Financial Literacy in M&A: A Comprehensive Guide

Merger

The combination of two or more companies that come together and become a new business, usually with a new name.

Acquisition

When a company purchases all of or a controlling interest in another, typically smaller, company. The acquired company is either absorbed into the parent organization or operated as a subsidiary.

Management Buyout

When the management team acquires majority or minority ownership in the company it manages. Management teams often partner with a private equity group to finance the deal.

Employee Stock Ownership Plan (“ESOP”)

An employee benefit plan whereby the owner sells the company to an ESOP trust, which holds the company stock on behalf of the employees.  

For more information on ESOPs, check out our article The Power of the ESOP in Acquisitions.

Leveraged Buyout (“LBO”)

An acquisition financed with a significant amount of debt that is secured and repaid with the company’s cash flows. LBO is a common strategy among financial buyers who seek to increase returns by employing high leverage.

Recapitalization

A reorganization involving a substantial change in a company’s capital structure.

Growth Capital

Financing provided to a company to facilitate growth or expansion. Growth capital typically encompasses both growth equity and growth debt. Growth equity involves a sale of a minority or majority equity interest, while growth debt refers to loans provided by investors for the same purpose. Investors usually provide growth capital through a combination of both equity and debt financing.  

Restructuring

The reorganization of a company that has filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code.

Investment Banker

The investment banker is responsible for developing marketing materials and finding a suitable buyer or raising capital for a company. The investment banker will also advise in negotiations and on which transaction structure will maximize proceeds for the seller.

For more information on the role of an investment banker in a sell-side or buy-side transaction, check out the articles below:

Sell-side: Why Investment Bankers Are Your Most Valuable Asset

Buy-side: Leveraging an Investment Banker for Your Acquisition Strategy

Potential Acquirers

The targeted list of companies that may be interested in acquiring your company. The investment banker will build this list of potential buyers to help you market your company appropriately.

• Strategic buyer – A company in the same or a tangential business that is interested in acquiring a company to fit within its long-term business plan.
• Financial buyer – An institutional investor interested in the return it can achieve by acquiring a business. Financial buyers target a five-to-seven-year holding period per investment.
• Family office – A financial buyer that invests the assets of one or many families. A family office is a “hybrid” in its flexibility to make strategic investments due to its less restrictive investment holding period requirements.

For more information, check out our article on how potential acquirers value your business.

Legal Counsel

A lawyer who is focused on corporate M&A and will advise on the legal and regulatory requirements and filings related to the transaction. Legal counsel is responsible for drafting and reviewing closing documents.

For more information on the importance of an effective M&A attorney, check out our article 4 Reasons to Use an M&A Attorney.

Tax Accountant

A professional who supports the transaction team by advising on the tax ramifications of the transaction.

ESOP Trustee

A person who serves as the legal shareholder responsible for managing the assets and valuing the stock price of the ESOP trust.

For more information, check out our article The Role of an ESOP Trustee, and How to Choose One.

Valuation Advisor

An independent person who may be engaged to prepare a fairness opinion on the transaction. The valuation advisor will analyze the transaction price and terms, and will determine the fairness of the deal terms for the selling shareholders.

For more information, check out our valuation services: https://www.pcecompanies.com/services/valuation/fairness-and-solvency-opinions

EBITDA

Earnings before interest, taxes, depreciation, and amortization (“EBITDA”) is a measure of a company’s financial performance. Interest expense, tax expense, and depreciation/amortization expenses are removed to isolate operational performance. This metric allows better comparability between companies with different capital or tax structures.

Check out our article What Is EBITDA? to learn more.

Add Backs

EBITDA adjustments for one-time, irregular, and non-recurring items. Examples include non-business-related expenses, such as owner expenses run through the business and discretionary expenses.

Adjusted EBITDA

EBITDA adjusted for add backs for the purpose of normalizing performance. This metric removes any distortion caused by non-business-related expenses.

Capital Expenditure Requirements

Estimated future capital expenditures required to maintain existing property, plant, and equipment and to invest in upgraded technology. Capital expenditure requirements are excluded from free cash flows available to shareholders.

Net Working Capital

The difference between a company’s current assets and current liabilities. Commonly, net working capital is calculated on a cash-free, debt-free basis:

(Current Assets – Cash) – (Current Liabilities – Short-Term Debt)

Check out our article and video How Net Working Capital Impacts the Value of Your Business to learn more.

