So far, I have discussed numbers of business acquisitions [Merger and acquisition] from the accounting and financial’s perspective. In this post, I highlight fundamental understanding [and eventually enriched with real tips] for a real business acquisition implementation; the types and process of business acquisitions. It’s impossible to discuss all the attributes associated with a business acquisition, as documenting the legal issues alone would demand a book be written [absolutely not for a blog post]. This post gives you just enough fundamental for real action. Enjoy!
Types of Business Acquisitions
Business acquisitions tend to come in one of two types: asset deals or stock deals:
Business Acquisition Type #1: Asset Deals
Asset deals are generally based on purchasing only the business assets of value (to the acquirer). Under an asset deal, specific assets of a business are acquired with the remaining legal entity left intact to either wrap up its affairs or continue with another business opportunity. This process may include buying just the ongoing business operations, including inventory, property, plant, and equipment, as well as the intangible assets (customer lists, patents, trade names) and leaving the remaining assets, such as trade receivables, prepaid expenses, and cash, with the old legal entity.
The acquiring company purchases the assets and then integrates them into their operation for the purpose of realizing economic gain. The selling company is left to finalize its business affairs by liquidating the remaining assets, paying off the creditors, and hopefully having a return available to the owners or shareholders.
In a variety of situations, the selling company may still have an ongoing operation intact as the sale may only involve one division or segment of the business. Hence, the selling business continues its operations as usual with the exception of having one less division to worry about. Asset deals tend to be associated with smaller businesses or companies looking to shed a specific business interest.
Business Acquisition Type #2: Stock Deals
Stock deals, on the other hand, are generally based on purchasing the entire business entity (including buying all assets and assuming all liabilities). Under a stock deal, instead of purchasing specific assets of the selling company, the stock or equity of the selling company is purchased at fair market value with all assets being acquired and all liabilities assumed. The acquired company usually survives as a legal entity and continues to operate as subsidiary of the acquiring company or is in some capacity merged into a new entity formed for the specific purpose of acquiring the target company.
Generally, the equity holders of the acquired company sell their holders (stock, LLC membership interests, and so on) for cash, equity, or stock in the acquiring company, a note payable, or a combination of these items. Stock deals tend to be associated with larger, publicly traded companies (as well as the larger privately held businesses) that have ample liquid resources and freely traded stock to complete the transaction.
You can realize significant tax benefits and savings opportunities by structuring a business acquisition correctly. The most significant benefit is being able to realize a gain on the sale of a business using federal established long-term capital gains tax rates as opposed to short-term ordinary income tax rates or better yet, structuring a transaction that allows the gain to be deferred from income taxes. Long-term capital gains tax rates are roughly 50 percent lower than short-term ordinary income tax rates.
Obtaining proper professional accounting, legal, and taxation advice during the acquisition process represents an essential element of any business acquisition or sale and should be included in the planning process from the very beginning.
Although a number of advantages and disadvantages are present with each form, the same premise usually holds under either transaction in that the general business interests of the acquired company are maintained on an ongoing basis because the acquisition was based on the premise that an economically viable operation is present.
Structuring the Sale of a Business
The following overview of key structuring issues provides some basic insight as to how business acquisitions are put together. This list isn’t meant to be an all inclusive list, but instead highlights some of the key structuring points that are generally a part of any business buy-sale agreement:
1. Forms Of Consideration
It should go without saying that the acquiring company will need to remit some form of payment or consideration to the selling company, usually in the form of cash, stock, or equity issued by the acquiring company, debt (such as a note payable), assuming debts or liabilities of the selling company, or a combination of these items. For sellers, the preference is to get cash or liquid stock/equity in hand in the beginning to help manage future unknown risks associated with deferred consideration. For acquirers, the tendency is to conserve cash and manage the financing element of the transaction with some debt or restricted stock/equity.
Remember, negotiating the value of the transaction is one thing. Agreeing on what consideration will be received (and when) is something entirely different.
