Critical Issues in M&A Transactions

There are several critical issues that should be addressed early on (at the Letter of Intent (LOI) stage or as soon as possible after the execution of a LOI) when negotiating a merger or acquisition transaction. The seller and the acquiring company should consider the following issues when contemplating a transaction.

These issues should be discussed with the buyer’s or seller’s team of advisors, which should consist of an M&A advisor, corporate/transaction attorney and tax advisor. This team of advisors will benefit any party in a transaction by hundreds of thousands to millions of dollars depending on the size and complexity of the transaction.

5 Critical Merger and Acquisition Transaction Issues

1. Cash vs. Earn Out vs. Seller Financing vs. Equity

The method of payment for a transaction, whether in cash or non-cash methods, may be a determining factor for both parties in consummating a transaction. The following are key factors to determine:

Cash. Cash is the most desired, most liquid and least risky method from the seller’s side of the transaction. Cash tends to be the buyer’s strongest position and should pre-empt rival bids better than equity or other methods. A strong seller can expect 50% – 70% cash in most cases, but don’t count on 100% cash in a great majority of sales.

Earn Out. Since a company is a living, ever changing entity, most acquiring companies want to both incentivize and gain some assurance that the seller has a strong on-going concern and that the seller should be able to achieve its forecast in the future. An Earn Out involves quarterly or annual cash payments to the seller for achieving Revenue and/or Net Profit goals, as well as, other goals in some cases for a one to five year period. There are typically stipulations to achieving the Earn Out payments such as the founder(s) staying employed with the acquirer or other criteria.

Seller Financing. For most sellers, seller financing is far more favorable than an Earn Out, but most transactions do not include seller financing. In some circumstances, seller financing for a minor portion of the transaction can be more beneficial to the seller than the risk of an Earn Out and may suit both the seller and acquirer.

Equity. Equity involves the payment of the acquiring company’s stock, issued to the stockholders of the seller, at a value relative to the seller’s value. There are transaction costs and risk, as well as, tax implications to receiving stock as part of a transaction so both your M&A advisor and tax advisor should be consulted early in the process of the negotiations. The issuance of equity will generally provide more flexible deal structures and can be very lucrative to the seller in an up market.

2. Deal Structure

There are basically three methods for structuring a transaction:

A) Stock sale, B) Asset sale, and C) Merger. The seller and the acquirer have competing interests.

Primary issues relating to the deal structure are:
(i) Limitation of liability, (ii) Third party consent requirements, (iii) Shareholder approval, and (iv) Tax consequences. You should work closely with your M&A advisor, attorney and tax advisor when discussing the best method of each transaction early in the sale process. Typically, privately-held companies are acquired as an Asset purchase.

Limitation of Liability. Unless negotiated otherwise, with a Stock sale, the seller’s liabilities are transferred to the buyer as part of the transaction. Similarly, the surviving entity in a Merger will assume all liabilities of the other entity. With an Asset sale, only those liabilities that are designated as assumed liabilities are assigned to the acquirer, while the balance of the liabilities remain as an obligation of the seller.

Third Party Consents. To the extent that the seller’s existing contracts have a provision against an assignment, a pre-closing consent to assignment must be obtained. No consent requirement exists for a Stock sale or Merger unless the contracts contain specific provisions against assignment upon a change of control.

Tax Consequences. A transaction can be taxable or tax-free depending upon the deal structure. Asset sales and Stock sales have immediate tax consequences for both parties. However, certain Mergers can be structured such that at least a portion of the sale proceeds can receive tax deferred treatment.

A) An Asset sale is most desirable to an acquirer, because a “step up” in tax basis of the assets occurs for the acquirer equal to the purchase price, which is typically the fair market value. This enables the acquirer to significantly depreciate the assets and improve profitability post-closing.

B) With a Stock sale, the selling shareholders pay long-term capital gains provided they owned the stock for at least a year. Additionally, the acquirer would have a cost basis in the stock purchased and not the assets, which would remain unchanged and cause an unfavorable result provided the fair market value is higher.

C) With a Merger, there is an opportunity to defer some (or possibly all with a merger of equals) of the tax liability whereby the value remains tax free until its eventual future sale.

Shareholder Approval. Selling shareholders are required to grant approval of a Stock sale. In most states, non-consenting shareholders of an Asset sale or Merger shall be entitled to exercise appraisal rights if they question the value of the deal and its terms.

3. Working Capital Adjustments

M&A transactions typically include a working capital adjustment as a component of the purchase price. The buyer wants to insure that it acquires a target with adequate working capital to meet the requirements of the business post-closing, including obligations to customers and creditors.

The seller wants to receive consideration for its assets that enabled the business to operate and generate profits. In terms of measuring the working capital, the agreement will include a method that compares the actual working capital at the closing against a target level established in the non-binding Letter of Intent.

4. Representations and Warranties

Both parties will be required to make certain negotiated representations and warranties about the business and the process of fulfilling the transaction. These representations and warranties should be taken seriously as any missteps in the post-closing period will result in the other party referring back to these provisions of the agreement with real consequences. Only promise what you can live up to. Gaining guidance from your M&A advisor and attorney will be extremely helpful.

5. Closing Conditions

A section of the transaction agreement will include a list of closing conditions which must be met in order for the parties to close the transaction. These are often negotiated at the time of the definitive legal agreement (although sometimes a detailed list will be included in the Letter of Intent).

These conditions may include, Board approval, the absence of any material adverse change in the seller’s business or financial conditions, the absence of litigation, the delivery of a legal opinion from seller’s attorney and shareholder approval. Additional provisions that are key to a transaction for an acquirer are non-competes and non-solicitation of employees and customers.

Well in advance of commencing the sale process, assemble your team of a seasoned M&A advisor, corporate/transaction attorney and tax advisor. Contact CEO Advisor, Inc., an M&A advisory firm with over 35 years of M&A experience.

Call Mark Hartsell, MBA, President of CEO Advisor, Inc. at (949) 629-2520 or email

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