KEY ARTICLE TAKEAWAYS
- Learn the common terminology for M&A transactions
- Understand the complexity of M&A transactions
- Learn the next steps you should take if you are preparing to sell your business
M&A Terms Every Business Owner Should Know
Most business owners only experience selling their company once. Dealing with lawyers, accountants and investment bankers can be intimidating – they use a whole lexicon of terms that can be unfamiliar and confusing to business owners. We have identified and define the terms used most often – we hope they will help you be less confused with the entire M&A process.
Want to get a sense for what it takes to sell your company? Start with this exit checklist.
Add-Backs or Adjustments
“Add-Backs,” or Adjustments to Earnings, are additions to reported net income figures typically proposed by sellers for one-time expenses (e.g., unusual litigation, moving, etc.) or expenses that a buyer should not expect to incur after closing (e.g., in some cases, owner compensation if the owner will not be employed going forward, or other similar expenses). Buyers and sellers often disagree about what are truly one-time expenses (one of our favorite sayings is: “Life is a series of one-time events”), or what expenses a buyer should not expect to incur going forward (e.g., a buyer will still need to pay a manager even if the owner is departing). Whether you are a buyer or seller, be deliberate and careful in your evaluation of these types of adjustments.
Adjusted Net Book Value
Adjusted Net Book Value is the Book Value of a business that has been adjusted to reflect the current market value of the assets and liabilities of a company. For example, some companies accelerate depreciation on fixed assets for tax purposes, and the fair market value of those fixed assets might be considerably higher than what is reflected in the company’s accounting records. In this case, an adjustment to the value of these assets is required to determine Adjusted Net Book Value.
Asset Purchase Agreement
An Asset Purchase Agreement is a contract between a buyer and a seller pursuant to which the buyer purchases certain assets of the seller and assumes certain liabilities. These agreements will typically contain representations and warranties from a seller about the assets and business of the company, and will include other material transaction terms.
Asset Value can refer to one of two things: the book value of a specific asset (i.e., what is the value of an asset as listed on the company’s accounting records), or the fair market value of a specific asset or group of assets. You may hear Asset Value used in place of Book Value, but this is not precisely correct because Book Value includes not only Asset Value, but also subtracts the value of liabilities of a company.
A Balance Sheet is an accounting record for a company that lists a company’s assets, liabilities, and shareholders’ equity.
The “Book” in mergers and acquisitions refers to a detailed presentation about a business for sale, including information on its financials, sales, operations, employees, management, and other important information. This “Book” is typically presented to potential buyers to solicit interest in a business for sale.
“Book Value” can refer to two different concepts: first, Book Value can refer to the value ascribed to a particular asset or liability on a company’s balance sheet. Book Value can also refer to the value of a company’s assets minus its liabilities as portrayed on the company’s balance sheet. Book Value is often contrasted with Market Value, which reflects the value of a company’s equity (assets minus liabilities) as determined by what a willing buyer would pay to a willing seller in an arm’s length transaction (versus the value of a company’s equity as reflected in its accounting records and balance sheet).
A Buy-Sell Agreement is an agreement between and among shareholders in a company that details the terms under which the shareholders can sell their stakes in the business (either to a third party or to one another). In particular, a Buy-Sell Agreement will typically provide for what happens in the event that one of the shareholders leaves the business and he or she needs to dispose of an equity stake in the business. A Buy-Sell Agreement can also address what happens in the event of the death or incapacity of a key shareholder, and can require that the company procure Key Man Life Insurance to fund the Buy-Sell Obligations in such event.
Capitalization Table or Cap Table
The Cap Table is a table or spreadsheet that illustrates the ownership breakdown of a company: who the owners are, what percentage of the company they own, and at what valuation. Cap tables do not include debtors to the business, only those who have some equity (like shares in a corporation, or membership interest in an LLC).
Capital Expense or Investment is an expenditure by a company for an asset that is typically capitalized on a company’s balance sheet as an asset that will be depreciated over time (versus running through a company’s profit and loss statement as a current expense). Examples of Capital Expense or Investment are furniture and fixtures, real estate, computers, equipment, vehicles, and other long-lived assets.
