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Loading ...M&A Basics
There is a general process that holds true for M&A processes. For purposes of this discussion, we will be taking the potential buyers point of view. This walk through is of course a simplified, high-level walk through but it should provide a useful base. We will be adding more details and examples around the M&A process soon. The M&A process can be broken up into a couple segments as shown below. The M&A process includes several documents including:
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Source the Deal. Potential buyers must source deals so they have targets to acquire. To source deals, investment professional utilize several channels including intermediaries, investment bankers, family and friends, etc.
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Execute NDA. Once a deal is sourced, a Non Disclosure Agreement (NDA) should be executed before any information is exchanged.
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Information Exchange. Receive basic information from target, including financial statements, customer concentration, etc.
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Evaluate Investment. Now, the deal must be evaluated against the investment criteria set forth. Does the deal meet your investment objectives? If not, this is the end for this particular process. If the deal does, we proceed to the next step.
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Submit a Letter of Intent (LOI). This document provides an initial indication for the target. If your initial indication is sufficient, you will proceed to the next step.
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Conduct due diligence. This is a catch-all for all the analysis that you have to perform to get comfortable with the deal. Areas of due diligence include the following below. If the due diligence all checks out, you will proceed to documentation.
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Financial Due Diligence - typically, a buyer will hire accountants to perform detailed financial due diligence. The accountants verify the process and procedures of the target’s accounting controls and ensure the accuracy of the financial statements. In addition, the buyer often has the accountants analyze the financials of key clients.
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Business Due Diligence - the buyer usually has its own managers and operators conduct the business due diligence.
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Insurance Due Diligence - buyer has insurance benefits provider review the target’s current benefits and insurance plans. The insurance benefits provider may identify some areas for cost savings or identify potential issues that could lead to increased expense later.
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Legal Due Diligence - buyer has its lawyers review the target’s existing customer contracts, supplier agreements, employment agreements, any intellectual property, patent wards, etc.
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Technology Due Diligence - If the target has a large technology component to it, the buyer will review the target’s existing technology (either uses someone in-house or hires a consultant). This is to verify that the technology is legitimate and worthy of the consideration the buyer has agreed to pay.
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Customer Due Diligence - A target is generally extremely apprehensive to have its customers talk with potential buyers until the target is 100% certain the transaction is going through. Therefore, customer due diligence usually doesn’t happen until just before the transaction closes. Obviously, this will vary depending on buyer and target, etc.
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Legal Documentation of Transaction. Documentation is the legal documentation of the transaction and includes all associated agreements with the closing. Generally, documentation begins during the due diligence once it seems likely there are no issues. The reason the buyer waits is to avoid large legal bills resulting from the documentation. The key documents include the following below. Sometimes deals may fall apart during the documentation phase.
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Purchase Agreement - outlines all aspects of the transaction in painstaking detail - who is getting paid what, how much, when, employee roles and compensation, etc. We will be providing a detailed walk through of an purchase agreement soon.
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Escrow Agreement - outlines how much of the transaction consideration is being held back and for how long. It’s typical for buyers want to hold back part of the transaction proceeds and deposit it into a bank account to earn interest while waiting for one full audit cycle. This is done to help protect the buyer against any issues that may arise post-closing. Again, amounts may vary widely depending on the size of transaction, customer concentration, if the owner is going to be continue to be involved.
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Senior Management Agreement (SMAs)- a buyer will want to execute SMAs with key employees of the target. This is to ensure that they are incented and fully aligned with the buyer and cannot leave to help a competitor.
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Stock Option Plan - legal documentation of a company’s stock option plan.
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Equity Option Award - outlines the number and vesting schedule for equity options for plan participants. Again, buyers use equity option awards to incent and retain key employees.
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Closing and Transfer of Funds. If no issues arise during documentation, the deal is completed. Now, the hard work begins as the buyer must now operate the new company effectively to earn a good return on its investment.
