Demystifying M&A Deal Points: Understanding the Essentials

How Deal Points Make & Break Negotiations 

Welcome back to our ongoing blog series tailored exclusively for entrepreneurs in the lower middle market ready for their next success. In this installment, “Demystifying M&A Deal Points: Understanding the Essentials,” we explore the intricacies of deal points in mergers and acquisitions, a crucial element for any entrepreneur looking to maximize value and ensure strategic growth. 

We know the entrepreneur’s journey is fraught with challenges, but with the right guidance, the potential for innovation and growth is exponential. This empowers entrepreneurs to confidently navigate complexities and transform obstacles into opportunities for success.

At SEA, our focus remains steadfast in providing business owners with the insights necessary to successfully navigate the complex landscape of business transactions. 

Understanding the Essentials of Deal Points of M&A

Deal points are the backbone of M&A transactions, forming the terms that dictate the financial, legal, and operational agreements between the buying and selling parties. 

These points can vary significantly depending on whether it is a stock sale or an asset sale. For example, in a stock sale, parties may opt for an F-reorganization with a step-up in basis through a Section 338(h)(10) election, carrying tax implications. Key elements such as seller notes, earn-outs, rolled equity, escrow terms with baskets and caps, and net working capital also play a crucial role. Additionally, the ongoing role of the owner post-close and the expectations for key management need to be clearly articulated to prevent future disputes.

The role of the owner post-close is critically important in navigating M&A transactions, especially in ensuring a smooth transition and the continued success of the business. 

  • Does the owner control key relationships, key vendors, strategy and vision of the company? 
  • Do sales and marketing depend on the owner? 
  • Does the owner have to sign off on every proposal, estimate or contract? 

The answer to these questions dictates the structure and role of an owner post-close.

For the business owner who is still heavily involved in the operations, a clearly defined role is important to the deal as it maintains stability, helps retain key customer relationships, and transfers valuable institutional knowledge. For business owners who have built a next layer of management and are out of the day-to-day operations, there can be a much quicker transition, if not an immediate one. 

Understanding these points is essential for entrepreneurs, as they provide leverage during negotiations, helping to protect interests and maximize the value derived from the deal.

Sell-Side Deal Points in M&A Transactions

From the perspective of a seller, some deal points require particular attention. Negotiating favorable terms for aspects such as the structure of payment — be it through cash at closing, deferred payment structures like a seller note, or contingent payments like earn-outs — can significantly impact the deal’s attractiveness and the seller’s financial return. It is also vital to negotiate escrow terms to minimize withheld funds while adequately protecting the buyer from potential post-deal liabilities.

Here are three common sell-side deal points:

  1. Purchase Price and Payment Terms

The purchase price is the amount agreed upon by the buyer to acquire the business, and it is often the most critical deal point. Payment terms detail how this price will be paid — whether in cash, stock of the buying company, deferred payments such as seller notes, or through earn-outs based on future performance. This deal point must be negotiated to ensure that the payment structure aligns with the seller’s financial goals and risk tolerance. It’s important for sellers to secure favorable terms that include upfront cash to mitigate risks associated with future business uncertainties. While 100% cash is the goal of many owners, the amount of cash at the closing table is largely dependent on the type of business, consistency of growth and revenue over time, diversity of clients, key management team and how much the owner has transitioned out of the day-to-day operations of the business.

  1. Working Capital 

This deal point involves adjusting the purchase price based on the net working capital of the business at closing compared to a previously agreed-upon target. The target working capital is typically based on historical averages and is intended to ensure that the buyer receives the business with sufficient liquidity to operate normally post-close. If actual working capital is below the target, the purchase price may be reduced, and if it’s above, the purchase price could increase. This mechanism protects both parties — the seller ensures the business is not stripped of resources leading up to the sale, and the buyer avoids paying for assets not received.

The big picture idea of net working capital is that a buyer wants to ensure the continuation of the business and that they will have the means necessary to meet the future obligations on day one. 

  1. Representations (Reps) and Warranties:

Reps and warranties are assertions made by the seller regarding the state of the company, including its financial condition, compliance with laws, condition of assets, and other material matters. Reps and warranties serve as a form of protection for the buyer, giving them recourse if certain aspects of the business are not as stated at the time of sale. For the seller, accurately disclosing the business’s condition is crucial to avoiding post-closing disputes and potential indemnity claims. This deal point typically includes negotiations on the scope, duration, and materiality thresholds of the warranties, as well as the indemnification terms that will govern any breaches of these warranties. There are differences between fundamental representations i.e. a buyer will not take over past tax liability, and general representations i.e. a list of top clients for the past two years. Fundamental reps survive in accordance with their specific statutes and limitations, while general reps survive for a certain period of time.

Each of these deal points plays a fundamental role in shaping the final terms of an M&A transaction from the seller’s perspective, helping to safeguard their interests and facilitate a fair and effective transfer of business ownership.

Entrepreneurs must beware of common pitfalls in sell-side negotiations. These can include underestimating the importance of net working capital adjustments, which can alter the final purchase price, or failing to secure a clear agreement on the role of the owner and key management post-transaction, leading to challenges in transition and integration processes.

Protecting Sell-Side Interests: Involving an M&A Advisor

In sell-side transactions, the M&A advisor plays a crucial role in safeguarding the seller’s interests, particularly through strategic deal structuring and effective management of the due diligence process. During the due diligence phase, the advisor ensures that the seller’s interests are protected by carefully managing the flow of information and proactively addressing any issues that arise. By effectively managing this process, the advisor helps maintain the deal’s momentum, minimizes disruptions, and ensures that the seller is not unduly burdened by risks, thus facilitating a smoother transition and more favorable outcomes for the seller.

As we continue to unpack the essential Dos and Don’ts of M&A Transactions, it is important to recognize that knowing when to seek an advisor is essential – especially when your business receives an unexpected offer. 

In our next installment of “I Received an Offer, What Do I Do?”, join us for “Strategic Information Release: Timing is Everything.” 

We’ll explore the timing of information disclosure during acquisitions and how SEA’s expert insights can help maintain control and maximize leverage throughout the negotiation process.

What’s the SEA Difference?

When entrepreneurs work with SEA, they are able to collaborate with a team of M&A experts to overcome challenges, make informed and valuable decisions and optimize their strategic exit. At SEA, we are committed to understanding your transition goals and tailoring our process to ensure a clearly defined outcome. 

Whether you’re on the buy-side or the sell-side, our comprehensive advisory team is ready to navigate challenges, optimize strategies, and contribute to a seamless and successful exit. 

Reach out to us anytime at (215) 489-8881 or schedule a conversation.

Strategic Exit Advisors