2. Minimum Working Capital
When a company acquires another business, the acquiring company usually requires a minimum amount of net working capital to be retained in the business. Minimum working capital is defined as the amount of current assets less current liabilities that is required to support the ongoing business operations. In effect, the minimum working capital represents the permanent capital investment needed to support a given operating level. For example, if a business has $2 million in current assets and $1 million in current liabilities, the net working capital is $1 million.
If you’re selling a business, you may feel that this positive $1 million of net working capital is yours and should be added to the purchase price. The acquiring company, however, will state that this $1 million of net working capital is required to support ongoing operations. The key concept related to this issue is centered in determining what a reasonable net working capital amount should be. If the parties to this transaction agree that $750,000 is the appropriate figure, then the selling party would be entitled to receive another $250,000 of consideration.
3. Assuming Long-term Debt
Another concept selling companies often get confused with is based in how long-term debt is treated in the transactions. For example, say that a business was valued at $3 million but had $2 million of long-term debt. A transaction to sell this business could be handled in one of two ways. First, the acquiring company could remit $3 million of cash and not assume any of the long-term debt. The selling company would then be responsible for paying off the long-term debt of $2 million, leaving $1million of net proceeds. Second, the acquiring company could remit $1 million of cash and then assume the $2 million of long-term debt. The selling company still nets the same amount of $1 million, but now it becomes the responsibility of the acquiring company to pay off the $2 million of long-term debt.
When business valuations are calculated, long-term debt is often reduced from the gross value to determine the net value of the assets being acquired to reflect the fact that future cash flow will be consumed to repay the debt.
When selling a business, pay attention to what types of consideration will be received in relation to the creation of potential income tax obligations. By accepting stock or equity in the selling company, potential income tax obligations that may have resulted from a gain realized from the sale may be deferred (but not avoided) until you actually dispose of the stock or equity. Of course, you absorb added risks if stock or equity is accepted because you have no guarantees that the value of the stock or equity will remain the same (or that a market will exist to sell the stock or equity).
The potential benefits realized from accepting the stock or equity (including potential deferring tax obligations, realizing appreciation in the stock or equity, and so on) need to be carefully weighed against the additional risks accepted (including incurring potential losses in the stock or equity and others).
4. Restrictive Agreements
A number of restrictive agreements are usually required, the majority of which tend to fall on the seller. For example, the acquiring company will want to ensure that the selling company or its founders do not compete against it in the future. You usually have the use of a noncompete agreement for a set period of time within set geographical boundaries.
When stock or equity is provided as consideration from the buyer to the seller, the acquiring company will often place a restriction period on when and how much of the stock can be sold after the fact to avoid too much of their stock being “dumped” on the open market at once (driving down the price). This step is also undertaken to ensure the seller is committed to seeing the acquisition through to a successful integration with the buyer’s business.
5. Representations and Warranties
Both parties will be required to provide representations and warranties as to the viability of the business being acquired and that the acquiring business is of sound “mind and body.” In this day and age of fraud, deceit, and misrepresentations, both parties want to ensure added legal protection is in place to prevent the “take the money and run” attitude from prevailing. Representations and warranties are a normal and customary part of any business acquisition and are usually supported by active involvement from legal counsel. At first glance, the representations and warranties may look burdensome, but it really comes down to one key point: Are you, as the seller, willing to stand behind all of the statements, information, data, reports, and so on provided to the buyer?
From a seller’s perspective, you should only make representations and warranties that are, or will be, under your control. For example: if your business owns intellectual property such as a trade name that represents an integral part of the acquisition, the buyer may ask you to represent that your company has 100 percent ownership rights to the trade name, and that no other organization has the right to legally use the trade name. This representation is one that you should be clearly able to make. However, if the acquiring company wants you to represent that one of your key suppliers will continue to provide material at a set price and quality level and no current contract is in place, you should not represent this because you can’t guarantee the performance of an unrelated third party.
6. Variable Acquisition Control Features
A number of business acquisitions place controls on the valuation and consideration paid by implementing such elements as variable debt payments (or earn-outs), continued employment agreements for key management, meeting future operating performance objectives, and so on. The general idea is that some future event needs to occur (for example, management needs to stay intact for three years, X number of stores need to be opened, or the acquired businessneeds to produce Y cash flow) before additional consideration will be remitted. This setup tends to favor the acquiring company, but can also benefit the seller in that added deal kickers can be put in place if the acquired business actually performs better than expected. As a general rule, the more risks within a transaction, the higher portion of consideration paid based on variable acquisition control features.