Discounted Cash Flow Analysis

An income approach to valuation that estimates the value of a company based on the net present value of its future free cash flows.

Comparable Company Analysis

A market approach to valuation that estimates the value of a company based on metrics of publicly traded companies operating in a similar line of business.

Precedent Transaction Analysis

A market approach to valuation that estimates the value of a company based on recent prices paid for companies operating in a similar line of business.

Cash-Free, Debt-Free Basis

A transaction scenario where the selling company pays off its debt at the time of the transaction, and the seller keeps any remaining cash. Most M&A deals are structured with consideration on a cash-free, debt-free basis.

Working Capital Adjustment

A purchase price adjustment based on a negotiated working capital requirement. This adjustment prevents manipulation of working capital at the time of transaction closing that could impact company value.

Enterprise Value (“EV”)

The entire firm value of a company. The following formula calculates EV:

Market Value of Equity + Market Value of Net Debt

Equity Value

The value of the company that is owned by the equity shareholders. The following formula calculates equity value:

Enterprise Value + Cash – Debt Outstanding +/- Working Capital Adjustment

Transaction Multiple

A financial metric used as part of the market approach to valuation. Commonly used transaction multiples are EV/EBITDA, EV/revenue, EV/EBIT, and price/earnings.

Discount for Lack of Marketability

A discount applied to the valuation of a closely held company to account for the illiquid nature of the investment.

Discount for Minority Interest

A discount applied to the valuation of minority interest to account for a minority shareholder’s lack of control of the business operations.

Teaser

A brief marketing document prepared by an investment banker and circulated to potential acquirers to introduce the investment opportunity. To maintain confidentiality, it does not mention the company name.

Non-Disclosure Agreement (“NDA”)

A legal document required to be signed by potential acquirers to ensure confidentiality is maintained. A potential acquirer must sign the NDA before accessing secured company information.

Confidential Information Memorandum (“CIM”) aka Corporate Profile

A detailed marketing document prepared by an investment banker and provided to potential acquirers who have executed NDAs. The CIM offers key investment considerations, a company overview, financial statements, and other critical details.

For more information on preparing a CIM, check out our article: Preparing a Confidential Information Memorandum: What You Need to Know

Indication of Interest (“IOI”)

A letter provided by potential acquirers expressing conditional, non-binding interest in buying the company. The IOI will outline a preliminary value range and high-level transaction terms, due diligence requirements, and other conditions required to be met prior to finalizing the transaction.

For more information on IOIs, check out our article: Using the IOI to Save Time and Maximize Value in Your Business Sale

Letter of Intent (“LOI”)

A more formal term sheet submitted by a potential acquirer after an initial period of due diligence has been completed. An LOI will typically specify an exclusivity period during which the potential acquirer may complete due diligence and other conditional requirements before finalizing the transaction.

For more information on LOIs, check out our article: Key Terms to Know When Negotiating a Letter of Intent

Due Diligence

A fact-finding investigation performed by a potential acquirer to confirm information about the investment opportunity. A potential acquirer will submit a due diligence request list to the target company after sending an LOI.

For more information on how to prepare for a due diligence process, check out our article Tips for Pre-Sale Due Diligence.

Definitive Purchase Agreement

An agreement between a buyer and a seller that finalizes terms and conditions related to the sale of the company’s stock or assets. Negotiations focus heavily on the specific details of this agreement.

For more information, check out our article Key Terms for Purchase Agreements.

Quality of Earnings (“QoE”)

A financial due diligence report prepared by a third-party professional who examines the accuracy and sustainability of EBITDA and earnings. The QoE provides buyers with confirmation that financial information is not skewed due to aggressive accounting policies.

A QoE can accelerate the sale process by helping you identify and address any problems before a potential buyer encounters them. If you would like to learn more, check out our article The Importance of a Sell-Side Quality of Earnings (QoE).

Fairness Opinion

A professional report, prepared by an independent investment banker or valuation advisor, that provides the seller an opinion as to whether the proposed transaction price is fair to the selling company.

Signing

After the purchase agreement has been negotiated and agreed upon, the documents are signed by the buyer and the seller. If certain closing conditions must be completed after signing, signing and closing can be two separate events.

Closing Conditions

Obligations specified in the purchase agreement that must be satisfied for the transaction to close. Closing conditions vary but could include transaction approval from a government authority, provisions that representations and warranties are valid as of the closing date, and other deal-specific conditions that must be addressed prior to closing.

