Archive for the ‘Deal Structure’ Category

Know What You Are Getting With An Earnout

Friday, July 3rd, 2009

A Guide To Structuring An Earnout


“Experience is what you get when you don’t get what you want.” – Dan Stanford 

Before one digs deep into the structure of the earnout it is important to understand the motivation of the parties in structuring the earnout. Is the purpose of the earnout to bridge a valuation gap based on legitimate differences of opinion about the amount of future earning streams? Does the earnout have to do more with potential business transferability issues? Is the earnout primarily about creating incentive for delivering high performance?

Historically, earnouts have been used by M&A advisors to bridge a valuation gap between the seller and the buyer. Sellers typically tend to value their business much higher than a buyer and an earnout can be great way to satisfy both parties. Astute acquirers have also used earnouts to incentivize and motivate sellers to deliver on a performance promise post close.

The above thinking has changed significantly in the recent past. The recession and credit crisis have put the acquirers in the catbird seat and acquirers are demanding earnouts primarily as a negotiating lever – sometimes in situations where none would be warranted by historical precedents.

The structuring and negotiating of the earnouts should be based on a clear understanding of the motives. Regardless of the motives, all earnouts have several key components:

Duration of the earnout: Most earnouts last between one and three years. Anything shorter than a year is typically meaningless to the acquirer. In most cases, duration longer than three years significantly increases the chance of unforeseen events impacting the business and makes projections used for earnout unrealistic. To the extent used, longer term earnouts need to be written to decrease the uncertainty and reduce the inherent risks.

Identification of milestones: Milestones for earnouts can be financial or non-financial. For financial earnouts, sellers typically prefer revenue based milestones because they are easier to achieve and monitor. On the other hand, acquirers prefer net income based milestones because revenue based incentives may motivate the sellers to drive revenue at the expense of profitability. An EBIT or EBITDA based milestone can often provide a good compromise between a buyer’s and seller’s needs. To reach a comprehensive agreement, acquirers and sellers should clearly understand the factors effecting EBIT/EBITDA, including the pre and post close accounting methods used to compute the milestones.

Operation of the business during earnout period: The goals of the acquirer and the operation of the business post-acquisition could be substantially different from the seller’s goals and the pre-acquisition operational model. For the earnouts to be meaningful, the acquired business should be operated in a predictable way that, among other things, reduces mismanagement and malfeasance on the part of both the acquirer and the seller. Employment agreements should also be put in place to ensure the seller has a say over relevant control issues. The earnout may also be adversely impacted by how the acquiring company allocates operational overhead and other expenses in the earnout calculations. A merger or acquisition of the acquiring company or the acquiring division, or a divestiture of the division or a product line, could also create situations where the earnout metrics become meaningless. It is imperative that the earnout document contain clauses detailing operational, accounting, and employment specifics and identifying conditions under which the earnout may have to be modified or accelerated.

Establishing if/when milestones are achieved: Typically it is the acquirer’s responsibility to identify when an earnout milestone is achieved and provide the calculations pertinent to the earnout. A prudent seller should ensure that he has access to audited/auditable books that relate to the earnout calculations should a dispute arise. The parties also need to establish mechanisms to deal with any challenges to the earnout calculations.

Method of payment: An earnout may be paid in cash, stocks, bonds or other securities. If the payment is made in forms other than cash, the seller needs to be cognizant of the potential variability in the payment stream. The acquirer may offer 10,000 shares of the company’s publicly traded stock at a stock price of $50 at the time of the deal and unanticipated events could result in the stock price being $5 on the day of the earnout payment – effectively driving the value of the earnout to 1/10th of the anticipated value. Earnouts paid in private company securities could be even more of a challenge as they are illiquid and are more easily subject to manipulation.

Tax impact: The earnout language should be drafted meticulously to ensure proper tax treatment of the earnout. Depending on how the earnout is written, the payments could be capital gains, payroll income or independent contractor income – all with very different tax implications. It is imperative that the language be carefully addressed to avoid conflict and to reduce the tax bite.


Earnouts, no matter how well crafted, can contain pitfalls for both sellers and acquirers. Parities to an earnout agreement must understand each other’s motives and craft an operationally workable win-win agreement that reduces scope for potential conflict and litigation. It is imperative that both parties know what they are getting themselves into with an earnout agreement.

Credit Crisis: What Does It Mean To Mid Market M&A

Monday, November 3rd, 2008

Impact of Tight Credit Markets on Business Sale Transactions

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffett 

Until about a year back, life in the mid-market M&A lane was somewhat predictable. Most companies entering the deal making process had respectable growth rates, rosy outlooks, and credit was plentiful. Private Equity Groups and lenders had access to money they could put to use on the right deal. More often than not, the sticking point in the deal was the valuation.

