CHAPTER 15
Deal Terms
The seller isn’t just interested in the price you’ll pay for their company. They also want to know where you will get the money, when you will pay, what (exactly) you are buying, how long the process will take, and their time commitment to the business after the sale. Answers to these questions help the seller assess your ability to close the deal, your offer price, and the postsale plans—important aspects of the deal for any seller to evaluate. Before you can make the offer, you need to determine your position on each of these important parameters.
How You Are Financing the Acquisition
If you are like most buyers, you will use a combination of debt and equity to finance your purchase. We will discuss both of these in more detail later, as you get closer to the actual acquisition. At this point, you will need to discover approximately what percent of the purchase price lenders will be willing to lend, how much investors will be willing to invest, and how much seller debt the seller can be expected to hold.
Debt
Debt, a fixed claim of the firm, requires the firm to make prespecified interest and principal payments or face significant adverse consequences. The debt will come in the form of a loan from a bank, nonbank lenders, and sellers.
Most buyers use senior loans—that is, loans that stand first in line to be paid—to cover between one-third and one-half of the cost of their acquisition. Senior loans—often from a bank—have the highest-priority claim on the cash flows and assets of the business. As you are researching a financing plan, contact a handful of local banks and discuss whether your potential acquisition would qualify for a bank loan, particularly one backed by the Small Business Administration (SBA) if you are acquiring a company in the United States. Ask how big such a loan might be and at what rate. If the answer is yes, you’d qualify, that’s great; the loan amount you are given should form the core of your financing plan. If not, you will need to rely more on other sources, such as non-bank lenders and seller financing.
Approximately 1,500 of the 7,500 banks in the United States participate in the SBA’s flagship small-business financing program to provide loans for these kinds of acquisitions. If you qualify, this excellent vehicle for obtaining a loan for your acquisition enjoys four advantages over typical bank debt. First, you can borrow more money than you can with other kinds of loans: The SBA will allow you to borrow up to 80% of the acquisition cost of qualifying small businesses up to a maximum loan size of $5.0 million (conventional lenders typically lend 40% to 50% of the acquisition cost). Second, because three-quarters of the loan is guaranteed by the SBA, it is less expensive than other bank debt. Third, the loan is long term, typically ten years. And fourth, as long as you meet your required payments, there are few other requirements to meet during the life of the loan.
If your acquisition doesn’t qualify for a bank loan, you can still borrow from nonbank lenders such as finance companies or private lending partnerships. These lenders are often willing to lend when banks are not and are willing to customize loans in ways that banks are unable to do. On the other hand, nonbank lenders often require extensive covenants that are typically more stringent than bank covenants. The cost of nonbank debt is typically much higher than the cost of bank debt.
All of these loans are senior loans and must be paid first, ahead of other creditors and equity holders (other than tax distributions made to equity holders to pay income taxes). If you don’t make scheduled payments, the senior loan holder also has first claim on your company’s assets, which can be sold to repay the loan. Senior bank loans often require collateral and a personal guarantee and will require the business to meet certain operational and financial metrics during the life of the loan.
Seller debt
Most buyers finance about one-third of the cost of their acquisition directly from the seller. Beyond providing financing, seller debt creates an economic incentive for the seller to help the business succeed after its sale. Seller notes are an obligation from the company to the seller and generally have interest rates that are slightly higher than bank loans. They are subordinate to any senior loans, so if the company defaults, the senior loan gets fully paid before the seller note collects anything. Seller notes generally do not receive personal guarantees or have covenants with financial tests. However, it is common for seller notes to have restrictions on adding additional senior debt or on distributing cash to equity holders while the seller note remains outstanding.
Earn-outs are similar to seller notes in that in these arrangements, part of the sales price is paid on a deferred basis. But in the case of earn-outs, that payment is pegged to company performance. It enables the seller to be paid a higher price if future company performance hits certain targets, while the buyer has the protection of only paying more if the company demonstrates this additional success.
