The Devil is In the Details: Why Deal Structure is So Important in M&A
By all measures, M&A activity continues to be very high early in 2022 after a near-record year in 2021. Pitchbook estimates that there were over 38,000 global M&A transactions in 2021 worth a total estimated value of nearly $5 trillion. Financial sponsors are more active than ever, representing almost 38% of buyers in those transactions. Buyers of all types are flush with cash, financing remains cheap and readily available, and growth remains a key objective buyers will pursue through M&A (note 1 below).
So with seemingly everyone looking for a dance partner, or in some cases, multiple dance partners, the market for attractive acquisition targets is becoming more and more competitive – leading to higher valuations. And buyers are increasingly focused on identifying and driving synergies to justify higher prices – but they need to protect themselves from risk of overpaying in transactions. Buyers are using deal structure elements to achieve these goals – limiting the amount of cash they pay at closing while still offering higher and higher prices.
Deal structure impacts sellers as well – it determines how much of the purchase price is paid in cash and when. Which is the better deal for a seller – a $20 million offer paid fully in cash at closing, or $25 million where $15 million is paid in cash at closing, $5 million is offered in rollover equity, and $5 million is paid via earnout? Depends on the seller’s objectives and tolerance for risk, among other factors. In the second transaction, only the $15 million in cash at closing is guaranteed vs. the entire $20 million in the first.
This is why deal structure is so important – because the price alone doesn’t define a deal. Yes, business owners often focus on the price – it’s an important data point, no doubt. But looking only at the purchase price ignores the fact that much of the consideration may not be paid at closing, and may never actually be paid at all. If you are considering selling your business, it’s more important than ever to understand what’s being offered by the buyer, what it takes to earn it, and when it will be paid. We like to think of it in three primary pieces:
Cash at Closing
Deferred / Non-Cash Consideration
Contingent Consideration.
Bonus Tracks: More on earnouts
Earnout as bridge between parties
Earnout landmines
1. Cash at Closing – “Cash Now”.
All things equal, the more cash paid at closing, the better – anything paid at closing is not at risk to the seller. Anything NOT paid at closing is subject to some form of risk – equity or credit risk, timing risk, or contingency risk, among others.
2. Deferred / Non-Cash Consideration – “Cash Later”.
Portions of the purchase price that are either cash not made available to the seller at closing, or not directly paid in cash.
Holdback Escrow / Indemnity Basket: These have some contingent elements – holdback escrow / the indemnity basket only gets released when and if sufficient time has passed, and after any indemnity claims are settled. (Reps and Warranties Insurance can help limit the size of this component). Typically this is settled in cash when released, but often 6 months or more after closing.
Equity consideration. Equity consideration only becomes “certain value” to the seller when it’s converted to cash by selling – introducing equity risk for this portion of the purchase price.
If it’s public company equity, it may be subject to lockups or registration requirements, meaning it can’t be sold right away at the value indicated in your purchase agreement.
If it’s private company equity, there also may not be a liquid market to sell - which also increases equity risk.
Seller financing or seller notes. Typically structured similarly to a loan or a bond issued by the buyer to the seller for some portion of the purchase price. This means as a seller, you are taking on credit risk associated with the buyer (and reverse due diligence becomes even more critical).
3. Contingent Consideration – “Cash If…”.
A portion of the purchase price only paid if something happens. This allows buyers to offer a higher price with a safety net, while also presenting upside potential for the seller (although the total value may be uncertain at closing). The most common structure is the earnout:
Earnout. Typically detailed in the purchase agreement and often revolves around achievement of metrics or milestones, such as total revenue, growth or margins, just to name a few.
If the metrics or milestones are achieved, it’s a good outcome for both the buyer and the seller – buyer defers a portion of the purchase price until it knows the seller hits the metrics, which can be months if not years after closing.
If the selling company doesn’t reach the earnout metrics or milestones, the contingent pieces are either paid only in part or not at all.
We advise sellers to break down offers into these 3 components and align them against their transaction priorities. Some sellers prefer certainty, and will choose the offer that presents the most cash at closing, while others want to capture upside potential and choose offers that maximize the purchase price, even if some consideration is deferred or contingent. There’s no single right answer for all business owners, but analyzing an offer this way can help clarify the details and allow sellers to achieve their transaction objectives.
Bonus Tracks: More on earnouts
Earnout as a bridge between parties. When there is a disconnect on price, the earnout can help bring the two parties closer together. Often the gap exists because the seller has more confidence in their projections than the buyer (understandably). If the seller has strong confidence in hitting the high end of the forecast, an earnout can be a way the seller can capture upside where the buyer also wins.
Earnout landmines. When structuring a transaction, it’s critically important for the seller to be realistic in setting earnout targets and very specific in documenting the earnout mechanics.
If the earnout targets are too high, the earnout consideration won’t be earned and the total purchase price will be lower than the seller hoped.
If the earnout is capped too low, the seller risks leaving money on the table if the targets are exceeded.
If the earnout is not very carefully structured in the purchase agreement, there is risk the buyer and seller disagree on whether the earnout was actually achieved and it may be delayed in getting paid or possibly never paid at all.
At Amplify Consulting Services, we are here to help you think about your transaction – our objective is to ensure you’re prepared when it’s time. If you’re considering your future plans for your company, let us help you work through it.
We offer hands-on transaction support throughout the planning, prep and process, and will roll up our sleeves to work with you at every step, in addition to coaching through webinars and seminars. Reach out and let’s discuss your objectives and how we can help you achieve them. Visit our website at www.amplify-cs.com or get the conversation started by reaching out at info@amplify-cs.com
Sources:
1). Pitchbook, “2021 Annual Global M&A Report”, as published at https://pitchbook.com/news/reports