All that changed in the last year. As we approach the end of 2008, most businesses are finding that the environment has changed dramatically. A business owner looking to sell is typically in a situation where the trailing 12 month numbers look less than attractive, business outlook is no longer rosy, and credit is extremely tight. The view for the acquirer is not much better. Valuation is not the biggest sticking point any more. Even if the acquirers think they have negotiated an excellent bargain, financing the acquisition is highly problematic.

By some estimates, the value of business deals year to date has dropped by about 35% in spite of a large volume of unexpected distress deals. Excluding the distress sales, total transaction values appear to have plummeted by as much as 50%. In appears that one out two business sale transactions is not materializing largely due to the liquidity crisis.

Unfortunately, the end is not in sight. In spite of the intervention of the government in the recent past, credit is unlikely to be plentiful for the foreseeable future. Optimistic forecasts call for business trends and transaction dynamics to remain unfavorable until the second half of 2009. So, how can sellers and acquirers facilitate a meaningful business sale transaction in the interim?

The answer, while not the most optimal, is surprisingly simple! If lack of liquidity is the problem, then providing or facilitating liquidity is the solution. There are several ways in which sellers can provide or facilitate liquidity in a business sale transaction:

1.    Structuring the deal to reduce third party debt in the deal: This can be done by increasing the money required upfront, taking part of the transaction amount in the deal as earn-outs, retaining part of the equity post-acquisition, increasing the payout time on deferred monies, and other mechanisms that defer the payment schedules. Due to the inherent risks of this approach, extreme care should be taken in inking the terms of such a deal.

2.    Separating asset types for hybrid financing: This can be done by separating asset types (real estate, inventories, receivables, etc.) and finding an optimum way to finance each of the elements. For example, the real estate component could be done in a separate lease-buyback transaction or inventories could be financed by creative lender financing.

3.    Seller financing: While it is not possible in every instance, to the extent possible, sellers can float the required credit to the acquirer. The biggest disadvantage of this approach is that the acquirer’s failure in operating the business can result in a dramatically reduced return to the seller.

4.    Seller loan guarantees: Liquidity can also be facilitated by sellers guaranteeing third party debt in the deal. This approach could potentially reduce the seller’s liability substantially compared to the previous scenario but otherwise is similar in many ways.

With these deal structures, the seller’s vested interest in the deal, post-acquisition, increases dramatically. The biggest risk in any of these approaches is that the acquirer’s ability to make payments will depend on the future success of the business. The acquirer may mismanage the company, or the economic conditions may become more unfavorable, or some other unanticipated event could dramatically reduce the acquirer’s ability to pay down the obligations. Sellers should be cognizant of the risks in these approaches and take precautions to mitigate the risk and improve the return.

On the upside, there are some significant benefits to the sellers. Empirical data indicates that if a seller can assist in financing the deal, the deal value can improve as much as 40%! The deferred payment stream could also result in substantial tax benefits to the seller. Another major advantage of this approach is that the sellers would very likely be able to negotiate a higher rate of return on the deferred payments than the returns available to them elsewhere.

In spite of the sellers’ preferences, sellers should also be aware that, in these tough economic times, acquirers and lenders prefer these deal structures and some may even require them.

From a seller’s perspective, proceeding down this path should be done carefully with enormous attention being paid to the caliber of the acquirers, deal terms, collateral support for the payments, and possibly backup insurance facilities to further mitigate the risk.

What Professional Business Valuations Don’t Tell You

Thursday, March 27th, 2008

The Myth Of Fair Business Valuation

“In business, you don’t get what you deserve, you get what you negotiate”. – Chester L. Karrass 

So, how can Bear Stearns be worth about $20 billion dollars in January 2007 and be worth only $238M in 16th March 2008 – just 14 months later? And how can it be worth about $1B on within days after JP Morgan announced the $238M deal? What is the fair valuation?

The answer is simple and holds a message that every business owner should be keenly aware of: There is NO fair value for illiquid assets.

While the 100:1 valuation swing that Bear Stearns saw within a span of about an year is uncommon for public sector companies, it is not at all uncommon for mid-market businesses. We routinely see business owners who have suffered enormously from dramatic valuation compression due to poor planning and/or picking wrong advisory teams. Let’s look at what “fair valuation” of illiquid assets means in the context of mid-market business owners and shareholders who are getting ready to sell or recapitalize their businesses.

Some business intermediaries and financial advisors insist that the seller get a professional valuation before placing the business in the market. Some intermediaries even insist that the business must be marketed at its “fair value” or “appraised value”. Professional valuation specialists charge thousands or tens of thousands of dollars to come up with a fancy report that narrows the value of the business to a precise number or a narrow range of values. This type of report is typically tens of pages long and addresses valuation factors such as financials, industry sector, strength of management team, value of the assets, the purpose of the sale, etc. A typical report also uses various valuation methodologies to arrive at a weighted average number that is given out as value of the business.

