Mergers and Acquisitions (M&A) in simple terms is the process by which one party buys— whether in whole or in part—someone else’s business. Although M&A can be simply defined, the process is anything but easy. There are dozens of legal implications, seemingly innocuous clauses that can sneak up on even the most careful entrepreneur, and potentially significant sums of money to be made or lost.
This field guide is a five part series and will discuss in detail the five phases of M&A:
- Part 1 – The Letter of Intent
- Part 2 – Due Diligence
- Part 3 – The Definitive Agreements
- Part 4 – Closing
- Part 5 – Post-Closing
Part One – The Letter of Intent
The letter of intent (LOI) can be deceptive. The LOI’s purpose is to outline key aspects of a potential deal, i.e., what each party is looking for and how the deal should be structured. Because of the nature of M&A, many of the terms may be subject to change based on the outcome of due diligence and other factors. As such, you should focus on the following concepts in the LOI:
(1) Binding and Non-Binding Clauses
(2) Financial Terms of the Deal
(3) Structure of the Deal
(4) Post Sale Handcuffs
(5) Due Diligence Expectations
(6) Critical Binding LOI Provisions
(7) Setting the Tone
Binding and Non-Binding Clauses
It would be a mistake to think that a LOI does not contain binding clauses merely because it purports to be “non-binding.” Often called “non-binding,” LOIs can still contain binding provisions, and their formation will set the tone for the rest of the M&A process.
Yet, many entrepreneurs fall into this pitfall of believing the entire document is non-binding. They receive a LOI and sign it without seeking legal counsel. At this point they may no longer be allowed to shop for different offers or reveal certain information if the LOI contained an exclusivity or non-disclosure clause. It is imperative to understand all of the clauses and provisions contained within the LOI before you sign it.
Most LOIs are non-binding as it relates to any obligation to actually consummate the deal, or be bound by other material deal terms such as the purchase price. In fact, most of the document will contain non-binding terms and provisions. These will generally include the specific terms of the deal and explain what a final consummation look likes. The terms of the deal are non-binding because both parties want to maintain leeway in case of unforeseen circumstances, including not consummating the deal itself.
Beyond non-binding provisions, there are often several binding provisions: confidentiality, exclusivity (otherwise known as “no-shop”), governing law, dispute resolution, and notices and other general provisions found in most LOIs.
The incredible importance of these binding provisions means you need to know what they precisely entail in each case. Any time you receive a “non-binding” LOI, wait before signing it. Always seek out legal advice about the potential ramifications of all of the provisions tucked inside.
Financial Terms of the Deal
One of the most important aspects of any LOI are the financial terms. These terms help determine price considerations while also including possible caveats, which can be cause for adjustments to the purchase price as well as contingent payments or earnouts. Even though technically these are part of the “non-binding” set of provisions—meaning they still don’t obligate the parties to consummate the deal—financial terms establish the expectation of the buyer, including what they are willing to initially offer, and under what terms, to acquire the seller’s business. Like in any good contract, the alignment of these expectations is critical as to why the parties would enter into a sale.
The main consideration regarding financial terms is the purchase price. Although the LOI sometimes may not include an exact dollar amount, it will provide a method or formula for its determination. In many cases, buyers calculate purchase prices using a multiple of earnings, such as earnings before interest taxes, depreciation, and amortization (EBITDA). Basically, the buyer is interested in the free cash flow they are buying into after deductions.
Many LOIs also include provisions for escrow or seller’s holdback to offset against the final purchase price if certain conditions are not met or issues arise. One example of where this can be triggered, is if the seller fails to meet a working capital target. A working capital target is simply an agreed-upon amount of assets (often cash) to be left behind by the seller ensuring the business has sufficient operating capital to carry on with regular operations post-closing. Another example where this can be triggered, is if the seller breaches a provision in the representations and warranties. Representations and warranties are certain assurances made in the purchase agreement about the state of the business and its history. If any of these assurances turn out to be false, the seller may be required to compensate or reimburse the buyer based on the terms of the deal.
Although neither of these will be triggered during the LOI phase, it is critical to understand where the seller will be expected, as a part of the deal, to set aside money in escrow to satisfy any of the above issues that the buyer might run into. Since this money will be held back to compensate the buyer if things don’t go according to plan, it directly impacts how much funds the seller can expect to receive up front.
