The 5 contract terms that imperil most M&A transactions

Shared: February 19, 2020

By: T3 Sixty

There is always an intense focus on the sales multiple when it comes to business mergers and acquisitions (“M&A”). In most M&A transactions, one company absorbs another; the terms “mergers” and “acquisitions” refer to technical differences in how a deal gets completed. Multiples are important, but there are many other key elements of a sale that buyers and sellers need to pay close attention to and can scuttle a deal if not prudently addressed. Here are five critical negotiation terms that buyers and sellers frequently contest because each can have a significant impact on the bottom line for both parties in the transaction.

The form of a deal A buyer may offer to purchase the assets of a seller (an “asset sale”) or the seller’s stock in the company (an “equity sale”). In asset sales, buyers purchase specific elements of a company such as intellectual property customer accounts, physical assets, etc.; in equity sales, buyers acquire the stock of the whole company. The two methods can have implications on taxes due related to the sale, the assumption of liability by the buyer and the process to assign or assume the contracts of the seller. Frequently, an asset sale is advantageous to the buyer, as it may allow a buyer to insulate itself from the seller’s liabilities.

Earnout structure Offers with substantial up-front payments, or cash paid at the closing of the transactions, are advantageous for sellers for obvious reasons. However, sellers interested in remaining in the business can negotiate a higher total payout through an offer weighted toward future “earnout” payments. The key here is to make sure that the buyer and seller are aligned on what the criteria is for future payments to the seller based on metrics of the combined entity that determine the earnout. In addition to the mathematics of the earnout, both parties should also clearly understand the lines of authority that affect the earnout after the acquisition. For example, if the earnout is based on earnings before interest, taxes, depreciation and amortizations (EBITDA), then the parties should be clear on who controls elements that affect EBITDA such as hiring and spending decisions.

Indemnity and holdback The legal nuances of each party’s responsibility for indemnifying the other party if future issues arise are nearly always a topic of intense negotiation and require an attorney’s expertise. As is often the case with contracts, the topic of indemnity is all about protecting the parties against what could happen, though typically such issues do not occur. Regardless, it is a key risk area so both parties must give it careful attention. An acquisition also often includes a “holdback,” or an amount held in escrow at closing that can be accessed if certain incidents occur such as lawsuits. For a seller, waiting years for this holdback amount has a real monetary effect but also provides protection for the buyer.

Working capital A target for working capital — generally defined as the difference between current assets and liabilities — is often set as part of an offer to purchase a business. This ensures that the business continues to operate between offer and transaction close in the same manner it operated before the offer – so no surprises arise that could have affected the offer itself. However, the definition of working capital can have different elements depending on the type of business. For example, calculating the impact to a net purchase price based on a change in working capital for a declining business or a startup business still operating at a loss can be complex.

Retention In many business acquisitions, the health of the existing business such as revenue streams, technology prowess and customer service heavily depend on the people involved. Setting terms of sale and future employment that incentivize key people, particularly leadership, to remain in the business and productive is frequently a condition of closing a sale. These terms may include an earnout described above, but also an established salary and an employee cash or equity bonus structure. Both the buyer and seller benefit after the sale if these incentives are aligned to grow the business.

Takeaway Getting a transaction from offer to close is a complicated procedure, which requires care, diligence and close attention to detail. There are many interrelated decisions buyers and sellers must answer during an M&A transaction and they require a thorough and coordinated approach to yield the best deal for both parties. In addition to a keen awareness of the five terms outlined in this article, buyers and sellers should also use subject-matter experts such as accountants, lawyers or transaction advisors to address key parts of the transaction.