Preliminary Transaction Documents in SMB Mergers and Acquisitions: Part Two – Buyer Considerations
Author’s Note: This is the second in a series of articles prepared to accompany and supplement the new DealSense Plus v4 that includes a term sheet that can be edited in Microsoft Word. This term sheet can serve as a starting point for drafting a Letter of Intent or similar Preliminary Transaction Document.
Preliminary Transaction Documents (Preliminary Docs) such as a Letter of Intent, Memorandum of Understanding or Agreement in Principle are useful vehicles for outlining the broad brushstrokes of a contemplated M&A deal. They provide a generally non-binding summary of the main deal terms (except for confidentiality, no-shop and other clauses that will be discussed in the next edition). Preliminary Docs give both the buyer and seller an opportunity to agree on a framework for negotiating and finalizing the definitive agreement.
A Preliminary Doc provides a threshold through which buyer and seller can pass before starting due diligence and giving the green light to the expenses associated with their respective professionals.
This installment explores the planning and preparation that goes into a Preliminary Doc from a buyer’s point of view. Sellers and their advisors can use this installment to improve their understanding of the buyer’s point of view in order to more diligently plan and respond to Preliminary Docs that are submitted.
A Buyer’s Perspective
MoneySoft has long advocated the premise that a buyer’s acquisition process:
- Originates with a business and strategic vision that shapes the buyer’s acquisition criteria.
- Includes deal flow development, opportunity evaluation, presentation of an offer, due diligence, contract drafting and negotiation as well as funding and the closing.
- Continues beyond the closing until such time as the anticipated values and benefits of the transaction have either been attained or a remediation or rehabilitation plan is executed.
After an acquisition opportunity has been identified and the necessary introductions made, the next phase is to execute a non-disclosure agreement and provide the buyer with a Confidential Information Memorandum (also known as a “Selling Book”).
The Confidential Information Memorandum contains a descriptive narrative and financial information about the business. If a read of the deal book interests a buyer, there may be a site visit, preliminary discussions with the seller and requests for additional information by both parties.
Discovery about the business, its outlook and financial performance is essential. Another important item for discovery is the seller’s motivation(s). Money matters, but sometimes there are softer issues that matter deeply to a seller. The deal that meets the seller’s dollar needs as well as their psychological needs is the one that will most likely interest the seller.
Deciding to Enter the Arena
Eventually, the buyer reaches a decision point. The buyer can decide to take a pass on the opportunity, put it on the back burner or make a move to buy the business interest.
There are five fundamental questions that a buyer can ask themselves in order to facilitate a decision on whether to enter the arena by making a play for the company:
- Does the business align with and advance their business vision and strategic goals?
- Has the seller revealed their real motivations for possibly selling the business at this particular time and are those stated motivations reasonable?
- Is there value within the business that can be unlocked by the buyer if a deal goes through?
- Is this specific business the best one to pursue at this time given other deal opportunities (alternatives) that are on the buyer’s acquisition radar?
- Is the degree of evaluation and discovery conducted up to this point sufficient for the buyer to feel comfortable enough to prepare and present a Preliminary Doc?
When a prospective buyer answers these questions with an emphatic “yes…!,” it is a pretty clear indication that the business is an opportunity to pursue.
Before proceeding to the price, terms and other items to address in the Preliminary Doc, the buyer might want to perform a quick reality check by asking a bonus question: “what will happen if we don’t go after this deal at this time?”
If the initial evaluation indicates that an acquisition candidate is aligned with and furthers the buyer’s business vision and strategic goals and the buyer wants to proceed, the next step is to develop a purchase price package for the seller’s consideration.
The Purchase Price Package
The purchase price package includes all forms of consideration paid to the seller for the business interest and other business benefits to be acquired. One of the first orders of business is for the buyer to determine the proposed purchase price, structure, payment method and terms that will be the heart and soul of a Preliminary Doc.
The following is a list questions that a buyer needs to address when developing deal terms for Preliminary Doc:
- Who is the seller? The seller can be a business entity, an individual or multiple parties. Part of the buyer’s initial discovery process is to determine the appropriate sellers in order to make sure that they are parties to the Preliminary Doc.
In stock purchases, it is possible that there are holders of warrants, options and other equity rights that might have an interest in the transaction. Failure to address the holders of “other equity rights” in the Preliminary Doc can cause confusion and infighting. This can jeopardize the deal and create a great deal of bad will—definitely something to avoid.
Due diligence can be time-consuming and expensive. It is also be an “opportunity cost” for the buyer who is unable to work on parallel projects. For that reason, a buyer wants to know who the sellers are and who will need to sign-off on the deal. A buyer does not want to complete the due diligence process and find out that there are some sellers who have “not bought into” or are antagonist toward the idea of selling.
A savvy intermediary or sell-side advisor will work with the sellers and stakeholders (especially important in a family business) to make sure that there is a consensus to sell before the company is brought to the market.
