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M&A Terminology | Stony Hill Advisors

M&A Terminology | Stony Hill Advisors
Business Owner's Guide to M&A Terminology
Business Owner's Guide to M&A Terminology

The reality is that you will not own your business forever. The baby boomer generation owns close to 70% of the estimated 4,000,000 lower-mid market businesses in the U.S. ($2mil - $20mil revenues). And the number of family-owned businesses that are transitioned to the next generation is on the decline. The convergence of these statistics is that over the next 10-15 years a large number of privately owned businesses will be on the market.

Entrepreneurs/business owners have some contrasting qualities; part risk taker – part strategic planner and deciding to sell your business will take a significant amount of both. But one thing is for sure – the better the planning, the better the outcome.

This guide is designed to help translate some common M&A terminology. It also provides some recommendations to help you achieve a positive outcome for what is likely the most important business decision you’ll make.

Capitalization of Earnings – A very common “income method” of valuing a business. The calculation is earnings (usually EBITDA or SDE– see definitions below) divided by a cap rate (see definition below). A business with “earnings” of $1.5mil and a cap rate of 25% will have a valuation of $6mil. (i.e. $1.5mil Earnings / 25% (.25) = $6mil) Seller Planning Point: Have your accountant prepare various scenarios that paint the most positive picture of your earnings. Initial negotiations with potential buyers may focus on the definition of “earnings”: last year, trailing twelve months, averaging the last three to five years, simple average, weighted average, etc. - future earnings may also be a component of the calculation in certain situations.

Cap Rate (Capitalization Rate) - Represents the return the buyer requires on the investment in light of the market rate for other investments of comparable risk. An investment in a mortgage at 4% or a stock mutual fund at 8% would be considered by most a relatively low-risk investment. An investment in a business is high risk and thus requires higher returns. The larger the return (cap rate) required by the buyer, the lower the multiple (see definition below). Seller Planning Point: Buyers and Sellers typically talk more about “multiples” than “cap rates” possibly because it’s easier to multiply by an integer than divide by a decimal. But keep in mind that they represent the same value.  A 25% cap rate is equal to a multiple of 4.0 (1 / 25% (.25) = 4.0). 

Multiple – The multiple is the reciprocal of the cap rate. A multiple of 4.0 is equal to a 25% cap rate (1 / 4 = .25 (25%); a multiple of 5.0 is equal to a 20% cap rate (1 / 5 = .20 (20%)) and so on. Using the same example as above, a business with “earnings” of $1.5mil and a multiple of 4.0 will have a valuation of $6mil. Seller Planning Point: While “earnings” for the most part are objective, the cap rate (or multiple) is rather subjective. Strategic Buyers (see definition below) will generally pay a larger multiple (i.e. require a lower cap rate) than financial buyers due to perceived added value and/or synergy of the acquired company.

EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) – The definition is pretty self-explanatory: start with Earnings (Net Income) and add back Interest, Taxes (on Income), Depreciation and Amortization. Just as SDE (see definition below) is the “earnings” used for valuing smaller and typically owner-operated companies, EBITDA is the “earnings” used for valuing larger companies with an existing management team. EBITDA has long been a popular way to compare companies because it eliminates the effect of accounting and financing decisions which can have an impact on earnings.

SDE (Seller Discretionary Earnings) – SDE is commonly used to define “earnings” in a valuation calculation especially when the buyer plans to become the owner-operator of the business.  SDE is calculated by starting with the EBITDA of the business and adjusting it by adding back expenses of the business that are considered ”discretionary” (i.e. owner compensation, owner benefits, non-business expenses, etc.) – a process called Recasting (see definition below). The objective of SDE is to define how much cash will be available to the new owner on an annual basis and thus it allows the new owner to calculate both return on investment and the payback period. Seller Planning Point: Your CPA/accountant is critical when calculating SDE since every dollar of “add back” has a direct impact on the value of your business. If a business sells for 3.0 times SDE, every $1.00 of “add back” is worth $3.00.