Closing

When all closing conditions are satisfied, the deal is legally recorded, and funds are exchanged. This is the moment the transaction is completed.

Transaction Structure

The transaction structure is the framework that outlines how the merger or acquisition will be achieved. The transaction structure is meant to spell out the rights and obligations of both the acquiring company and the target company. An M&A transaction may be structured as a sale of either the company assets or the company common stock.

Asset Sale

The seller remains the legal owner of the company while the acquirer purchases the assets of the company. The seller typically retains cash and must repay long-term debt at the close of the transaction. An asset sale is advantageous to the acquirer, who may “step up” the tax basis of assets and obtain depreciation tax deductions.

For more information on asset sales, check out our article How to Structure the Sale of Your Business: Asset or Stock.

Stock Sale

The seller transfers the company’s common stock to the acquirer. The acquirer assumes both the company’s assets and its liabilities. A stock sale is typically a more straightforward process compared with an asset sale and does not provide the acquirer with the same tax benefits. The seller still retains the cash, and debt will be repaid using the proceeds of the sale.

Price/Consideration

The transaction payment method can comprise cash and non-cash considerations. Non-cash considerations include stock, seller notes, earnouts, holdback escrow, etc.

Seller Note

An alternative to bank financing wherein the buyer issues a debt security to the seller as partial payment for the company. The seller note has a claim on the company’s assets subordinate to senior debt.

Earnout

Consideration that is contingent on the company’s future performance. The contractual provision will state the financial goals the business must achieve so that part of the purchase price can be paid to the seller at a specified time.

For more information, check out our article on Contingent consideration.

Escrow or Holdback

A portion of the purchase price is placed in a third-party escrow account to serve as security for the acquirer for potential claims against the seller. Holdback is typically used to alleviate concerns about the seller’s financial ability to cover post-closing indemnity claims if they should arise.

Rollover Equity

Equity that is rolled over by original shareholders into the new equity capital structure post-transaction. Private equity buyers typically require owner-managers to roll over equity to align incentives.

For more information, check out our article Key Considerations in an Equity Rollover.

Indemnification Provisions

Negotiated language of the definitive purchase agreement that allocates risk between parties. Standard indemnification provisions focus on undisclosed liabilities, the timing of escrow holdback, and threshold limits on indemnification claims.

Fundamental Reps and Warranties

Representations defined in the purchase agreement that are so material, the buyer would not have agreed to the transaction if they were false. Often included as fundamental reps and warranties are the seller’s ownership of the securities or assets, the seller’s power and authority to transact, and titles to securities or assets, among others. Losses incurred due to a breach of a fundamental rep are subject to a separate cap, often equal to the aggregate amount of the purchase price.

For more information, check out our article on Understanding the value of representations and warranties insurance. https://www.pcecompanies.com/resources/understanding-the-value-of-representations-and-warranties-insurance

Non-Fundamental Reps and Warranties

Representations made within the purchase agreement that are not clearly defined as fundamental are, by default, non-fundamental. These representations are subject to the cap and basket limits.

Cap

The upper dollar limit of a seller’s indemnification obligations to the buyer, i.e., the total amount of losses and damages a buyer is entitled to recover from the seller. Fundamental indemnification claims are normally excluded from the cap.

Basket

The threshold amount of losses that a buyer must incur before being entitled to any indemnification from the seller.

Mini-Basket

The threshold amount an individual loss must exceed for a specific claim before it counts toward the general basket.

Tipping Basket

A type of basket that entitles the buyer to full recovery of all losses, from the first dollar of losses, once the incurred losses have reached the basket threshold. This basket structure is more favorable to the buyer.

Non-Tipping Basket, aka True Deductible

An alternative to a tipping basket, this entitles the buyer to recover only losses that exceed the deductible. This basket structure is more favorable to the seller.

Survival Period

The time frame during which parties may bring an indemnification claim.

Reps and Warranties Insurance (RWI)

An insurance policy used in M&A transactions to protect against losses arising from a breach of specific representation in the definitive purchase agreement.

To learn more, check out our article Understanding the Value of Representations and Warranties Insurance.

Transaction Fees

In an M&A engagement, a transaction fee is typically a performance-based payment made by the client to the advisor or investment bank upon successful completion of the deal. This generally accounts for the bigger chunk of the advisor’s compensation.