An earn-out is a good way to resolve different views of company value during a purchase negotiation. For example, when Greg Mazur was negotiating to buy Great Eastern Premium Pet Foods (GEPP), an earn-out arrangement helped him close a disagreement about valuation. Over the prior two years, GEPP’s revenues had increased by about 15%. The seller projected strong continuing growth and initially sought a price of $2.5 million. Greg liked the business but knew that the pet food market was mature. He thought this mature market would ultimately limit how fast GEPP could grow. He negotiated a deal to pay $ 1.24 million at closing (about 4x EBITDA), with an earn-out of 1% of annual sales in each of the following five years. The seller believed that these terms brought him closer to his pricing goal and Mazur knew that the earn-out would be significant only if GEPP was successful under his future ownership—not to mention that the earn-out would align the interests of the seller with Mazur’s in the five years following the transition.
Equity
You will also need to raise funds from investors who are typically family, friends, and high-net-worth individuals in your network; the amount of the purchase price that isn’t financed with debt or seller financing will come from equity. Equity has no prespecified payments, and equity investors share in the risk of the business with the entrepreneur—that’s you. Generally, equity investors in small firms require that their capital be repaid before you get any significant payments, and then you and the equity investors share in the benefits of ownership.
If you followed our advice from chapter 5, “Paying for Your Search,” you have kept in contact with potential investors throughout your search, whether they are funders of your search, advisors, or simply individuals whom you identified as potential future investors. You should now approach them to gauge their interest in providing equity to finance your acquisition. They will want to hear about the business of the prospect, its historical performance, the terms of your purchase, the likely rates of return, and other metrics such as the amount, type, and cost of debt you will use. Before you make your offer, you need to be sure that there is sufficient interest from potential equity investors at the specific price and financing plan you are considering.
Transaction Structure
The actual acquisition of the company can take two forms: buying the company’s stock or its assets. Generally, buying assets is more favorable to you as a buyer because you obtain the operating business while leaving behind all liabilities other than those you specifically agreed to assume. An asset purchase minimizes the chances of a nasty surprise from finding undisclosed liabilities after your purchase. There are also substantial tax advantages available to buyers who purchase assets. Occasionally, however, it is only practical to buy stock: With C-corporations in the United States, for example, there are prohibitive taxes involved with asset purchases, and sometimes there are licenses or third-party contracts that are difficult to transfer from the seller to the buyer, except by selling the stock of the company. If your prospect is a C-corporation, we strongly suggest getting professional tax advice early on, certainly when you are considering the offer price and when you are deciding on the specific terms of the proposed transaction.
You’ll also want to explicitly make your offer on a debt-free, cash-free basis, as explained in chapter 12, “Filtering for the Owner’s Commitment to Sell.” Such a basis means that the seller is responsible for paying off any loans owed by the business before the acquisition and that he or she gets to keep any cash on hand.
Working Capital Peg
Most assets—the building, the equipment, the trucks, the customer lists, and so forth—don’t change dramatically between your offer and the completion of the acquisition. However, working capital—receivables, inventory, accounts payable, and accrued expenses—changes every day. Your deal will need to specify both how much net working capital will be left in the company at closing—the working capital peg—and what the adjustment to the purchase price will be if the working capital amount on the closing date turns out to be different from the promised amount. Generally, the peg is set so that when you close on your acquisition, you should have neither a net working capital deficiency, which forces you to invest more money into the business, nor an excess, which allows you to draw out a cash distribution.
Timing of Closing and Exclusivity
Most sellers end up being surprised at how much time elapses between their agreeing to an acquisition and the closing: It is at least three or four months. During that time, you will invest much time and money into confirmatory due diligence, raising debt and equity financing, and structuring the legal documents associated with the acquisition. We cover those tasks in part V, “Completing the Acquisition.” You want to know that the seller is working in good faith with you and only you. Buyers will often propose a closing date and exclusivity period that seems reasonable—say, 90 days—but this time is likely to be extended.
Transition Period
You will probably want the seller to help with the transition of the business over to you after the sale. The seller can introduce you to key customers and suppliers, can help teach you how the firm operates on a day-to-day basis, and can provide you with management advice. The length of this transition period depends on the complexity of the company, your familiarity with the business and its industry, and your relationship with the seller. Three months of full-time commitment from the seller is generally sensible, with occasional access thereafter for up to a year. A longer period can stall the organization after the transaction, and a shorter arrangement may not give sufficient time for your education. You will also want to agree on a noncompete period for the seller. In such an agreement, the seller cannot take on a role that is in competition with the original business. Generally, noncompete agreements with sellers are four or five years long.
Next Steps
With the offer price and deal terms in hand, you are ready to structure the acquisition offer. That’s the topic of the next chapter.