Documents & Terms
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Non-Disclosure Agreements (NDAs) - a confidentiality agreement between two parties. This basically prevents one of the parties from disclosing the information specified in the agreement. This helps to ensure proprietary and sensitive material is kept confidential. Here’s a more detailed explanation of NDA agreement
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Engagement Letter- outlines the scope of work that a service provider / vendor will provide to the client, including the type of work that will be performed, how much work will be performed, the payment method for the work (hourly vs. fixed fee), and the timing of the payments. In addition, an engagement letter defines the deliverables that the client wants to receive. Here’s a more detailed explanation of an engagement letter.
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Indication of Interest (IOI) - this is a letter that the Buyer sends to a purchaser. It basically gives an offer range for the business as well as ownership percentage the buyer is seeking. Here’s a more detailed explanation of an indication of interest (IOI).
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Term Sheet- This is basically a one or two-page document that provides a little more detail to supplement an Indication of Interest (IOI).
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Letter of Intent (LOI) - A letter of intent is the preliminary agreement entered into between a buyer and a seller. This document summarizes the transaction terms and conditions that have in principle been agreed to by both parties. Here’s a more detailed explanation of an letter of intent (LOI) .
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Stock Purchase Agreement (SPA) - agreement by which the owners of a company sell their shares of stock to a buyer. Basically, a SPA details the terms of the transaction (who receives what, how much and when; legal conditions and/or issues). Here’s a more detailed explanation of a Stock Purchase Agreement.
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Asset Purchase Agreement (APA) - agreement by which the assets of a company are sold to a buyer. Basically, an APA details the terms of the transaction - who receives what, how much and when; legal conditions and/or issues. Here’s a more detailed explanation of an Asset Purchase Agreement.
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Escrow Agreement - ensures parties fulfill contractual obligations and helps mitigate disagreements. For example, a buyer typically escrows part of the purchase price to protect itself in a transaction. The escrow is typically released after one and/or two audit cycles. Basically, a buyer wants to make sure it is buying a sound business. Here’s a more detailed explanation of an Escrow Agreement.
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Senior Management Agreements (SMAs) - an employment contract between a company and its key executives. This formalized a Company’s relationship with its senior managers. SMAs outline such things as base and incentive compensation, employees’ roles and severance terms. Here’s a more detailed explanation of an employment agreement .
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Stock Option Plans - stock option plans govern employees receiving ownership (or right to exercise option for ownership) in a company. Business owners use stock option plans to retain and motivate workers since they share in any upside. We believe Google employees are quite happy it had a stock option plan! In addition, business owners receive tax savings, which helps cash flow. There are two types (i) incentive stock option pans and (ii) non-qualified stock option plans in our stock option plans overview.
Some Common Terms
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Deal Fees- Generally related to a financial advisor and outlines the scope of work that a financial advisor will perform for the client and specifies how the financial advisor will be compensated. For example, financial advisors typically earn a fee that is equal to 2%-5% of the total deal price. This fee may be more or less depending on certain characteristics (nature of the deal, complexity, etc).
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Earnouts - payment(s) contingent on some future financial or measurable target. For example, a buyer may agree to pay the owner of a business an additional $5 million the year following an acquisition if earnings grow by at least 20%. Depending on the complexity on a transaction, earnouts can be either straightforward and easy to understand or very complicated and hard to quantify the real value. Some examples will help you to better understand how earnouts work.
Some Deal Terms - (more to come)
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Price - how much are you paying / receiving?
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Timing of Payments - when are payments paid or received?
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Conditional Payments - are any payments contingent (commonly referred to has earnout payments). For example, is part of the compensation based on company achieving a certain amount of revenue by the end of next year? two years from now?
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Management Roles / Retention - is the transaction contingent on the an individual being given certain duties or being retained prior to the closing?
Types of Review of Financial Statements
There are several different tasks an accounting firm or auditor performs for a company. When you are considering buying or selling your company, you should want audited financials as these are the most detailed and provide the most comfort in terms of the financials. In addition, a regular pattern of at least reviewed financials demonstrates good discipline and process.
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Audited - most desirable from the perspective of banks, investment firms, etc. because audited financials provide the most reliable numbers. Auditors and CPAs perform significant procedures and analysis to assess your Company’s financial information.
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Reviewed - Not as rigorous procedures and analysis as compared to an audit.
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Compilations - prepared by a CPA but without any significant procedures or analysis performed to assess the validity of the financial information of your company.