So, what does it mean to have a “professional valuation report” or a “fair value report”? Does this mean that the seller will know the exact selling price of the business? Not really!

Professional valuations and fair value opinions aim to provide a “fair business valuation” but they are all contingent on multiple assumptions. The valuations are as good as the assumptions upon which they are based. Two of the key factors in valuations – future growth rate and operational synergies – are highly subjective and no two views on these topics are likely to be identical. Unfortunately for business owners, the exact conditions laid out by valuation professionals never occur in real life!

On top of variability in key valuation factors, sale terms such as the type of sale, the payment schedule, consulting clauses, earn-outs, and the reps and warranties can easily cause a 20-40% swing in what the seller gets to take home. Setting aside sale terms, which are typically not covered by a valuation report, the seller will be lucky if the real sales price comes within 10% to 20% of the professional valuation. In several of our most recent deals, the initial valuation report was off at least 30% from the final sales price.

The reality of business sales process is that the value of a business is determined by the acquirer much more than any other factor. The same business could be viewed completely differently by two different acquirers depending on their strategic needs and their perceptions of future cash flows.

The business sale process also plays a big role. Acquirers tend to pay much more for a deal that they believe is competitive. While negotiating in a recent deal, one buyer, after realizing the seller needed to sell for medical reasons and thinking that there was no competition on the deal, said: “I know I got a price reduction but if I wait long enough wouldn’t the seller have to pretty much give the business away?” Fortunately for the seller, we ran a soft auction and there was another acquirer at the table who ended up consummating the deal per seller’s terms.

From our experience, the type of buyer and the type of sale skew the valuation to such an extent that it is unwise for a business owner to be not familiar with these variables and their impact before the beginning of the sales process. Business owners should be aware that these two factors play a disproportionately large role (see chart) and consequently any “professional valuation” has only limited applicability in the business sale process.

From a deal making perspective, running a competitive bid process and finding the right acquirer for the deal involves broad based search, discipline, substantial amount of negotiating, creative deal making, and people management skills. The competitive bid process tends to be longer and will require more cooperation from the seller but the upside is substantial.

The Bear Stearns deal on March 16th, 2008 was clearly based on “Fire Sale Value”. To avoid a fire sale, and to stay in the green zone of valuations, mid-market business owners should plan early, hire a competent M&A advisor who can help plan and orchestrate the sales process, and take every precaution possible to plan their exits. The key messages for business owners looking to sell or recapitalize their businesses are:

      There is no fair value for illiquid assets. It all boils down to what a willing buyer can pay and what the business owner is willing to accept.

      To maximize valuation, working with the right acquirer is extremely important. Picking an M&A advisory team that can sell the value of the business to the right buyer can go a long way in feathering the next egg.

      Be prepared for a drawn out sale process. Competitive bid process, an important tool used by M&A specialists to maximize exit valuation, can take time.

      Plan early and never sell in desperation.

Beware Of The Private Equity Buyer

Tuesday, March 11th, 2008

What Business Owners Need To Watch Out For When Dealing With PEGs


One of the biggest obstacles to deal making for mid market companies is the lack of financing. With SBA guaranteed funding being capped at $2M, doing deals north of $3M with individual buyers becomes a challenge. Some businesses can find synergistic corporate acquirers but that is not a likely outcome for many businesses. Depending on their situation, business owners need to determine if Private Equity is the right option for the company. Here is where the business owners may find out that the Private Equity Groups (PEGs) can be saviors. For many mid-market companies, acquisition by a PEG is the most realistic exit.

While PEGs can be saviors for business owners, sellers have to be very careful in dealing with PEGs. Once the business owner determines that a PEG is the right option for liquidity, he/she has to be keenly aware that PEGs are in the business of buying and selling companies. A lot of what PEGs do is financial engineering and PEGs are extremely sophisticated and savvy in making deals that are beneficial to them. Many PEGs, in spite of being private “equity”, resort to debt extensively to facilitate transactions. Debt in the deal could mean financial conditions in the acquisition which increases the uncertainty in the deal. 

Deals with PEGs are generally far more complex than those done with individual acquirers or synergistic strategic acquirers. Given the intricacies of the deal, and to combat the experience of the PEG, business owners need to have a deal making team of their own to ensure that the PEG does not take advantage of the business owner. From our experience, here are some common things that business owners need to prepare for when dealing with a PEG:


Ø  Clean up the books and have the financial statements recast and proper pro-forma financials developed. Make sure that forecasts are not overly aggressive and especially avoid underperforming the plan during the course of the deal.

Ø  Be prepared for due diligence and review all material issues to catch any problem areas early in the process. Late surprises can have a dramatic negative impact on deal value and in some cases kill the deal. Even a minor due diligence item is likely to be used to aggressively drive down the deal value or introduce conditions that are onerous to the owner.