Cash Flow Statement
The Cash Flow Statement is a financial statement that shows the true cash flow of a company (i.e., it explains the change in cash balance of a company over a period of time, as compared to simply determining net income, which may not be the same as the cash generated by the company). Utilizing the Income Statement and Balance Sheet of a company, the Cash Flow Statement explains the change in a company’s cash position over time by adjusting net income for non-cash expenses such as depreciation and amortization, as well as for increases or decreases in working capital, financing (raising or repaying debt or equity investment), and fixed asset sales or purchases.
Cash-on-Cash Return is a term (sometimes also referred to as Return on Investment) used to describe the rate of return on a particular investment by comparing the actual cash generated by a company and distributed to an investor with the cash investment made by the investor. For example, if an investor received $100 in cash in a particular year after an investment of $1,000, his Cash-on-Cash Return would be 10 percent.
Common Equity (sometimes also referred to as Common Stock) reflects the value of a company’s assets minus its liabilities minus any Preferred Equity that would have preference over the Common Equity. It is typically the highest risk/highest potential return portion of a company’s capital structure.
Consulting Agreement in the context of mergers and acquisitions refers to an agreement between a company and typically an exiting owner/seller in which the exiting owner/seller continues to provide specified consulting services to the buyer for a specified period of time. These services might be related to the core operations of the acquired business, or they may be related to the transition of ownership (e.g., transitioning key employee, customer, and supplier relationships).
Current Assets refers to assets such as cash, accounts receivable, inventory, and marketable securities (cash equivalents on short notice) that are used and replenished during the normal operating cycle of the business. Current Assets can be contrasted with Fixed Assets, which have a longer life and are depreciated over time.
Current Liabilities consist of items such as accounts payable, accrued liabilities, and liabilities with maturities (when the liability must be paid) of less than one year. Current Liabilities can be contrasted with Long-Term Liabilities, which have maturities of greater than one year and typically consist of debt instruments and other longer-term deferred liabilities (pension liabilities sometimes fall into this category).
All debt has two components: interest and principal. Together, the amount you owe in a given period of both interest and principle is called your debt service. Interest is an expense the appears on the income statement, but principal exists on the balance sheet.
Discount Rate refers to the rate at which a stream of future cash flows is discounted to determine Net Present Value. The higher the degree of risk or unpredictability of a set of future cash flows, the higher the discount rate. It can also refer to the rate of return required by investors for a particular investment.
Discounted Cash Flow Value
Discounted Cash Flow Value refers to the calculation of a company’s Enterprise Value on the basis of its ability to generate free cash flow over time. To compute the enterprise value, the free cash flows are discounted back to present value at a rate that reflects the risk as estimated by the buyer or seller (which rates will often differ based on their respective assessments of the level of risk in a company).
Due Diligence refers to the process by which a buyer evaluates a seller’s company. Due Diligence will involve a review of the company’s financials and key documents and contracts, interviews with management and other key employees, customer and supplier reference checks, market research, and other processes designed to help the buyer understand and evaluate the seller’s business.
Due Diligence Period
One of the terms in an LOI is typically the due diligence period, which is the amount of time the seller is willing to grant to buyer to get all of the questions they need answered to feel comfortable finalizing the deal. Due diligence can be a grueling time for sellers, in which they are required to provide basically all information available about their own company in anywhere from a few weeks to several months.
M&A Transactions are not like transactions made at the grocery store, they involve complicated structures where sometimes only part of the purchase price is paid on the day of close. Sometimes buyers will want there to be an incentive for the sellers, especially if they are going to continue to be involved with the business after the sale. An earnout is an incentivized portion of deal proceeds that is dependent on the business’s performance after the sale. This can be a revenue or profit threshold, or any number of more specific metrics. Sometimes these payments are all-or-nothing: if you hit the goal you get the earnout amount, otherwise you don’t get any of the earnout. Others are on a sliding scale where you may receive partial payment for partially hitting the goal.
EBITDA refers to Earnings Before deducting Interest, Taxes, Depreciation, and Amortization costs, and is often used by buyers and sellers as a proxy for operating cash flow in a business (i.e., the cash flow generated by the business prior to paying interest expenses, taxes, or incurring capital expenditures).
