Selling a business is often one of the most significant events in a business owner’s life. Following years of dedication and sacrifice, many exiting business owners experience both hope for a substantial payout upon sale and trepidation regarding the sale process. Though experts in their industries, business owners may feel unprepared to navigate the complex landscape of mergers and acquisitions (M&A) transactions.

While business sellers generally assemble a team of advisors (accountants, attorneys, investment bankers, etc.) to assist with the M&A process, sellers should have a baseline understanding of M&A terminology. Having this understanding will help sellers maintain agency over the decision-making process, create more efficient communication with the buyer and M&A team and, ultimately, lead to a more successful transaction.

Below are several important M&A concepts that business owners should be aware of:

Asset vs. stock sales

In negotiating M&A transactions, buyers and sellers will need to agree on how to structure the transactions. Often, the critical question is whether the transaction should be structured as a sale of the assets or the equity of the target company. Generally, buyers prefer asset sales, while sellers prefer equity sales. Buyers want to acquire substantially all of the assets of a business while narrowly assuming liabilities. Conversely, sellers prefer to sell the business in its entirety, including all assets and liabilities.

Another principal reason for these predilections centers on tax consequences. In an equity sale, sellers expect the sale proceeds to be taxed at preferential capital gains rates. In an asset sale, buyers can receive a desired step-up in the tax basis of the target company’s assets.

In light of these conflicting preferences, the parties can compromise by agreeing to treat an equity sale like an asset sale for tax purposes. The parties may elect to purse an F Reorganization or §338(h) (10) election. Such elections, though, may increase a seller’s tax liability. Accordingly, sellers should consult their M&A team to determine any potential tax liability and negotiate appropriate recoupment from buyer (sometimes called a gross up).

Due diligence

Prior to purchasing, a buyer will engage in an extensive review of the target business. A buyer will generally deliver lists to the seller requesting financials, employee records, benefits information, contracts and other business records. Buyers may engage third-party consultants and advisors to assist with the process (real estate appraisers, insurance consulting firms, CPA and tax advisors, environmental consultants, etc.). Buyers may also complete a quality of earnings (QofE) report to assess the business’s historical earnings to determine future revenues.

The duration of the due diligence review varies based on the transaction and the particular buyer. However, following the execution of a letter of intent, sellers should expect that the subsequent 30 days (at a minimum) will involve responding to due diligence inquiries.

Earnouts

In many transactions, the buyer will pay the entire purchase price to the seller in cash at closing.

Sometimes, however, only a portion of the purchase price will be paid at closing, with the remainder to be paid pursuant to an “earnout.”

In an earnout, a portion of the purchase price is contingent upon the future performance of the acquired business. This mechanism is often used to bridge valuation gaps between buyers and sellers. Careful attention should be paid to the proposed earnout terms, including the earnout time period, the relevant performance metrics (often based on revenue or EBITDA targets), and the payment structure (lump sum vs. installment payments).

Escrow

In the M&A context, escrow refers to a financial arrangement whereby a portion of the purchase price is segregated at closing and transferred to an account (often maintained by a third-party escrow agent) to be held until certain conditions have been satisfied. The duration of the escrow period and the escrow amount will vary based on the specific risks involved in a particular transaction, and are often important negotiation points.

One way that escrow is used is for indemnification obligations. A certain percentage of the purchase price will be set aside in an escrow account to safeguard against potential liabilities. In the event the buyer suffers post-closing losses due to breaches of the seller’s representations, warranties or covenants, the buyer may make a claim against these escrowed funds to compensate for the loss.

Escrow is also used for purchase price adjustments. Following the final determination of the purchase price after closing (see purchase price calculation below), a seller may be entitled to additional purchase price, or a seller may be required to return a portion of the purchase price. In order to provide the buyer a source of recovery, a certain dollar amount will be set aside in an escrow account to cover any shortfall in the purchase price.

Ramey Sylvester

Jack Hepburn

Purchase price calculation

The purchase price is often based on a formula. See example below:

Purchase Price = Enterprise Value + Cash – Debt – Seller Expenses +/- (Net Working Capital – Target Working Capital) Prior to closing, the purchase price is calculated based on the seller’s estimates. Then, following closing, the buyer will calculate the purchase price (usually 60-120 days post-closing), based on a review of the financial records. Thereafter, the purchase price will be adjusted upward or downward based on the difference between the calculations.

An important component of the purchase price is net working capital (NWC).

NWC is the capital that will remain with the business after closing that will allow the business to continue to operate. The NWC is generally the current assets (excluding cash) less the current liabilities (excluding debt). The parties will agree to a target amount of working capital prior to closing (often the 6-month average of NWC), and the purchase price will be calculated based on the difference between the actual NWC and the target NWC.

By understanding key terms and components of M&A transactions, sellers can alleviate anxieties, stave off deal fatigue and equip themselves with some of the tools needed to ensure a successful and profitable transaction.

Ramey Sylvester’s practice focuses on business and transactional matters, concentrating on mergers and acquisitions, private equity transactions, private offerings and corporate governance. She can be reached at ramey.sylvester@mclane.com.

Jack Hepburn is a member of McLane Middleton’s Corporate Department, where he advises businesses on transactional matters related to entity formation, mergers and acquisitions, commercial contract review and drafting, and corporate governance. He can be reached at jack.hepburn@mclane.com.