Ø  Remember that due diligence can go both ways! Check the PEG’s reputation and how they have transacted prior deals. Is the PEG a good match for the seller? If the deal requires the seller to stay on post-close, the seller should contact the owners of the businesses previously acquired by the PEG to understand their perspective on working with the PEG. If the PEG is not a match, it may make sense to walk away early before expending too much time interacting with the PEG.

Ø  Without a competitive environment, a PEG, or anyone else for that matter, is unlikely to pay top dollar for the company. To strengthen the negotiating position, make sure the M&A advisor is pursuing all possible angles to cast the widest possible net.


Ø  A PEG could easily lock up an inexperienced seller with a basic LOI and drain the seller with a drawn out negotiating process. A comprehensive LOI reduces back end negotiating and is to the seller’s advantage.

Ø  Negotiate key terms of the deal in the LOI. This is where the seller has the maximum leverage. Depending on how well the M&A advisor orchestrates the deal, this is when the acquirers perceive competition and do the best they can to get what they want. Once the LOI is signed, the leverage starts shifting and the longer the deal takes to close, the more leverage the PEG is likely to gain.

Ø  If the deal is a competitive deal, try to resolve as many key terms as possible before choosing which LOI to accept.

Ø  While LOIs in general are non-binding, there could be specific elements that are binding. Watch out!

Deal Terms

Ø  If at all possible, get a stock deal. The advantages are many and in most cases are well worth taking a lower valuation to compensate for the tax disadvantages of the buyer.

Ø  Whether a stock or asset sale, ensure that the M&A advisor and accountant work closely to make the deal as tax beneficial as possible. Tax issues could have a dramatic impact on what the seller gets to take home. So, leave no stone unturned!

Ø  For a stock deal, make sure there is a “basket” clause in the LOI to avoid being nickel and dimed on non-material post-close liabilities.

Ø  In a stock sale, get agreement to cap the potential post-close liability to a reasonable percent of the transaction value. This clause must be in the LOI because it can be much tougher to get it in the acquisition agreement once an LOI lacking it has been signed.

Ø  Watch out for financing conditions in the LOI. In today’s tight credit environment, financing conditions introduce a potentially risky and sometimes unacceptable delay to closure.

Ø  Be very cognizant of the debt, equity tradeoffs. Keep in mind that the seller is selling an equity share and not taking out a loan.

Ø  If possible, get a “non-reliance” clause to prevent the buyer from suing seller post-close based on oral statements and other things that are not part of the written acquisition agreement.

Ø  If possible, get the PEG to sign off on a termination or “break-up” fee if the deal falls through for any reason other than seller’s non-performance.


Ø  PEGs are extremely disciplined about the process. Sellers get emotional at their own risk! Emotions can be easily exploited so it is better to let the deal makers interface regarding deal points without exposing the seller’s emotions.

Ø  Without competition (or the perception of it), a PEG will seize the opportunity to exploit deal issues for monetary gain. As the deal draws out the PEG knows that the seller has already spent a considerable amount of time and money on the process and without competition for the deal the PEG has an upper hand.

Ø  If the deal is getting bogged down, brainstorm with the negotiating team and look for creative ways to get the desired outcome. It may be difficult to salvage a deal if the positions are too entrenched and/or emotions take hold. Creativity and objectivity are key ingredients to good deal making.

Ø  A PEG will have multiple members of their team working on the deal. Watch out for the good-cop, bad-cop routine. Without sufficient care, it is easy to end up making multiple concessions during the process without getting much back in return. Having the deal terms handled by an M&A advisor is an easy way to avoid this problem.

Ø  When dealing with multiple PEGs, keep in mind that each deal is different – different players, different negotiating leverage, different risks, and different timing. Strategize a plan specific to each PEG with the advisory team. Be keenly aware of the seller’s personal limitations, deal-breakers, and wish-list, and the amount of time and money that is being consumed in the deal making process.


While PEGs can be a boon for mid-market sellers, it is imperative that the sellers understand that they are dealing with a professional buyer. A good advisory team, careful preparation and negotiating skills are necessary to maximize the benefit. Sellers beware: One line in the contract can make the difference between a good deal and a bad deal.

Is Private Equity The Right Option For Your Business?

Tuesday, March 11th, 2008

What Private Equity Investors Look For In A Company


To understand what Private Equity Groups (PEGs) look for in a company, one needs to understand the meaning of Private Equity. So, what is Private Equity?

Private Equity is long-term, committed capital provided in the form of equity to help private companies grow and succeed. If your growing mid-market company is looking to expand, Private Equity could help. Private Equity could also help if you are trying to recapitalize the company, exit the company, or transition the company to new management.