EBITDA Multiple refers to the multiple of EBITDA used to determine a company’s enterprise value. This is often used by buyers and sellers as a short-cut to determining the value of a company (prior to deducting any long-term debt a company owes). Buyers and sellers should be careful when using these “rules of thumb,” as they often mask underlying risks and opportunities in a business which can increase or decrease the value of a company.
Employment Agreement, similar to a Consulting Agreement, in the context of mergers and acquisitions refers to an agreement with either the seller or one of the seller’s key employees regarding the terms and conditions of his or her employment with the new buyer. These terms and conditions can include salary, bonus programs, benefits, payments in the event of a termination of employment, non-compete and confidentiality provisions, as well as other terms and conditions.
Enterprise Value refers to the overall value of a company (including both equity and debt). Valuations of a company are often done as an Enterprise Value, from which you would need to subtract any Long-Term Debt or other longer-term liabilities to determine the Equity Value of a company.
Equity Value refers to the value of the equity in a company, and is typically determined by subtracting the amount of Long-Term Debt or other longer-term liabilities from the Enterprise Value of a company. Equity Value typically refers only to the value of the Common Equity in a company, but can also include Preferred Equity.
An Exclusivity Clause is a provision in a Letter of Intent or Indication of Interest in which a seller agrees that it will not solicit interest in its business from or talk to third party potential bidders other than the buyer for a specified period of time. This provision is generally granted by sellers to buyers in exchange for the buyer’s commitment to expend time and resources conducting Due Diligence prior to signing a formal Asset or Stock Purchase Agreement. Exclusivity Clauses can run anywhere from a few days at the minimum to two months or more, and they are often extended during the Due Diligence process if it takes longer than anticipated.
Financial Buyer refers to buyers who buy primarily based on financial returns and may be indifferent with respect to the industries in which they invest. Financial Buyer also refers to investors such as private equity firms, buyout firms, venture capital firms, or other professionally managed funds of capital. Financial Buyers are typically contrasted with Strategic Buyers who are not professional money managers, but who are industry players interested in using mergers and acquisitions to help them grow, expand geographically, or otherwise complement their core business strategies.
Free Cash Flow
Free Cash Flow refers to the amount of cash generated by a business after all of its operating expenses, capital investments, and disposals have been accounted for, and after accounting for changes in working capital (whether positive or negative). It can be calculated on a pre- or post-tax basis.
A fundless sponsor is a buyer who, unlike a private equity fund, does not have a committed pool of capital to draw on to make an acquisition or investment. For each acquisition or investment, the fundless sponsor must go out and raise both debt and equity from other investors. For this reason, transactions with fundless sponsors may take longer and be at higher risk of not closing. When evaluating a transaction with a fundless sponsor, it is critical to look at their past history of being able to raise funds to complete deals – if they have a long track record of success, they will be less risky with which to transact.
Generally Accepted Accounting Principles (GAAP) refer to a set of accounting principles and standards issued by the Financial Accounting Standards Board (FASB). GAAP rules are standards set by policy boards to help improve the consistency of a company’s financial accounting results. In most transactions, the seller will be required to represent that its financials as reported have been made consistent with GAAP.
Hybrid Buyer refers to a buyer who is a cross between a Financial Buyer and a Strategic Buyer. Often these are companies that are being financed by a private equity or investment firm to do a “roll-up,” or series of acquisitions in a particular industry.
Income Statement refers to the financial statement of operations of a company in which revenues, cost of sales, and operating expenses are presented to calculate the Net Income of a company.
Any time a buyer acquires the equity of a business, there will be some known and unknown risks that come with that transfer of ownership. Buyers usually required some amount of purchase price to be set aside with an escrow agent.
Indemnity is legal security and protection from financial liability (and in the case of M&A transactions, from breaches in reps & warranties – see reps & warranties). When someone buys a business, they assume some risk and will therefor require that the seller makes some assurances that if untrue, must be covered (financially) by the seller. In most deals, buyers and sellers will agree to leave a certain portion of the deal proceeds with an escrow agent so that the buyer can more easily access that money to cover any breaches to representations made. If no escrow account exists, then the buyer would have to personally obtain the money from the seller (who may be on a beach in Mexico now that they have sold their business).