Recasting – Recasting is the process of recalculating “earnings” by adjusting (i.e. eliminating) items of income or expense that will not be incurred by the ongoing business. As previously mentioned, common adjustments when recasting to compute SDE are owner compensation, owner benefits and non-business expenses. However one time or non-recurring items of income or expense should also be included in a recast of SDE or EBITDA such as income/loss from a lawsuit, sale of equipment, discontinued operations, etc.

Due Diligence – A thorough review of an organization to assess the accuracy and completeness of its financial records, operational procedures, documented records, contractual commitments and other areas deemed important by the potential buyer. The due diligence process typically starts upon completion of the term sheet and/or letter of intent. Seller Planning Point: The due diligence process can be a major distraction to running the day to day business so plan accordingly. Confidentiality is also a major consideration and the ability to share documents electronically is a major advantage.  Make it a standard practice to scan all of your important documents so they can be easily transmitted. This includes financial statements, tax returns, HR policy manual, employment agreements, lease agreements, customer/vendor contracts, shareholder agreements, intellectual property documents, etc.

Asset Sale – The sale of a business can be structured as an Asset Sale or a Stock Sale with the major implications being taxes and liability. In an asset sale, buyer and seller agree on what specific assets and liabilities are included in the transaction and, for federal tax purposes, must also agree on the allocation of the purchase price to the assets purchased. From a tax standpoint, buyers usually prefer asset sales because they will attempt to assign market values to the assets being purchased which will maximize future deductions. Sellers on the other hand want to maximize the portion of the proceeds that will be treated at the lower capital gains tax rate. Buyers also favor Asset Sales from a liability standpoint since they are shielded against certain future claims against the seller’s business. The vast majority of lower-mid market business transactions are treated as Asset Sales. Seller Planning Point: Goodwill which is taxed to the seller at the lower capital gains rate for federal tax purposes is frequently the largest asset in the transaction. This being the case as long as the seller can get comfortable about the future liability issue, an Asset Sale can be advantageous for both parties. Consult your tax advisor for different tax treatments between federal and state taxation.

Stock Sale - In a stock sale, the buyer is purchasing the entire business as a whole and is essentially stepping into the shoes of the seller. From a tax standpoint, sellers generally prefer a stock sales since 100% of the gain on the sale is treated as a capital gain (assuming the stock was owned for more than 12 months). And from a liability perspective, sellers prefer a stock sale since they are generally shielded from future claims. Seller Planning Point: Most sellers of lower-mid market companies will need to get comfortable with the transaction being treated as an Asset Sale in order to maximize the value of their business and increase the pool of potential buyers. If however your business has important contracts or licenses that are not easily transferable, the buyer may have some incentive to consider a stock sale.

Asset Allocation – If your transaction is treated as an “asset sale”, the amount of federal tax you will pay will be based on what portion of the proceeds will be taxed as ordinary income or capital gains. The IRS requires the buyer and seller to agree on the allocation of assets even though as a general rule what is good for the buyer is bad for the seller, and vice versa. Most buyers prefer to allocate as much of the purchase price to hard assets that can be depreciated quickly as compared to goodwill, other intangibles, buildings, etc. that have longer depreciation schedules. Seller Planning Point: Early in your exit planning process, have your CPA prepare an analysis of the tax consequences of a potential transaction. And since asset allocation will be another negotiated item, it’s best to address this with the buyer, at least in general terms, in the early stages of the deal.

Strategic vs Financial Buyers – There are different types of buyers with different goals and objectives. The type of buyer will significantly impact important components of your transaction including company valuation and your role, if any, post-transaction. A strategic buyer might be another business in your industry or a companion industry that views your business as synergistic to their own growth objectives. Your products/services, your team, your customer base, or frequently some combination of the mix, is attractive to the strategic buyer and will frequently result in a premium valuation. A financial buyer can be another business or individual who is motivated solely by the income/earnings generated by your business. Private Equity firms, for the most part, are financial buyers and typically have no interest in running the day to day operations of your business; however, they will provide management oversight. In some very small businesses, financial buyers can be individuals who plan to be an owner-operator and are in reality purchasing a “job”. Seller Planning Point: Your M&A advisor should be focused on finding a pool of potential strategic buyers to provide you the best opportunity for a premium valuation.