Unlike debt financiers who require capital repayment plus interest on a set schedule, irrespective of your cash flow situation, Private Equity is invested in exchange for a stake in your company. After the equity infusion, you will have a smaller piece of the pie. However, within a few years, your piece of the pie could be worth considerably more than what you had before.

Private Equity investors’ returns are dependent on the growth and profitability of your business. If you succeed, they succeed. If you fail, they fail. PEG’s capital infusion and involvement have proven beneficial to companies and many companies have gone much further with Private Equity than they otherwise would have. PEGs will seek to increase a company’s value, without having to take day-to-day management control. In some cases, PEGs bring in their own management team and facilitate a management transition. Given the high amount of risk these investors incur, and the duration of their investment, PEGs invest in the business on the strength of the manager’s business plans, knowledge, trust and negotiations with him.

Generally speaking, unless a business can offer the prospect of significant growth within five years, it is unlikely to be of interest to a PEG. For some high growth companies and companies with limited “hard” assets, Private Equity may be the only option for capital.

However, Private Equity is not for every business. Private Equity may not be suitable for companies with limited capital needs, for companies with stable cash flow, or for companies with substantial hard assets. For these types of companies, debt financing may be a better alternative. Many small companies whose main purpose is to provide a good standard of living for their owners are also not suitable for Private Equity investment, as they are unlikely to provide the necessary financial returns to this type of investor.

Assuming the company is suitable for Private Equity investment, investors look at several criteria before providing the equity for your business.

Strong Management team

Unless the intended purpose of the equity transaction is management transition, the quality of the management team is by far the most important criterion for many Private Equity investors. Most investors do not invest in a company unless they are satisfied with the management team.

Growing Market Segment

The value added by Private Equity in many cases is their ability to grow the “pie” and in that context the growth potential in the target market segment is a very critical factor. PEGs also want to ensure that the company is well positioned to grow within the target market segment.

Realistic Growth/Expense Plan

Unrealistic planning will create a doubt in investors’ minds about the management’s business skills. Similarly, under budgeting for material, labor and equipment costs will reflect poorly on the management team.

Exit Route

The PEGs are in the deal for the long term but they need a workable exit to get their money back. The exit could be business sale, management buyout, IPO or something else. PEGs need to have the confidence that there is a clear, planned path to their exit.


Unlike debt, equity investment does not come with any overt security collateral. To mitigate risk, PEGs typically require a seat on the company’s board and a codified management plan to protect the PEG’s interest.

Contingency Planning

No business grows without hiccups. Understanding what could go wrong and putting contingency plans in place to deal with specific situations can go a long way in gaining a PEG’s trust.


PEGs check the business credit rating, the management team’s reputation, and enthusiasm and determination of the team before they invest. The best business ideas are not worth much without good people and PEG’s want to make sure that they are getting a strong, positive team with good marketplace reputation.

Good Rate of Return

When everything else checks out, it comes to terms. PEGs look for a good return for the capital they are risking on your venture. The return a PEG is willing to accept is a direct function of how desirable your deal is and how much competition exists for your deal.

In summary, PEG investors must be assured that the capital being deployed by them will yield the returns they are seeking. If the investment is considered worthwhile then there will be competition to do your deal. Competition often means you get a higher valuation, better deal terms for your company and more cash proceeds for you.

Financing Options For Mid Market Companies

Monday, March 10th, 2008

Debt Capital, Equity Capital & Convertible Debt


There are three basic types of funding options for mid market companies: debt, equity and convertible debt. In this article, we will discuss the trade offs of each of these funding options in the context of a mid-market company.

Debt Capital

Debt capital is money raised for a company that must be repaid over a period of time with interest. Debt financing can be either short-term or long-term. Unsecured debt is rare and lenders typically secure debt with assets of the company. This also means that service, technology, and other asset-lite companies have a hard time raising debt capital.

Common debt financers include banks, credit unions, finance companies, and credit card companies.

Advantages of debt capital

Ø  Raising debt capital, for profitable asset intensive companies, can be faster than raising equity capital.

Ø  Debt capital is typically cheaper than equity capital because the financing companies pick only the lowest credit risk companies and further secure their loan with assets.

Ø  The lender does not gain an ownership interest in the business and this allows the business owner to remain in the driver’s seat of the company without being answerable to investors.

Disadvantages of debt capital

Ø  The loan amount and the interest payments can saddle the balance sheet and income statement of the company.

Ø  Any downturn in the business or unexpected capital needs can make it difficult to make the interest payments and send the company into a debt induced downward spiral.

Ø  For some debt instruments, the terms can be complex and may onerously burden the business.

Ø  If the debt is personally guaranteed, liability will extend to non-business assets.

Ø  If the company gets into trouble, the debt financier could become adversarial.

Equity Capital

Equity capital is money raised by a business in exchange for a share of ownership in the company. Equity financing allows a business to obtain funds without incurring debt and without having the burden of associated interest/principal payments. For a growing company with cash needs and for companies with an erratic earnings stream, it can be a big advantage to not have to repay a specific amount of money at a particular time.

