extended reporting (tail) insurance to address the risk associated with error and omission claims. Other tail coverage is available for employment practices liability and cyber insurance. If a transaction is large enough, it may support the purchase of representation and warranty insurance.

Ancillary Closing Documents

In addition to the acquisition agreement (typically, the asset purchase agreement or stock purchase agreement), the parties will execute and deliver related documents at closing, and these may include:

  • Escrow Agreement. If a custodian is holding part of the purchase consideration, this will identify the amount of escrow, the custodian’s investment authority, the time and manner in which distributions may be made for payment of indemnification claims, and the time for payment to the owners/seller;
  • Employment Agreements for the Owners;
  • Employment Agreements for Key Employees;
  • Bill of Sale (and title transfer documents);
  • Assignment of Contracts;
  • Assignment of Intellectual Property;
  • Lease of Real Property. If real estate is being conveyed, deed and title transfer documents will be provided;
  • Seller’s Certificate is an attestation by an authorized officer attesting to the identity of the Seller’s officers and their authority to act on behalf of the Seller and attesting to the accuracy of the representations and warranties at the time of closing;
  • Third-Party Payoff Letters and payment instructions (as may be necessary to satisfy any bank or lender);
  • In a stock sale, resignations of the Seller’s officers and directors;
  • Subscription Agreement. If buyer equity is being issued as part of the purchase consideration, the subscription agreement reflects the terms by which the equity is being issued and should include the operating agreement or other buyer documents that govern the rights, benefits, features, and restrictions applicable to the equity being issued; and
  • Other closing deliverables may include evidence of the Seller’s extended reporting (tail) insurance coverage.

Post-Closing Considerations

Reducing the risk associated with a decline in business value will always be important to the Buyer from an economic perspective and the Seller from a reputational and legacy standpoint, and when there is a conditional deferred payment of a portion of the purchase price (an earn-out payment).

Sellers and buyers may utilize the following to protect the business after the closing:

  • Employment Agreements. The Buyer will typically require employment agreements with key employees and the owners as a condition to close, and when an earn-out is involved, the owners will want to ensure their continued employment to achieve the payout targets;
  • Retention Bonus Arrangements. Sellers may want to carve out a portion of the deferred purchase price as an incentive for employees to remain with the Buyer during the earn-out period;
  • Pre-Closing Communications. The pre-closing communication of the transaction to the Seller’s employees is critical. The owner will want to keep the transaction confidential until there is certainty that the closing will occur. Making the announcement too early without details creates an atmosphere of anxiety. Waiting too long puts pressure on employees being asked to sign new employment agreements with the Buyer. Announcing to the Seller’s employees without a comprehensive analysis and comparison of the compensation and benefits available from the Buyer will create an adverse reaction among the Seller’s employees. A well-planned and coordinated presentation to Seller’s employees with time for questions and answers with both Buyer and Seller goes a long way toward employee satisfaction and retention and
  • Before the closing, ensure that the appropriate Seller and buyer personnel understand their roles and responsibilities to maintain the continuity of the business operations. Once the deal is announced to the Seller’s employees, communications between the buyer representatives and their seller counterparts will reduce uncertainty and smooth the transition.

LOI Considerations

Considerations for Buyers & Sellers When Negotiating a Letter of Intent (LOI)

A letter of intent (LOI) serves as an essential milestone in a merger and acquisition (M&A) transaction by setting the preliminary parameters, structure, and terms for negotiating a definitive sale-purchase agreement between a buyer and seller of a business. The LOI is utilized to define many of the critical terms of a proposed transaction, including:

  • Legal parties to the transaction;
  • Assets, liabilities, or shares to be acquired;
  • Purchase price (including form and timing of payment of the purchase price);
  • Anticipated closing date;
  • Exclusivity periods;
  • Transition periods;
  • Termination provisions; and
  • Obligations and essential conditions of closing.

Although many of the terms of LOIs are non-binding and subject to negotiation, the LOI sets the “tone” and “expectations” of the parties upfront before the commencement of due diligence and the drafting of the sale and purchase agreement.  Both parties must communicate openly and clearly with a complete understanding of the critical terms of an LOI to facilitate a smoother transition to a definitive purchase agreement. Suppose the vital terms of the LOI are not fully understood. In that case, it may lead to disputes or failed expectations between the parties and ultimately result in a delayed, abandoned one or more costly transaction.

The following is a representative (not all-inclusive) list of some of the more critical path issues that should be considered by the buyer and seller when negotiating an LOI:

Is the proposed structure of the acquisition clearly defined in the LOI? There are many ways to structure an M&A transaction; for example, all of a company’s stock can be purchased, or the purchase can be limited to certain identified business assets and liabilities, such as a particular product or service. Significant tax implications would need to be considered depending on the agreed-upon structure. Additionally, the transaction’s due diligence, timeline, and purchase price (including payment terms and conditions) could vary significantly depending on the negotiated structure. Suppose the framework of the structure is agreed to in the LOI stage. In that case, expectations regarding the due diligence and contract negotiation process, net proceeds, and transaction timeline can be set. Buyers and sellers should consult with qualified transaction professionals (accounting/tax advisors, legal counsel, bankers, etc.) before executing an LOI to mitigate the risk of the negotiated terms being improperly vetted or incorrectly understood by the buyer and seller before executing the LOI.

