03 Feb Inside the M&A Process: How Deal Terms & Transaction Structures Affect Your Bottom Line
The average e-commerce founder fulfills several specialized roles in service of their brands. However, most entrepreneurs do not possess a working knowledge of the technical and legal nuances involved in structuring high-value M&A transactions.
While founders may be digital marketing or product development experts, they lack expertise in structuring and executing complex business sales. Consequently, founders who pursue a strategic exit without representation will almost certainly leave material value on the closing table.
Most founders tend to focus primarily on the amount of cash given to them at closing as the only material source of value and / or risk. There are, however, dozens of other factors to consider when approaching a prospective sale of your business.
The ability to analyze and assess all elements of an M&A transaction is essential to achieving the optimal outcome when selling a company. So, what do you need to know?
Components of Transaction Structures Can Vary Between Deals
As every business (and founder, for that matter) is unique, there isn’t a formula for structuring the perfect M&A transaction. Negotiating the best deal for the seller and their individual goals and risk tolerances requires finesse.
Buyers also have their own objectives, which may align or conflict with the seller’s best interests. Thus, it is imperative that the prospective acquirer’s disposition be considered when pursuing an M&A transaction
Essentially, the M&A process is like a high-stakes poker game wherein every detail is critical to your success. Most transaction structures involve some amount of cash consideration that is paid to the seller when the deal closes. This component is straightforward and easy to understand.
However, the myriad non-cash components of transaction structures convey greater value and / or risk, and often require more thorough analysis to fully comprehend.
Here are just a few of the non-cash components you might expect to encounter during the sale of your business.
An earnout is one of the most common types of “contingent payment” elements of M&A transactions. Basically, earnouts are payments (normally in cash, but sometimes in stock) that are to be made at a later date based on the financial performance of the company.
Payment of earnouts is contingent upon achieving future target metrics for revenue, net income, EBITDA, or other hurdle measurements agreed to in advance. Buyers want sellers to assume that earnout payments will be received and incorporate them into the overall purchase price.
However, determining the true probability of receiving those future payments requires forecasting (1) how a buyer will manage the company after the closing, (2) future demand dynamics for the business, and (3) macro and micro economic performance within a country or market, etc.
Any value attributed to this component must be weighted against the likelihood that the aforementioned metrics will not be met. Earnout payments are far from certain and are subject to a great many variables that are out of the control and influence of the seller.
Working Capital Pegs
A working capital peg is net working capital that is expected to be included with the sale of the company. They are common in the vast majority of M&A deals and are calculated as follows:
Ex. Working Capital Peg = (Cash + A/R + Inventory – Accounts Payable – Short Term Debt Payable)
Whereas buyers favor different approaches when setting the working capital peg, most will argue for a larger amount. The proposed figure may be substantially higher than normal convention would / should require. Needless to say, this benefits the buyer at the seller’s detriment.
Inattentive or inexperienced sellers could unwittingly lose millions of dollars of additional value through excess inventory or accounts receivable. A savvy representative with an understanding of working capital pegs can help sellers avoid this pratfall and retain the maximum value.
Representations and Warranties
The purchase agreement is the primary legal agreement governing an M&A transaction. As part of this agreement, the seller will be asked to make “representations and warranties,” or declarative statements about the business that constitute legal promises.
Representations and warranties may pertain to financial statements, legal compliance, customer interaction, or product testing and quality. In effect, the seller is certifying that all statements regarding these and other subjects covered in the agreement are true and correct.
The number and wording of these promises, as well as the consequences incurred if false, vary greatly between deals. Under certain circumstances, the seller may be forced by a court to return the entire purchase price to the buyer.
In less severe instances, unless worded so as to explicitly avoid it, large percentages of the purchase price must be paid back to the buyer for things the seller “should have known.”
There is a large amount of future risk (and therefore, value) tied to this part of the deal. Moreover, negotiating these representations and warranties properly is an integral part of achieving the optimal outcome from a strategic exit.
Additional Transaction Structure Considerations
There are dozens more elements that may factor into the terms and transaction structure of your deal. They include but are not limited to rolled equity, stabilization payments, seller notes, subordination of payments, offset of payments, indemnity escrows, purchase price adjustment escrows, SAFE notes, lock-up periods for stock, non-compete agreements, employment agreements, and many others.
Securing Representation Empowers You to Pursue a Transaction Structure That Benefits You
For business owners attempting to sell their company, comprehending the nuances of M&A transaction structures may seem overwhelming. An incorrect or incomplete understanding of the deal terms may have a materially detrimental effect on the value you receive. In some instances, this may even pose legal ramifications.
An experienced Investment Banking professional possesses the expertise to guide you through the M&A process, ensuring your interests are protected. To achieve the very best outcome, it is incredibly important that any business owner who wants to sell their company hires a qualified Investment Banker to help guide them through the process.
About Global Wired Advisors
Retaining an experienced Investment Banking professional is the first step in securing your financial future. Global Wired Advisors combines decades of transactional and operational expertise to provide institutional-caliber service to our Clients while helping them earn the maximum value for their digitally native or Amazon FBA businesses. If you’re considering a sale, or if you’d like to learn more about our process, click here to connect with one of our Advisors today!