Again, discovering the psychological and “heart” needs of the sellers along with their other motivations will allow a buyer to shape and structure a deal that gives them a negotiating edge.
- What is the “business interest” that is being purchased? In a SMB transaction, the entire business is often purchased. However, when the seller is a private equity group or a business with multiple units, the seller might only be selling a portion of its business interest.
As a general rule, buyers want to purchase assets to avoid unknown and successor liability issues. Sellers prefer to sell their stock so that the proceeds are taxed as capital gains and, if the business is organized as a C-Corporation, eliminate the double taxation (at the corporate level and personal level) on any distributions.
In some cases, the business can be transferred as a lease, license or other agreement. There are numerous advantages and disadvantages the come with each form of transfer and they are outside the scope of this article.
The business may include assets that are personal in nature or otherwise excluded from the transaction. These assets may or may not appear on the balance sheet. The seller’s advisor will often disclose such excluded assets in the Confidential Information Memorandum. In other instances, there may be assets or portions of the business that the buyer doesn’t want to acquire them. Confusion can be eliminated by clearly defining the business interest that is being purchased and the specific assets that will be excluded in the contemplated transaction.
Finally, in some businesses there are key employees whose continued involvement is necessary to successfully operate the business in the future. Since the business may be impaired without their contribution, a buyer may want to include an overview of the employment terms for key personnel in the Preliminary Doc. If not included in the Preliminary Doc, entering into an acceptable employment agreement with key personnel will certainly be a condition precedent to closing the transaction.
- How much does the buyer propose to pay for the business interest? The purchase price for the business interest is just one component of the total purchase price package that can be paid to a seller.
The business interest is separated from the purchase price package because the amount allocated to stock or assets is essential for accounting and tax purposes. The purchase price package is defined as the amount to be paid for the business interest plus and additional consideration to be paid for non-compete, employment, consulting, and lease agreements along with any contingent or earn-out payments.
- How will the seller be paid for the business interest? The payment methods include cash or immediately available funds, notes and stock.
Seller Financing can be accomplished through one or more funding agreements and the key terms include:
- -Length of the payment period.
-Number and amount of payments.
-Balloons, interest and principal deferrals.
-Secured or unsecured.
-If secured, senior or subordinated (junior) to secured debt.
Buyer Stock can provide the sellers with growth and income potential from the operation of the buyer’s business. It can also be helpful when included as part of a tax-free transaction. The key elements are:
- -The number of shares.
-The value per share.
-Common or preferred.
-Restrictions on transfer.
- Will the purchase price package include a contingent payment such as an earn-out? An earn-out or similar performance-based agreement can be an effective vehicle to bridge the “value gap” between the seller’s aspirational value and the price a buyer is willing to pay based the current trajectory of financial performance. It can also provide an incentive for sellers who remain active in the management of the business after the closing. The key elements of a contingency agreement include:
- -Type of agreement (earn-out, royalty, license fee or commission).
-Term of the earn-out or contingent payment.
-Distribution of payments.
-Method or form of payment.
(A series of articles about earn-outs can be found on MoneySoft’s website: www.634.02e.myftpupload.com/category/earn-out agreements.
- Will a Non-Compete Agreement with an assigned value be included as part of the transaction? There are a number of issues relative to non-compete agreements that need to be worked out with the buyer’s attorneys to insure that they properly protect the buyer and, most of all, that the key provisions are enforceable.
The territory or industry that the seller is prohibited from competing within, the length of time and the reasonableness of the allocated amount needed for the non-compete require input from a professional. The financial terms of a non-compete include: the total amount, the term, number of payments, amount of payments and payment schedule.
- Will the seller(s) have a continuing role in the operations of the company and will they be compensated for that role? The options include employment agreement, management agreement or consulting agreement. If a seller is going to be involved in a key position after the deal is consummated, it can be helpful to include a performance-based contingency or earn-out agreement as part of the deal terms.
Once the above questions are answered and quantified, the buyer is ready to proceed with the preparation of the transaction terms portion of a Preliminary Doc.
In the process of arriving at the total purchase package, the buyer will want to make sure that the deal creates value. The hallmark of a value-creating deal is one that produces reasonably expectable returns (based upon discounted free cash flow) that exceeds the cost of invested capital.
Aside from providing a granular analysis of financial data, robust projections (pre- and post-acquisition), free cash flow ROI analysis and the ability to combine (consolidate) two business entities; MoneySoft’s DealSense® Plus M&A software system includes an editable term sheet. The term sheet is sheet is generated based upon the buyer’s (or their advisor’s) financial assumptions and DCF ROI analysis. This term sheet can be edited in Microsoft Word and used as the basis for preparing a Preliminary Doc.
While this edition provided a look at the basic, barebones elements of a Preliminary Doc with a focus on the consideration to be paid to the Seller, the next issue will explore the additional points a buyer needs to consider before drafting and presenting a Preliminary Doc to the seller.
Robert B. Machiz
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September 6, 2011