What is the basis and methodology for determining the purchase price (EBITDA multiple, revenue multiple, asset valuation, etc.), and how will the purchase price be structured (cash, stock, earn-out, hold-back, or combination thereof)? If the valuation is based on EBITDA or revenue multiples, what periods will be the base period? If stock is included in the transaction, how will the valuation and timing of the shares be determined? Will the stock consideration be limited to stock in the company sold or stock in the buyer’s entire company? Additionally, transaction structures can include rollover equity. Rollover equity is a portion of the proceeds (generally a minority share) from the sale of a business reinvested into the company by the seller to serve as an incentive for a seller to stay involved and committed to the sold company post-transaction, as well as to a provide buyer with a vehicle to partially finance the overall purchase of the company. Understanding the significant components of the consideration at the LOI stage would allow for better tax planning.

Is the basis of accounting for 1) the financial statements, including EBITDA, 2) net working capital (NWC), 3) revenue and margin, etc., clear in the LOI (GAAP, accrual, modified accrual, cash, tax, or specific company basis of accounting, etc.)? If the LOI lacks clarity on the basis of accounting upon which financial results, EBITDA, revenue, margin, and NWC are defined, it could result in potentially significant unexpected financial results and purchase price implications as the transaction progresses. One of the most negotiated terms in an M&A transaction is NWC, and many LOIs include a provision that requires a seller to leave a “normalized level of net working capital” at the closing date. NWC is broadly defined as current assets less current liabilities; however, there are nuances to the calculation of normalized NWC, which could significantly impact the calculation and resultant financial proceeds at closing. It would be important for both buyer and seller to understand the accounting method used to calculate NWC. Will NWC be calculated using the seller’s historical method of accounting, GAAP, or a different method of accounting?  Additionally, the LOI could clearly define which current assets and liabilities will be included or excluded in the definition of NWC. It is also important for the buyer and seller to completely agree on the definition and basis of accounting for other key financial metrics such as EBITDA, revenue, margin, and debt.

If the M&A transaction includes an earn-out provision, are the terms of the earn-out provision clearly outlined and defined, including an example calculation and the basis of accounting that will be used for the earn-out (historical seller accounting, buyer accounting, or some variation thereof)? Earn-outs represent additional consideration that a business seller can receive based on the future performance of the business sold. Earn-outs can be structured based on EBITDA, revenue, gross margin, net income realized, or other metrics such as NWC, cash flow, or debt levels at specific points in time. Both parties should agree upfront to the metrics of an earn-out, including the basis of accounting that the earn-out will be calculated, to alleviate unintended surprises during the definitive purchase agreement negotiation or post-transaction disputes when it is calculated.

Do the parties understand how the valuation of the business is being determined? Is there an understanding of how/if the purchase price will be revised if more current financial results improve or decline? Clear and open communication as to how the company valuation was determined (e.g., multiple of EBITDA, revenue, or another financial or operating performance metric) can help facilitate discussion and agreement on how a change in the seller’s financial performance during the transaction due diligence and contract negotiation process would impact the purchase price. M&A processes can take considerable time and expense to negotiate and close, and a well-conceived and written LOI can alleviate surprises or disagreements as the M&A transaction progresses to close.

Does the LOI include the due diligence and transaction process timeline, including the types of due diligence being performed and the exclusivity period? The exclusivity period is when a seller is prohibited from marketing the business or continuing with activities related to the sale of a business with parties other than the prospective buyer with whom they have signed the LOI. Exclusivity periods should allow for enough time to facilitate a thorough buyer (and seller) due diligence process and work out the terms of a definitive agreement without either party taking undue risk. The LOI should also detail the party’s ability to extend the exclusivity period and the termination provisions. The key diligence workstreams should also be clearly described in the LOI so the parties can best prepare.

Who will pay the transaction-related fees, including representation and warranty Insurance? There may be an opportunity to include a breakup fee (including whether the terminating party is responsible for the transaction costs of the terminated party) to protect both the buyer and seller, if the transaction is terminated after a significant level of effort and expense has been incurred.

Have post-transaction employment, consulting, and non-compete agreements been negotiated for key employees and owners? Key terms of such agreements could be agreed during the drafting of the LOI, so there are agreements of the owners’ compensation, benefits, and obligations moving forward. The compensation package and responsibilities for a business’s ownership group and executives could be significantly different pre- and post-transaction close.

Buyers and sellers should always obtain advice from their professional service team before executing an LOI to ensure a clear understanding of the key terms and the implications resulting from executing the LOI.

 

A New Year Means A New Chapter

A New Year Means A New Chapter 

I hope 2022 is an incredible part of your story. If that means selling your business in 2022, there is a lot to be optimistic about.

Here is a summary of a survey done by KPMG:

·    The boom in global mergers and acquisitions in 2021 will surge into 2022, fueled by abundant investment capital, historically low-interest rates, and a rebound in global economic growth, according to a survey of 345 corporate deal-makers in the U.S. by KPMG.

·    “Based on the volume of new pitches in November and December — transactions that would come to market in Q1 and Q2 of 2022 — there are no signs of a slowing deal market,” according to Philip Isom, global head of M&A at KPMG. While facing high valuations, “most investors have limited time horizons to invest in, so they may be willing to reach further on price than they have historically.”

·    More than 80% of the survey respondents across several industries expect total M&A valuations to rise further next year, with about one out of every three predicting at least a 10% increase, KPMG said. Deal-makers said transaction levels will remain robust because companies “need to remain on the offense with the competition” and “feel pressure from investors to raise their own valuations.”

If 2022 is your year to add to your story, call me at 407-580-5317, and let’s make it the best year ever!

Have a wonderful holiday season!