Equity capital can be public or private. Public equity capital is only available for large companies (revenues over a hundred million dollars). Two key sources of private equity capital for mid market businesses are Private Equity Groups (PEGs) and corporate investors. Other forms of private capital such as angel capital and venture capital, are typically not available to mid-market companies. Angel investors and venture capitalists provide funding to young, nascent private companies.

Equity investors can be passive or active. Passive investors are willing to give you capital but will play little or no part in running the company, while active investors expect to be heavily involved in the company’s operations. Investing in a company’s equity over a long term without any security collateral is inherently high risk. As a result of that, this form of capital typically comes with an active participation from the investors.

Passive or active, equity investors are typically patient, long term investors. These investors seek to add value in an effort to help the company grow and achieve a greater return on the investment. In return for their risk and participation, private equity investors usually look for a 25% or more return on investment, and put a number of checks and balances on the company’s operations to achieve their goals.

Advantage of Equity Capital

Ø  Lack of recurring principle/interest payments makes the business more able to cope with the ebb and flow of the business and increases the margin of safety

Ø  Corporation’s risk is shared with investors

Ø  Right investors can add significant value

Ø  Smooth transition option for business owners looking to ease out of the business

Ø  May be the only possible type of capital for rapidly growing and asset-lite companies

Ø  Equity investor is committed to the company until exit. If the company gets into trouble, the equity investor is likely to help with the turnaround

Disadvantages of Equity Capital

Ø  Owner answerable to investors and some loss of control

Ø  Can be more expensive than debt capital (albeit at a lower risk)

Ø  It typically takes longer to raise equity capital than debt capital

Ø  Deal terms can be complex. Without good deal making support, the company may unknowingly allow the investor to undervalue the company and take a disproportionately higher percentage of the company compared to the value of the investment made.

Convertible Debt

Convertible debt is a hybrid of debt capital and equity capital. Convertible debt typically involves favorable interest rates and other terms on the loan in return for the option to convert some or all of the debt into equity at predetermined price levels. Convertible debt instruments are complex and require a substantial amount of work on the part of the deal makers. There are many different variations of convertible debt available depending on the needed trade-off between debt and equity.

Convertible debt is more likely to be seen in distressed or high risk companies, and some investors specialize in distressed convertible debt. However, the flexibility of convertible debt makes it an attractive option in a wide variety of situations. This option gives the management maximum flexibility and is worth considering for larger mid-market companies.

2008: Exit Planning For The Year Ahead

Thursday, January 17th, 2008

2007 is over! That is a welcome relief for many business owners.  After several years of solid growth, 2007 has been a harsh year for business executives. Empirical evidence suggests that a vast majority of businesses have seen their revenues stagnate or decline in 2007.

For Business owners who were planning to retire or cash out of their business for other reasons, 2007 was tough. Business was soft, long term interest rates were near 5 year highs, credit was hard to come by, and liquidity levels were low. All of these translated into a very negative environment for deal making especially in the housing, construction and retail industries. Business owners who had their businesses on the market saw less than stellar business valuations and, in several cases, found that their deals did not close as planned. Several other business owners who were planning on exiting held back – unwilling to face a reduced valuation and hoping things would be a bit better in the not so distant future.

As we look into 2008, it appears that we have not seen the bottom in the economy. Does this mean business owners should delay their exit/recapitalization decisions until late 2008 or 2009? Not necessarily!

When evaluating the consequences of environmental trends on the business sale/recapitalization process, it is useful to keep in mind that the business sale/recapitalization process for a mid market business can take about 12 months. Most acquirers/investors look carefully at business performance as they navigate through the deal process and positive trends along the way can be helpful in closing a deal and in getting the terms sought by the shareholders.

Here are some key factors business owners need to take into account while planning exit/recapitalization strategies this year:

Ø  Economy: While we have not seen the bottom in the economy, some segments of the market are starting to pick up. Most construction related businesses continue to be in the doldrums, but the prognosis for several other business categories is getting positive. Based on the commentary we are hearing from industry sources, it seems likely that most businesses will end 2008 with more positive trends than what they are seeing now. These positive trends can be beneficial to companies and shareholders with near term plans to exit or to recapitalize their businesses.

Ø  Interest Rates and Liquidity: Long term interest rates are inching downwards and credit is expected to get better as the year progresses. Twenty out of twenty top economists in a recent national poll forecasted interest rates to go down in the near term. Lower interest rates not only improve liquidity, but also have an effect of making valuations higher. Acquirers are likely to find a higher valuation more acceptable in a lower interest rate regime when they can finance the deal and still meet the cash flow metrics needed. Lower interest rates, coupled with improved liquidity, make the chances of putting together winning deals a lot more likely.