The LOI also may include provisions dealing with the terms by which the buyer will be financing the acquisition. The deal can be financed in a number of ways: self-financed by the buyer with its own capital, third-party financing, seller financing, or some combination of these. Seller financing essentially means the buyer will pay the purchase price to the seller in installments, typically through a promissory note secured by the property being purchased or other assets. As the seller, you finance the deal, taking on both interest and risk (if the buyer fails to make a payment). Third-party financing, on the other hand, typically involves a bank or financial institution as a middleman — the seller receives the money upfront, and the buyer makes payments to the third party lender.
Earnouts are additional pricing considerations that help provide a higher price for the seller based on post-closing performance. If specific targets are met after closing, the buyer agrees to pay the seller additional sum(s) of money. Earnouts are often offered in addition to the closing payment to mitigate the risk that the buyer could be paying too high while seeking to appease the seller, especially if the seller is not impressed with the initial offer. Earnouts also incentivize the seller’s participation post-closing if they remain on board as a key employee or fellow partner in the company.
In many cases, earnouts are based on revenue or earing milestones. But they can be based on several other factors as well, including production targets, achievement of sales quota, EBITDA milestones, gross margins, and many other things. Tracking and verifying earnouts can be a delicate process. That’s why the LOI terms can address milestone reporting requirements as well as the specifics of how accounting will be performed for each earnout.
Finally, in instances where the selling owner(s) play a key role in the business, you will sometimes encounter an equity roll, which is where the seller receives some portion of the purchase price in the form of equity in the buyer or its parent or other affiliate. One or the primary purposes is to incentivize the seller to continue to be involved in the business post-closing—usually under an employment or consulting arrangement. Also, sellers are incentivized with a potentially larger exit in the future with an equity roll. In an equity roll, for example, instead of receiving 100% of the sales proceeds in cash, you might receive 80% in cash and be required to “roll” 20% of that into stock at closing. The key point is an equity roll reduces the total cash to be paid by the buyer and, and more importantly, received by the seller.
Understanding and negotiating the financial terms within a LOI is a critical piece of the M&A puzzle. A buyer wants to establish an expectation of the financial terms it is willing to commit to when acquiring the business (subject to adjustments following due diligence). A seller then must understand that perspective and the effect of the economics of the deal, and take the opportunity to negotiate any changes before signing the LOI and getting too far down the road in the process.
Structure of the Deal
Acquiring a business through ownership is different than purchasing its assets. Although both involve acquiring ownership, the manner of and risks associated with the acquisition in each instance is different. There are a number of considerations that come into play when determining the structure of the deal, including the nature of the business to be acquired, business plans and operations post-closing, tax implications, and liability exposure. Therefore, another important aspect of the LOI is the anticipated structure of the deal.
An asset purchase tends to be the structure used most frequently in connection with smaller deals. Here the buyer is merely buying all or substantially all of the assets the seller currently owns and uses to run its business. In an asset purchase deal, the seller is going to be the company holding ownership of the assets. Many buyers seek asset purchases because it reduces the liability risks that may be associated with the seller and its past operations. Since the buyer is not buying the company itself, they would not inherit its obligations and liabilities other than those expressly assumed. However, this doesn’t mean the risks are not fully eliminated.
When conducting an asset purchase, it’s essential to spell out the scope of the assets intended to be acquired. Later on, a significantly more specific itemized list detailing all of the assets being sold will become a part of the definitive documents, but the LOI will first define the broad category from which those assets will fall within. One asset that can be specifically listed in this stage is accounts receivable, which is the money a business is owed for products sold or services rendered. Although not a tangible piece of property, it is an asset, and if the sum is significant and reasonably collectible, it can add to the final purchase price. But whether or not accounts receivable will be included in the assets to be purchased, will vary from deal to deal, so it is imperative to ensure it is addressed in the LOI.
The alternative to the asset purchase is the equity purchase. You tend see equity purchases more often in the middle to larger acquisitions typically based on the size and backing of the buyer (e.g., private equity backed).At its most basic, an equity purchase is when the buyer buys either part or whole ownership of the company itself. In an equity purchase deal, the sellers are going to be the owners of the company. Therefore, when the buyer purchases equity ownership (e.g., the company’s stock, membership interests, partnership interests, etc.), it is stepping into the shoes of and replacing the company’s shareholders, members, or partners who are selling their ownership.
As a result, when an equity purchase occurs, the company itself remains the same with only the ownership structure changing. Importantly different then from an asset purchase, the buyer acquires the company with all of the assets, but also all the company’s liabilities (known and unknown). An equity purchase usually results in less disruption to the company’s business including its customers, employees and other stakeholders because the company generally continues to operate as it did prior to the deal closing.