Indication of Interest or “IOI”
Indication of Interest is typically a letter (sometimes an e-mail) from a potential buyer expressing its interest in acquiring a particular seller. Typically non-binding on either party and similar to a Letter of Intent, an Indication of Interest will spell out a buyer’s proposed valuation range, transaction structure, and other material terms of a potential transaction. These are used early in the acquisition process to help buyer and seller come to an agreement on the particular terms of a transaction, and may include Exclusivity Clauses which forbid the seller from contacting other potential buyers for a period of time.
Lehman Formula refers to the formula (originally established by Lehman Brothers) that determines the commission to be earned by an investment bank, mergers and acquisitions advisor, business broker, or other transaction intermediary as a result of procuring a buyer for a seller’s business. These clauses are typically found in representation agreements between the seller and an intermediary charged with taking the seller’s business to market.
Letter of Intent or “LOI”
Letter of Intent – see Indication of Interest. The Letter of Intent is sometimes more detailed than the Indication of Interest, but the general purpose is the same.
Long-Term Liabilities refer to liabilities on a company’s balance sheet with maturities or due dates of longer than one year.
Stands for “mergers & acquisitions” and generally refers to the act of buying or selling businesses. M&A occurs within publicly traded and privately held businesses and can include transactions where only part of a business is bought or sold.
Market Value refers to the value placed on an asset (or company) in the open market by a willing buyer from a willing seller in an arm’s-length transaction. Market Value is typically distinguished from Book Value, which is the value as reflected on the company’s financial statement or accounting records and may not reflect actual fair market value.
Multiple of Earnings
Multiple of Earnings, similar to Multiple of EBITDA, refers to the multiple of a company’s earnings to establish the entity valuation of the company. This can be compared to a Price to Earnings Ratio, although the Price to Earnings Ratio typically refers to the Equity Value of a company divided by its net, after-tax income.
Multiple of Revenues
Multiple of Revenues, similar to Multiple of Earnings and Multiple of EBITDA, refers to a valuation based on a multiple of a company’s revenues to establish overall Enterprise valuation. This type of valuation is sometimes used for companies that are early in their life cycle and do not yet have operating earnings (as was sometimes the case for early Internet companies), or when looking at overall market valuations where the Multiple of Earnings or Multiple of EBITDA valuation ranges are too wide to rely on.
Net Income can refer either to pre- or post-tax net earnings of a company, which is defined as revenues or sales, less cost of sales, less operating expenses, less interest, and either before or after taxes.
Normalized Earnings (see Add-Back) refers to the Net Income of a company that has been adjusted by adding back non-recurring expenses or expenses a buyer should not expect to incur after an acquisition. In this sense, the earnings are adjusted to reflect these one-time or non-recurring expenses.
One-Time Expenses refer to expenses that are expected to occur only once. For example, a company that has incurred moving expenses from relocating offices might legitimately claim these are one-time expenses that will not be incurred on an ongoing basis (unless, of course, moving is a part of their business). Similarly, a company that was involved in major litigation only once in its existence (depending on the reason for the litigation, of course), might claim these are One-Time Expenses. Buyers and sellers will debate these items intensely as they have an impact on overall valuation for a company.
An Option (see Warrant, and sometimes referred to as a “Call Option”) is the right of the holder of the Option to purchase shares of equity in a business at a fixed price for a set period of time. Options are valuable to the extent the exercise price is lower than the fair market value of the underlying shares, or where the option period is long enough that there is plenty of time for the underlying share value to grow past the exercise price of the Option.
Owner Compensation refers to the overall compensation an owner receives from a business. This can include not only salary and bonus, but also benefits such as cars, insurance payments, benefits, or other “perks” the owner has received that have been paid for by the company. Often sellers will argue for Owner Compensation to qualify as an Add-Back, but careful buyers will understand that some of these expenses may in fact be required to attract a new manager going forward.
