This is Part IV in my six-part series on the anatomy of an M&A deal from the buyer’s perspective.
To read Part III, which covers due diligence and letters of intent, click here.
Rarely does an entrepreneur or investment group simply buy a business outright. Rather, for those on the “buy-side” of most mergers and acquisitions (M&A) transactions, the operative phrase is “securing capital”. If you’re thinking about acquiring a company, be prepared to spend much of the next several months convincing others to give you the money to do so.
The past three installments in this series of articles examined the broad preliminary stages of an M&A transaction from the buyer’s perspective: market analysis, prospecting, valuation, due diligence, and the drafting of a letter of intent. To be clear, buyers should formulate their financing game plans before or during these stages, and certainly long before negotiating with decision-makers at their target companies. No seller is interested in wasting time with someone who is not serious about making a deal.
That said, keep your eyes open and be ready to change course if and when the situation calls for it. Chances are you will need to amend your terms and compromise somewhat in order to meet the seller halfway. If you pay close attention, you also may discover financing or structuring alternatives that could sweeten the deal for both parties.
Whether you are in the midst of discussions with a seller or still identifying and researching your targets, here are a few financing options to consider:
Aside from cash, debt financing provides perhaps the simplest and most readily accessible route to capital. It means taking out a loan, typically from a financial institution or another secured lender—although some buyers can convince friends and family members to sign on as investors. Regardless of their position, lenders almost always require a promise of repayment through a personal guarantee or collateral such as accounts receivable, inventory, or full or partial ownership of real estate property. Loan agreements may also contain restrictive covenants that limit access to capital unless you can meet certain conditions within a specific timeframe. This option is usually best suited for deals involving small businesses, as lenders are less inclined to risk large sums of money if they do not already have a stake in the success of the deal.
Another prevalent way buyers incentivize their funding sources is by offering equity. Depending on your company’s size, age, and industry, stock or shares in the company may well be the most valuable bargaining tool you have. Understand that by selling equity, however, you are relinquishing at least partial control over your organization, and you may need to put a substantial portion of equity on the table to get the attention of high-worth financiers such as angel investors and venture capital groups.
Buyers often use a combination of debt and equity to woo investors. Mezzanine or subordinated debt is unsecured and allows backers to convert their investments into equity interest, in the event that a lender is unable to pay back the loan. A straightforward loan is senior to mezzanine debt—that is, a lender is obligated to pay back any secured loans first—but mezzanine debt carries higher interest rates to compensate for the risk.
Counterintuitive as it may sound, sellers themselves sometimes finance a portion of the deal. In return, buyers pledge to pay off the remaining amount in installments, subject to steep interest rates, over several months or a few years. As sellers maintain some control over their companies in the meantime, this arrangement has the added benefit of keeping prior owners tied to the continuing success of their businesses.
Additional Financing Alternatives
Though far less common than the options identified above, there are plenty of additional financing alternatives you may want to consider: peer-to-peer or marketplace lending, crowdfunding (including equity crowdfunding), microloans, grants, and the sale or leasing of property. Some buyers even dip into their 401(k) accounts.
After you have secured funding and agreed on a purchase price with the seller, and before you can close the deal, you will need to finalize the terms of a contract known as the purchase agreement. Although both parties ordinarily want to finish the transaction as quickly as possible at this point, negotiations over purchase agreements can be contentious and drawn out.
Every M&A scenario has its unique challenges, stumbling blocks, and points of dispute. Nonetheless, there are several conditions that come to bear on virtually every dialogue between buyer and seller:
Reps and Warranties
Representations (reps) and warranties are the facts of the deal: what the buyer and seller agree to be exchanging through the transaction. Reps and warranties describe the target company regarding its assets and liabilities, lay out the structure of the deal, and may range considerably in scope from one purchase agreement to another. Generally speaking, the more details you can get in writing here, the more leveraging power you’ll have in other areas of the negotiation.
The indemnification provision lays out all of the possible circumstances that would constitute a broken promise on the part of the seller, thus limiting your liability. You will need to determine if and to what extent your seller will indemnify you for a breach of covenant or false reps and warranties, as well as the minimum size of an indemnity claim, maximum number of concurrent or aggregate claims, and the duration of the indemnification period.
Once you have set the purchase price, there may be circumstances under which you feel you should have recourse to adjust it. For example, if the target business suddenly starts to perform much better or worse than expected during the negotiation process, you may want the option to save money by altering the price. Or, in fact, the opposite may be true.
If the other party is eager to sell, you may be able to negotiate an earnout provision, which would structure the deal so that you pay less upfront than you might otherwise. The seller would then earn the remainder of the purchase amount after the business meets certain financial goals. It is a sensible strategy when deployed wisely—for example, to hedge your bets against an as-yet unproven business—but it can also spark a defensive or skeptical reaction from sellers who are looking to make their exits in full, now.
Throughout this process, shrewd buyers know to pay attention to sellers’ implicit and explicit signals: What causes them to balk? Which provisions do they agree to without hesitation? Trust your seller and keep an open mind, but stay attuned to your instincts and continue to conduct due diligence until you are satisfied with the results.
In the penultimate installment of this series, I will dig into the closing process and offer a few general guidelines for winning shareholder approval of the deal. Buyers of all experience levels can benefit from a partnership with business transactions attorneys like the ones at Offit Kurman. Since 1987, we have been working with clients to achieve their long- and short-term objectives. From pre-transaction planning to closing, we can provide you with the knowledge and confidence to succeed during every stage of the M&A process.
ABOUT MICHAEL N. MERCURIO
Business attorney and M&A lawyer Michael N. Mercurio serves as outside general counsel on matters related to business law, M&A, and real estate law As a strategic partner to firm clients, Mr. Mercurio regularly counsels entrepreneurial individuals and assorted entities on all aspects of business and commerce, with a core specialty in mergers and acquisitions—both from the sell side perspective and buy side perspective.
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