Ø  Taxes: Unfortunately, selling a business with a gain means that a business owner has to pay capital gains tax or ordinary income tax on the gain. Since capital gains are taxed at a lower rate than ordinary income, a competent business M&A specialist attempts to structure much of the gains from the sale of the business as capital gains. In the last few years, business owners have been beneficiaries of a historically low 15% Federal Capital Gains Tax Rate.  With an impending new administration in the White House in 2009, most tax experts believe that the low 15% Capital Gains Tax rate is unlikely to stay at that level and there is a substantial risk of the rate being changed to something higher. The prospect of increased Capital Gains Tax should be carefully thought through in the context of the business exit/recapitalization process.

Ø  Deal Making Opportunities: Acquirers are a lot more likely to buy a business in a flat to upwards trending market than in a downward trending market. Deal making opportunities should become more abundant as the economic trends reverse through the year. Deal making opportunities are also likely to be aplenty if the business is in a growth oriented segment, or if the business is of a type that can be desirable to foreign companies. With the US Dollar being extremely weak, foreign entities are actively looking to make synergistic acquisitions. It is unclear how long the weak dollar will last but the prognosis is for the dollar to continue to be weak for the near term.

All things considered, early 2008 would be an excellent time for business owners to review their exit or recapitalization strategies and determine how to approach the business sale/capitalization process for optimum financial return.

Buyers Approach To A Stock Sale

Thursday, January 17th, 2008

Steps that acquirers need to take in a stock sale


In most small to mid market situations, it is advantageous for acquirers to structure the business acquisition transaction as an Asset sale. However, in some cases there may be significant advantage to going the Stock sale route. Also, asset sales may not be practical in some cases for contractual or other reasons. In such cases, acquirers need to pay special attention to three key factors:

v  Indemnification Agreement: Acquirer should get a bulletproof indemnification from the seller for any potential liabilities that may have occurred before the transaction closes but only surface after you close the deal. A stock sale without a proper indemnification agreement exposes buyers to potentially damaging legal and financial risk.

v  Seller Carry: Acquirer should get a significant amount of financing from seller as part of the deal. It is best to have this spread out over a period of few years so that you will have leverage in the event a claim materializes. The seller carry can come in handy if there is a lawsuit and the seller balks at keeping his end of the bargain.

v  Corporate Structure: The structure of the corporation being acquired may have significant impact on the tax status of the acquirer. If the acquirer owns one or more corporations prior to the sale, some post acquisition structural alternatives could significantly enhance the acquisition benefits.  These alternatives need to be reviewed carefully before the close for maximum leverage.

It is essential for acquirers to incorporate these key factors in any stock sale.

Stock Sale Vs. Asset Sale

Thursday, January 17th, 2008

An Overview of Tradeoffs


There are two primary ways of structuring the sale of sale of mid-market companies: Stock Sale and Asset Sale. This document compared the trade offs involved with each of these approaches. Acquirers should keep in mind that regardless of the tradeoffs shown below, asset sales may not be practical in some cases for contractual or other reasons. In such cases, stock sale is the only way to go.

Stock Sale Vs. Asset Sale Table


Asset Sale Stock Sale
Legal Risk No legal liability for the corporation prior to the purchase Legal liability for the corporation prior to the purchase can be mitigated if seller is willing to sign an indemnification agreement
Cash Flow Most of the assets purchased will be depreciable over 3-30 years with the average being approximately 10 years. This means that you may write off approximately a tenth of the purchase price every year. When you sell, you typically pay back the government for all the deductions you took.Advantage: Time value of money Low depreciable asset base means you do not get benefits of the excess depreciation you can take. On the upside, there is no depreciation recapture tax at the time of sale.
Governmental Administrative work to the extent you need to files Corporation, tax & employment application before the close of escrow. Corporation, tax & employment numbers & documentation in place – any changes can be done at a convenient time at your own pace.
Other Taxes Sales Tax on FF&E No Sales Tax
Employees Rehire employees – administrative hassle with hiring, benefits, payroll processing, etc. before the close of escrow Employee contracts continue. Any changes can me made at a convenient time and pace.
Workers Comp Workers comp rate could potentially be higher – sometimes significantly – you need to determine the impact and the net cost. Workers comp rates lower than yours? If so, you benefit from the lower cost and you may even be able to move some of your staff under this umbrella if it makes sense.
Customers May need to renew or renegotiate contracts Customer contracts likely to continue with minimum hassle
Vendors / Suppliers Re-establish contracts – negotiate transfer of leases and contracts – at the minimum you have administrative hassles and in some cases you may need to come up additional money for deposits. Vendor contracts continue. If any of the vendors offer superior services at better rates, you may move some of your existing business under the same umbrella.
Bulk Sale Need to conduct bulk sale in most cases – costs approximately $600 at current rates and takes about 20-25 days – this process delays the transaction. No need to do bulk sale – which means you close the transaction faster, cheaper and thus enjoying the benefits of the cash flow sooner. None of the creditors are aware of the transaction unless you choose to tell them.
Other Could consolidate book keeping, tax, and other regulatory filings with current entity to simplify operations. Need to continue the book keeping, tax, and other regulatory filings necessary to keep the entity in compliance.