Working Capital (Working Capital PEG/Hurdle and Adjustment) – The standard accounting definition for Working Capital (Current Assets minus Current Liabilities) is not always applicable for business transactions so the Asset Purchase Agreement or APA (see definition below) needs to be very specific.  In an Asset Purchase transaction, the APA will document the specific assets that are being purchased under the agreement.  In smaller transactions where the buyer and seller are owner-operators, with the exception of inventory, working capital typically stays with the seller.  However, in larger transactions, sufficient working capital is required to maintain seamless business operations during the transfer of ownership so working capital will be included in the sale. The required working capital is typically determined by a review of the historical working capital levels. The parties agree to the amount in advance (usually called the PEG or Hurdle) and how it’s factored into the purchase price. A post-closing balance sheet will be prepared for the exact date of closing. Any difference between the working capital PEG and the actual working capital (as defined by the APA) is called the working capital adjustment and results in a payment to the other party. Seller Planning Point: In situations where you have minority shareholders, it might make sense to wait for the working capital adjustment to be settled before making any shareholder distributions.

Earn Out - An Earn-Out is a contingent payment to the seller based on meeting some pre-defined target(s) and are commonly used to close a valuation gap between buyer and seller. Earn-Outs are frequently tied to targets such as future net profits. And in situations when the seller is staying with the business for a period of time, Earn-Outs help align the interests of the buyer and the seller. . Seller Planning Point: Before the term sheet is finalized, talk to your tax advisor to understand if Earn-Outs will be taxed as ordinary income or capital gains under the terms being discussed for your transaction. The APA should have language that protects the seller against any material changes brought on by the buyer and/or any changes in accounting methods that could negatively impact the ability to achieve the Earn-Out targets.

Recapitalization (Recap) – A recap is a reorganization of a company’s capital structure typically used when a private equity firm (PE) invests in a business where the owner(s) continue to stay on and run the business. A recap provides a liquidity event for the owner(s) and an opportunity for a second liquidity event since they maintain a minority ownership interest. The private equity group provides cash to purchase a majority interest in the business and typically has a +/- 5-year horizon to sell the business. Seller Planning Point: Recaps are not for all businesses and not for all business owners. But for businesses that meet the PE financial criteria and have a management team with a successful track record and the desire to continue running the business, it can be a great alternative.

Term Sheet / Letter of Intent (LOI) – The Term Sheet and LOI are similar but differ in form. Both documents serve to outline the intentions of the parties that they plan to consummate in a future agreement (the APA). The term sheet is the document that summarizes the details of the non-binding business agreement between the buyer and seller. The term sheet precedes the Asset Purchase Agreement and is intentionally light on legalese. Unlike the term sheet, the LOI may address issues such as confidentiality, exclusivity and potentially binding commitments of the parties. Seller Planning Point: Since the term sheet is the “business agreement” and not the final legal agreement, it is typically constructed by the primary negotiators which should obviously include the seller. A comprehensive term sheet will help limit any potential deal breakers when it gets to the APA document.

Asset Purchase Agreement (APA) – An Asset Purchase Agreement is the definitive document that contains all the terms and conditions between a buyer and seller related to the purchase and sale of a company’s assets. The APA is a complex legal document and should only be prepared by an attorney with sufficient experience in the field of business transactions. Seller Planning Point: The vast majority of business owners will sell one business and it will likely represent their largest single asset. Choose your legal counsel wisely and make sure they have extensive business transaction expertise. 

Representations (Reps) and Warranties – Possibly the most important element of the Asset Purchase Agreement is the Reps and Warranties section. Basically Reps govern what has happened in the past (or current status) and Warranties govern what may happen in the future. Reps and Warranties can cover a wide range of topics such as accuracy of financial statements, existence of potential legal issues, product liability issues, title to intellectual property, related party transactions, etc. The source of the vast majority of lawsuits between buyer and seller is the result of one party claiming that the other party "breached" a rep or warranty.  Seller Planning Point: Your attorney can limit your exposure by placing limitations on Reps and Warranties such as materiality, limited scope, length of time, seller knowledge (of the issue), etc.

Best of luck but with proper planning, you won’t need luck!

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