Helping Entrepreneurs Make Sense of M&A Deal Terms
Selling a company is hard. For starters, how do you know if you’re getting a good price, especially with a company that has little to no revenue? Is $10 million a good number? $50 million? $100 million? Nobody wants to be the sucker who sold a company for a fraction of what it was really worth, but everybody also knows the story of the entrepreneur who turned down the $400 million deal only to shut the doors 18 months later.
Once you get past price, deal terms just get more complicated, especially if you haven’t done a lot of work in this area. All of the sudden lawyers are talking to you about things like the size of the “basket,” “carve-outs to the cap,” “survival” and similar sorts of language that sounds wholly foreign at first. How is an entrepreneur supposed to know which of these issues to care about and whether the deal the company is getting makes sense and is a fair one in the marketplace?
To help entrepreneurs, investors, and lawyers get a better handle on deal terms, my company, Shareholder Representative Services recently completed an M&A Deal Terms Study, compiling information on deal terms from more than 80 private company acquisitions SRS has handled since 2007.
Here are some definitions and key findings from the study:
An escrow or holdback is the portion of the merger consideration that is deposited with a neutral third party (in the case of an escrow) or withheld by the buyer (in the case of a holdback) to be applied towards potential future indemnification claims by the buyer. Indemnification is where one party to an agreement (typically the seller) reimburses the other (typically the buyer) for any losses they incur as a result of the transaction. So the buyer will sometimes make claims against the escrow or holdback to recover such losses. After a specified period of time consideration remaining in the escrow or holdback account is released to the selling shareholders. The length and size of the escrow is very deal specific, so make sure whatever you agree to is fair as it relates to your business. Also, be sure to set aside an expense fund (in addition to the escrow) so shareholders can more easily fight claims.
- Two-thirds of deals have escrows in excess of 12 months
- 59 percent of deals have escrows in excess of 10 percent of deal value
Post-closing purchase price adjustments
Purchase price adjustments, typically working capital adjustments, are common and even expected. We find that the majority of the deals with adjustment mechanisms result in actual adjustments, which sometimes entail substantial work and legal fees. You might be able to avoid this by negotiating out the adjustment mechanism and instead adding to the reps and warranties. Representations are statements of fact by the seller regarding the condition of its business, covering virtually all aspects of the company. Warranties are the seller’s assurances to the buyer that the representations are true, and that if they are not, the buyer will be entitled to seek legal remedies.
- Two-thirds of deals have post-closing purchase price adjustments
Earnouts are commonly associated with life sciences deals where obvious milestones like FDA approvals are in play, but data shows that they actually come up frequently across all deal types. Be prepared to negotiate milestones and make sure they are clear and measurable, or you will run into problems in the post-closing period.
- 25 percent of deals have earnouts
- One-third of earnouts have periods in excess of 5 years
- 59 percent of deals allow the buyer to offset indemnity payments against earnouts
And those esoteric terms at the beginning of this article? These should be evaluated on a case-by-case basis, but here’s what they mean:
The basket is the threshold claim amount that must be reached before the seller becomes liable for the buyer’s losses. Typically, baskets function in one of two ways. Under a “deductible” basket, the seller is only liable for damages in excess of the threshold amount. If the agreement includes a “first dollar” basket, the seller is liable for all damages once the threshold amount has been reached.
Carve-outs to the cap
The cap is the maximum recovery a buyer may obtain for indemnification claims. Many agreements include separate caps for different types of breaches. Carve-outs are exceptions where the cap does not apply.
The time period after closing in which the buyer may make a claim against the seller or selling shareholders for breach of their representations, warranties and covenants. The time period is usually shorter than the applicable statute of limitations.
The bottom line is that entrepreneurs and investors who sell privately held companies face complex negotiations with outcomes that can have dramatic effects on net purchase consideration. While the specific deal terms may seem like a lot to digest, it’s well worth an entrepreneur’s time to learn a little about the ins and outs of the M&A process, as it can save enormous amounts of heartache and expense later.
To download a copy of the 2010 SRS M&A Deal Terms Study, go to www.shareholderrep.com/study.