Preferred Equity represents equity in a company that has a liquidation preference over Common Equity and will often have a dividend payment. It is the second-most risky portion of a company’s capital structure (after Common Equity), but can enjoy appreciation potential similar to Common Equity depending on the terms and conditions of the Preferred Equity.
Price/Earnings Multiple is a valuation methodology typically used in valuing publicly held companies. It refers to the ratio calculated by dividing a company’s equity value (or share price) by its after-tax earnings (or earnings per share). The higher the P/E Ratio, the higher the valuation of a company’s equity.
After an LOI has been signed, the binding, official, legal agreement (called the purchase agreement) outlining the sale of a company must be drafted, negotiated, and signed. In many deals, the signing of this agreement signifies the closing of the deal.
Recurring Revenues (versus One-Time Revenues)
Recurring Revenues (versus One-Time Revenues) refers to revenues of a company that can be expected to be generated on a regular basis over time (versus One-Time Revenues that are typically only expected to happen once). An example of Recurring Revenues would be the revenues a telecommunications company earns from its customers that have three year contracts to purchase their telecommunications requirements – these revenues are expected to recur (at least over the three-year period). An example of One-Time Revenues would be the revenues a construction company receives from a specific project which has a defined beginning and end. Buyers will typically place higher value on Recurring Revenue businesses than on businesses where the revenues are One-Time or project based because Recurring Revenues are more predictable.
Representations and Warranties
As part of the terms of a purchase agreement, every seller must make some representations and warranties regarding the business they are selling. Representations are legal assurances they are making to the buyer about the business. Some examples would be that the company has no outstanding tax liabilities or that the sellers are the owners of the business. Warranties are promises to indemnify (see indemnity) the buyer if the representation turns out to be false. Reps & warranties should be true as of the day they are made and could be grounds for a lawsuit if they are knowingly untrue. Most representations made have a limited amount of time where the seller is bound to indemnify the buyer (like an expiration date). Some reps, called fundamental reps, have no expiration date.
Return on Investment
Return on Investment (see Cash-on-Cash Return) refers to the rate of return an investor generates on an investment.
Secured Debt refers to debt of a company that is secured by the company’s assets (such as accounts receivable, inventory, and fixed assets). In the event of a liquidation or bankruptcy of the company, Secured Debt holders have first claim to those assets and the proceeds from their sale, and hence enjoy a relatively senior position in the company’s capital structure, but typically have lower expected rates of return than for Common Equity or Preferred Equity.
Senior Secured Debt
Senior Secured Debt is Secured Debt but has a senior claim to all other debt holders on the assets of the company. Senior Secured Debt occupies the safest portion of a company’s capital structure.
Short-Term Liabilities refer generally to accounts payable, current portions of long-term debt, and other liabilities that are due or mature in less than one year.
Stock Purchase Agreement
Stock Purchase Agreement (see Asset Purchase Agreement) is an agreement that sets forth the terms under which a buyer purchases stock or shares in a company from a seller. It will have similar terms and conditions to an Asset Purchase Agreement, with the major difference being the buyer in a Stock Purchase Agreement generally assumes all liabilities (whether known or unknown) in the company, whereas an asset purchase allows a buyer to exclude certain known and unknown liabilities from what he is assuming.
Strategic Buyer is a buyer typically in the same, related, or “surrounding” industry as a seller and who is interested in purchasing companies in its own industry or related industries for a strategic reason (i.e., consolidation, geographic expansion, product line extension, or other reasons such as these).
Subordinated Debt is debt of a company that is subordinate to Senior Debt. Subordinated Debt in the event of a liquidation is paid before any equity (whether Common Equity or Preferred Equity), but is paid after Senior Debt.
Warrant (see Option) is the right of the holder of the Warrant to purchase shares of equity in a business at a fixed price for a set period of time. Warrants are valuable to the extent the exercise price is lower than the fair market value of the underlying shares, or where the option period is long enough that there is plenty of time for the underlying share value to grow past the exercise price of the Warrant.
Working Capital is defined as Current Assets minus Current Liabilities and represents the investment in a company required to operate the business during its cash cycle (the time between when a company incurs and pays its expenses and the time it receives payment for its products or services).