Sellers and acquirers need to be aware that while several of these elements can be structured to the mutual benefit of both parties, some of the elements have less favorable impact to one of the parties and negations are necessary to structure a win-win deal.

Where it applies:

The intent behind establishing a type of sale (stock vs. asset) is to pick the most beneficial way to structure the transaction.

Structuring An Exit

Thursday, January 17th, 2008

An Overview of Tax Beneficial Strategies


There are several possible ways to structure a deal to suit the needs of a seller. This document summarizes some commonly used strategies and the associated trade offs:

Installment Sale

Installment sale is a simple strategy where a part of the sale price is deferred. The deferred amount is paid to the seller in several installments over a period of time.

Some variants:

v  Standard Installment Sale: Payments are spread evenly over a period of time.

v  Performance Based: Payment stream is tied to metrics agreed on by the buyers & sellers

v  Self Canceling Note: Payments are spread until the seller dies.


v  Smart way to structure a sale in special situations (ex: concentrated customer base)

v  Capital gains are deferred as payments are received

v  Self Canceling Notes pull the future interest of the asset outside of the estate


v  Risk of future payments

v  Capital gains rates may rise in future

Where it applies:

v  Seller has confidence in buyer to deliver on future payments

v  Buyer requires the structure due to economic uncertainties

v  Seller has captured most of the value in the upfront payments and does not mind risking the incremental money stream

Structured Sale

Structured sale is similar to an installment sale except that the payment stream is guaranteed by a third party


v  Capital gains are deferred as payments are received

v  Secured payment stream

v  Payment stream can be structured in a very flexible way


v  Capital gains rates may rise in future

v  Time consuming and expensive for buyer to setup

Where it applies:

v  Seller may need to substantially increase take-home dollars to make the sale happen. This tax advantageous method requires a motivated buyer to setup this plan.

1031 Exchange

Allows for a seller to roll equity and debt into a new property and defer the capital gains tax until some future sale


v  Capital gains deferral

v  Can move tax deferred dollars from active management to passive management


v  Limited time: 45 day to identify replacement property and 180 days to close

v  May not be able to find a desirable property

v  Capital gains rates may rise in future

Where it applies:

Excellent technique to defer capital gains assuming availability of good investment options

1042 Exchange

Complex exit strategy where privately owned stock can be exchanged for publicly traded stock. If a highly appreciated asset is owned by a corporate entity, shares of that entity can be sold and exchanged for shares of a listed stock.


v  Defer Capital gains tax. Exchange can be made with dividend producing Blue-Chip stocks


v  Capital gains rates may increase in the future

Where it applies:     

v  Might be applicable for business-owned assets that have appreciated in value

Charitable Trusts

v  This method is only applicable if the sellers have determined what they will leave to charity at death. It is possible to make a future gift to a charity in exchange for an income stream. This method allows for an income stream comparable to what is possible with direct sale of business. It is also possible to gift the income payments to charity and have the asset revert to the estate at death.


v  Charitable Organizations do not pay capital gains tax

v  Tax deduction that is some proportion of the value of the gifted property or asset

v  Asset is removed from the estate for purposes of estate tax

v  Asset and income stream are protected from judgments, liens and bankruptcy claims


v  The asset reverts to charity at death of the grantor(s)

Where it applies:     

v  When the seller has already decided on the amount of the estate that goes to a charity

Private Annuity Trust / Deferred Sales Trust

The capital gains benefits available with a Private Annuity Trust may be discontinued. In this method: Grantor(s) establish a trust, sells the asset to the trust and the trust sells the asset to the buyer. Trust makes installment-like payments to the grantor(s) over their lifetimes. Capital gains taxes are due as installment payments are made to grantor(s). At death of grantor(s), asset passes to beneficiaries.


v  Capital gains taxes are deferred and interest is earned on taxes not paid to government

v  Trust assets can be invested in almost anything. Grantor(s) have the ability to borrow money form the trust. Trust assets can be fully withdrawn as long as capital gains taxes are paid at time of withdrawal

v  Trust is held outside of the estate for purposes of estate tax and assets in trust are protected from judgments, liens and bankruptcy claims


v  The trust needs to have a third party trustee

v  Capital gains may rise in future, but the trust can be liquated as needed

Where it applies:

The intent behind establishing a PAT should be to exchange an asset for a lifetime income, to defer capital gains taxes or to avoid estate taxes or any combination