The deal structure will be reflected within the terms of the LOI. Understanding these structures can help you avoid signing a LOI and committing to going down a path that you don’t understand the consequences or ultimately want.
Post Sale Handcuffs
From a buyer’s perspective, it is not enough to merely buy (or buy into) a successful company. They also need to ensure the company will continue to be successful. To accomplish this, the buyer may need key individuals to remain involved going forward. But if not, the buyer wants assurances that the key individuals who made the company successful in the first place do not simply go somewhere else and begin competing. The significant source of insurance for the buyer in this case are the protective covenants.
Protective covenants typically bar the seller from competing or otherwise interfering with the company after the sale is completed. These covenants can include confidentiality, non-compete, non-solicitation of customers, vendors, and/or referral sources, non-solicitation of employees, and, finally, general provisions that prevent any other form of interference with the business at all. Typically, these clauses are tailored to a particular scope of the restriction, geographic territory, and time period usually ranging from three to five years in M&A.
In addition to protective covenants, buyers will also seek to protect their interests in terms of employment. In addition to the equity roll discussed above, to maintain an owner’s interest in a company following the sale, a buyer might also require the continued employment of certain key employees who are essential to daily operations, have valuable existing relationships with customers, and are important to the goodwill of the business.
Each of these concepts can be included explicitly in a LOI and therefore must be understood from the beginning to avoid a misalignment of expectations for any involved as to their role and future post sale.
Due Diligence Expectations
Due diligence is the financial and legal process where a buyer seeks to determine the structure and health of the business, potential risks and liabilities, as well as whether everything the seller is disclosing during the course of the deal checks out. We will dive deeper into the details of due diligence in Part Two of this series, but the LOI will set a general tone for how due diligence will happen and lay down the general rules for the process such as how each side will conduct the review, how to request information, etc.
Critical Binding LOI Provisions
As we discussed above, there can be any number of binding provisions within a “non-binding” LOI. Almost every LOI will contain at least a confidentiality provision, and sometimes they will contain an exclusivity or “no-shop” provision.
A confidentiality provision requires the receiving party to protect the disclosing party’s sensitive and confidential information and trade secrets from being disclosed or used except under limited circumstances and subject to certain requirements. Strong confidentiality clauses can even specify in what capacity information is allowed to be used, making it easier to prove if a violation has occurred. Its purpose is to allow both the buyer and seller to reveal sensitive information to each other throughout the M&A process, and especially during due diligence, with protections in place. If such information found its way to a competitor, the results could be disastrous. The buyer itself may even be a competitor greatly increasing the level of risk to the seller if the deal does not close. Therefore, it isn’t enough just to prevent that information from spreading. A strong confidentiality provision will also bar the buyer from using that information as a competitor if the deal falls through.
An exclusivity clause restricts the seller from soliciting offers from other buyers or even discussing the possibility of a similar transaction with anyone other than the buyer throughout the M&A process or for a set period. During such time, the seller will be barred from speaking to anyone about the possibility of a deal — it can be a stringent provision. The purpose of an exclusivity clause is not only to prevent the seller from finding something better when the buyer is dedicating time and money to attempt to acquire the business but also to prevent the possibility of a bidding war between the buyer and another prospective buyer causing the purchase price to increase due to competition.
In larger deals, exclusivity clauses can also include termination and breakup fees. Termination fees may be due if the seller chooses not to go through with the deal, and breakup fees may be due if the deal falls apart. Both fees, just like the exclusivity clause, are designed to incentivize the parties to work in good faith to complete the deal or help reimburse a party for costs spent in connection with a failed deal.
These critical provisions found within an LOI are binding upon the parties signing and can have significant consequences. As a result, they should not be taken lightly and must be reviewed and understood before signing the LOI.
Setting the Tone
How you develop or reply to a LOI can set the tone for the rest of a deal. It is vital that you understand what is contained within the LOI and the potential consequences before signing. Even if the LOI generally expresses something you might be interested in, it is always advisable to have a lawyer look over it. At best, they might find something they can rewrite to suit your interests better, find a critical term that was overlooked, help you understand the framework and expectations for the deal, or at a minimum, demonstrate to the buyer that you are prepared to take the M&A process seriously. Finally, if it is a critical element to the overall transaction, add it to the LOI. If you wait to add the term when developing the definitive agreements, this new term could destroy the entire deal. Do not be afraid to ask for what is important to you.