7. Management Continuity
It benefits both the business buyer and seller to ensure that a qualified management team is retained to operate the company moving forward. Structuring favorable employment agreements for key management team members helps the seller with securing a better valuation and provides the buyer with a certain amount of protection against attrition and creating a vacuum in leadership. If properly managed and structured, everyone stands to benefit from retaining key management.
10 Essential Steps Of Business Acquisition Process
Every business acquisition is a unique process. The following overview outlines the basic business acquisition process, from start to finish:
Step-1. Come to terms with separation anxiety
Before you even begin preparing and packaging your business for sale, you should ask yourself one critical question: Are you ready to let go? For most entrepreneurs, starting a business from scratch and building it over 20-plus years represents more of a quest than a financial goal. The business becomes a second home, a part of the extended family, and, if you will, one of the children. Don’t underestimate the emotional element of the business acquisition process.
Step-2. Prepare yourself
Properly preparing and packaging your business is of critical importance. All relevant business information, including financial data and reports, marketing collateral, product or service documentation, and just about any other piece of information you can think of, should be prepared for eventual review, evaluation, and examination. Being better prepared translates into a more efficient process with higher valuations received.
Step-3. Know your market
You need to be aware of what is happening in your market. If you wait too long to sell, you may not have much value left. You should always be aware of how the market shapes your business environment, and when the “market stars” may all align to provide the ideal environment to sell your business. Timing can be everything when selling a business.
Step-4. Secure proper professional support
For most businesses operations, internal expertise usually isn’t readily available to support the business acquisition process. As such, whether buying or selling a business, you should secure proper external professional support to assist with the acquisition process. This support includes but is not limited to legal counsel, accountants and/or tax professionals, financing groups such as investment bankers, traditional banks, and/or other capital sources, and business professionals with significant expertise in merger and acquisition activity. In addition, having an active and well qualified board of directors or advisory board can be a real asset in the process. Selecting the right professional support is critical. Just as with other consultation services, numerous companies offer services to support the business valuation and acquisition process, but make sure that you know what you’re buying before signing up.
Step-5. Engage in the courting process
Think of this process in terms of dating; love at first sight, while possible, rarely happens. This part of the acquisition process involves meeting with different parties, groups, and companies, who all have some type of interest in the acquisition. More times than not, the date will go okay, but you can tell from the initial discussions that a good fit and long-term relationship will not be feasible. The idea is to focus on big picture issues, visions, strategies, and/or common goals to make sure that both the buyer and seller are on the same page. While you can share some very preliminary information and discuss certain strategies, hold off on providing too much information and data until you’ve had a chance to court for a while. You need to make sure that you’re comfortable with the other party before a more formal relationship is pursued.
You shouldn’t rush to provide too much detail or confidential information because you should provide only the extreme basics, such as where the company operates, what its top line revenue is, its marketing information, and so on — in other words, information that, for the most part, is already publicly available via your Web site or from other public sources.
Step-6. Share preliminary information
The courting process should reduce the potential parties involved in the transaction and help eliminate the “looky-loos” and “wannabe players” from the process. At this stage, both parties in the acquisition process should be prepared to execute a nondisclosure agreement (NDA) and/or confidentiality agreement. Basically, this agreement legally binds both parties to not disclose any information to an outside and/or party who isn’t essential to the process. Once the NDA is executed, you can exchange additional information that is somewhat more confidential but still fairly summarized in nature to avoid providing too much detail too early.
Exchange only basic information, such as audited or reviewed financial statements, financial information, projections, reports, a business plan overview or executive summary, marketing collateral/material, and so on. The goal is to provide enough information on which to generate a basic offer but not provide too much detail that is confidential to your business. The idea is to take a more prudent strategy in distributing vital company information to parties that are really serious. If the offer isn’t even close to being in the ballpark, then there’s no point in moving forward.
Step-7. Create a letter of intent or term sheet
The good news is that you’ve made it to a point where you have an offer. The offer is usually provided in the form of a letter of intent or a term sheet. These documents are generated for the specific purpose of clearly spelling out what terms will be present in the acquisition and what will be expected of the buyer and seller in order to complete the acquisition.
Obviously, the terms address such items as the initial estimated value of the transaction, what types or forms of consideration will be used, when the consideration will be paid, what restrictions may be present, and all other key elements of the transaction.
The letter of intent or term sheet does not represent a legally binding agreement to finalize the acquisition. Rather, it represents more of an agreement to agree on how the “meat and potatoes” portion of the acquisition process will proceed. The idea is to use the term sheet or letter of intent as a basic framework for the final acquisition to ensure that all the parties have a basic understanding in place as you proceed.
Step-8. Practice due diligence
Up until this step, the amount of information distributed as well as the discussions and negotiations have most likely been extensive, but they’re nothing in comparison to what you’ll undertake during due diligence. In its simplest form, due diligence represents the stage during which “everything is bared” between the parties. You need to make available all accounting, financial, operational, customer, marketing strategies, vendor, legal, intellectual property, employee, and/or just about any other piece of vital company data to the acquiring party to examine and review.
Due diligence is generally managed by key company personnel rather than the CEO and/or presidents (of the respective companies) because the majority of work to be completed is centered on the everyday types of transactions, issues, reports, and/or other normal and recurring business events.
If properly prepared for with no significant skeletons in the closet, due diligence, although a very intensive process, should be completed with limited problems. On the flip side, if you’re not prepared and/or are attempting to hide something, due diligence is when the deal falls apart.
Consider the due diligence process similar to an independent CPA audit times three. Not only must all the financial and accounting data be examined, but, the acquiring party will want to see all other key operating elements of the business.
The concept of reserve due diligence is extremely important to understand. If you, as the selling company, will be accepting future payment from the acquiring company as part of the consideration received, you’ll want the right to examine the acquiring company’s financial and operational data in order to protect your interests. Legitimate acquirers understand this issue and generally do not have a problem with providing relevant data. If resistance is received, a red flag should go up.
Step-9. Conduct subsequent negotiations and prepare documents
If you think your deal was done with the letter of intent (see Step 7), think again. In almost every business acquisition scenario, something arises during the process that requires subsequent negotiations and acquisition restructuring efforts. Often, the due diligence effort turns up something that results in a need to restructure the letter of intent. Most minor findings and issues are easily managed between the parties by making revisions to the final acquisition documentation. For example, if uncertainties are discovered surrounding a key customer continuing to purchase a given level of products or services, the acquiring company may want to provide for more of the consideration in the form of a future payment than with cash upfront. The total value may not change, but the structure of the consideration may change to compensate the acquirer for additional risks.
The key during this process is to keep the communication lines open (especially between the respective attorneys) and remain flexible and adaptable to changing deal conditions. A certain amount of give and take between the parties will be necessary to finalize the deal. In addition, properly managing the communication of the transaction to key employees and the market in general is extremely important. Obvious risks are associated with communicating the sale too early, and you have still more risks if key employees consider leaving after what may be perceived as bad news. Keeping the deal mum until well into the process or until the deal has been publicly announced may well be the best tactic. And, if word does get out, a communication plan should be in place to address employee, vendor, customer, and other parties’ concerns and questions.
While the due diligence process can take anywhere from several months and even up to a year to complete, don’t forget to run your business. Many business owners begin to bask in the glow of perceived riches and forget to continue running and growing their business. Dropping the ball can jeopardize the future of the business and may also kill the deal as the acquiring firm is monitoring the business’s progress during due diligence.
Step-10. Close the deal
This step is easy; just be prepared to give your hand a workout by signing lots of documentation. Most often, the closing date and time is defined in the final documentation, which is generally referred to as the final acquisition definitive agreement. This agreement represents the legally binding document and finalizes the acquisition process. At this stage, you’ve finalized all deal points and negotiations with only the closing formality remaining.
Integrating the acquisition after it’s closed can be five times more challenging. A properly planned and structured acquisition considers the vast array of issues that must be managed after the deal closes.