The M&A A to Z
Our glossary of the Mergers & Acquisitions terminology you’ll need to understand when you are selling your business.
100-Day Plan
An acquiror needs a strategic plan for integrating your company after the transaction is complete. This often takes the form of a 100-day plan, which will the acquiror will use to map out the key milestones for the crucial 100 days following the acquisition.
100-day plans vary in their style and level of detail, but some of the common elements include:
Cultural integration – understanding the culture of the acquired business and working towards alignment with the acquiror.
Communication and engagement – keeping employees, customers and suppliers informed about the progress of the integration.
Financial integration – bringing financial processes including management accounts and budgeting into alignment with the acquiror’s business.
Team structure – evaluating the leadership and management structure and understanding how responsibilities and reporting lines may change after the transaction.
Operational integration – looking for opportunities to optimise operations by using the capabilities of the acquiror in areas such as supply chain management, production, distribution and customer service.
Synergies – identifying opportunities to create value by sharing costs and resources, cross-selling to customers and making the most of complementary products, services and expertise.
Performance tracking – setting up new KPIs (key performance indicators) and reporting mechanisms to allow the acquiror to monitor integration progress and evaluate the success of the acquisition.
Adjusted EBITDA
EBITDA can be a helpful measure of a company’s operating profitability, because it excludes financing costs and non-cash accounting expenses.
Adjusted EBITDA goes one step further by making additions and deductions to EBITDA, to make sure it properly reflects the operating performance of the business.
For privately-owned companies, one of the most common adjustments to EBITDA relates to shareholders who do not pay themselves a market rate salary.
For example, imagine a company with EBITDA of £1m, where the CEO pays themselves a small salary of £20k, collecting the rest of their remuneration as dividends. For EBITDA to be a fair reflection of profitability, two adjustments are required:
- Add the £20k salary back to show EBITDA without the CEO’s salary.
- Deduct the estimated cost of paying a non-shareholder chief executive at market rates – say, £120k.
This means that the Adjusted EBITDA of the company is now £900k (£1m + £20k – £120k).
Other common adjustments include:
- Rent. If a company pays no rent because it owns its buildings, an imputed rent figure may be added into the Adjusted EBITDA calculation.
- Non-recurring and extraordinary expenses. One-off costs relating to things like restructuring, redundancies, or legal fees and settlements can be added back to EBITDA.
- Non-operating income or expenses. Profit that is not related to the operations of the business (for example, gains or losses on the sale of fixed assets or investments) should be adjusted for.
Advisors
Most business owners will use several different advisory firms to help them with the process of selling their business. The advisory ‘team’ typically includes lawyers, accountants, tax specialists and corporate finance advisors.
Vendors will usually have accountants and lawyers that they know and trust, who may have been working with the business for years. However, these existing advisors are not always the right choice to represent the business in a sale transaction. It’s important to appoint advisors with relevant M&A experience, who are comfortable working opposite the larger law firms that the buyer is likely to appoint.
Cash Free Debt Free
Acquirors of businesses will often make offers on a ‘cash free debt free’ basis. This means the purchase price offered is based on the enterprise value of the target company, excluding its cash and debt.
In simple terms:
- ‘Cash free’ means the buyer does not take possession of the target company’s cash reserves, which can be distributed to the seller.
- ‘Debt free’ means the buyer does not take on the existing debt obligations of the target company, which will need to be settled by the seller at completion.
Structuring an offer in this way allows negotiations to focus on agreeing the value of the operating business.
It is worth noting that the seller may be required to leave some cash in the company on completion, in order to cover the day-to-day cash requirements of operating the business. The ‘excess cash’ amount, which can be distributed to the seller, will be agreed during negotiations.
Commercial Due Diligence
Most acquirors will carry out some form of commercial due diligence, as part of their overall due diligence process. Sometimes the acquiror will carry out this work themselves, but often they will appoint a specialist commercial due diligence provider.
Commercial due diligence aims to give the acquiror a more detailed understanding of the target company’s market, competitive landscape, customer base, sales performance, products, marketing, and other commercial aspects of the business. The team or specialist firm carrying out the commercial due diligence may wish to conduct interviews with key managers and potentially with important customers. Customer interviews are usually carried out under the guise of a survey commissioned by the target company itself, in order to preserve confidentiality.
Completion Accounts
When an acquirer makes a formal offer to buy your business, the price is always linked in some way to your company’s financial performance. Whether the valuation has been based on the Net Asset Value shown on your balance sheet, or a multiple of your EBITDA, your accounts are the starting point for agreeing a price.
But once you have accepted a formal offer, the due diligence and completion process will take several months. During that time, your company will continue to trade and its financial position will change.
The end result is that the value of your business at completion will be different to the value at the time you received the original offer.
This creates some risks and uncertainties for both buyers and sellers.
One common way to manage this challenge is for the sale price of a business to be dependent on Completion Accounts – accounts that are specially prepared as at the date of completion.
To take a simplified example, consider an acquirer who agrees to pay 8x EBITDA for Company A. During the due diligence process, the buyer and seller agree a figure of £1m, as an estimate of Company A’s likely EBITDA for the 12 months to the completion date.
The buyer therefore pays the seller £8m at completion – 8x the £1m EBITDA estimate.
After completion, accurate Completion Accounts are prepared, based on principles stipulated in the final Share Purchase Agreement (SPA). The Completion Accounts Profit & Loss statement reveals that Company A actually achieved EBITDA of £1.1m. The buyer therefore owes the sellers a further payment of £800,000 (8x the additional £100,000 of EBITDA).
For the buyer, the main advantage of the Completion Accounts approach is that it reduces the risk of overpaying for a business. If the business does not perform as expected between the agreement of the offer and completion, then the price paid for the business is reduced accordingly.
The Completion Accounts approach also allows sellers to capture the benefit of any additional value they create between accepting the offer and completing the sale of the business. But it is also true that Completion Accounts create uncertainty about the proceeds that the sellers will receive. As mentioned above, if performance is poor in the run up to completion, the final sale price will be lower than the sellers had hoped for at the time of the offer.
An alternative to completion accounts is to use a locked box mechanism.
Corporate Finance Advisor
When selling your business, your corporate finance adviser is also known as the sell side advisor.
The role of the corporate finance advisor or sell side advisor is to support the sellers throughout the entire transaction process. The advisors work is usually broke into a few distinct phases:
Pre-sale preparation – working with you to get the business ready for sale, anticipating and where possible resolving any issues that could derail the sale further down the line.
Buyer research – the advisor will use their network and research tools to find potential acquirors for your business. Depending on the nature of your business and your goals for the transaction, this could include both trade buyers and financial buyers, such as private equity firms.
Marketing – the advisor will help prepare the financial model and supporting narrative that will be used to create interest from acquirors. They will then start a sales process, opening dialogue potential buyers, and organising meetings between your management team and interested parties. Confidentiality is crucial at this point, and a good corporate finance advisor will make sure the identity of your business is only revealed to acquirors who have shown serious interest in the opportunity.
Negotiation – the advisor will solicit offers from the parties who have expressed interest and negotiate the offers, to maximise the value of the deal and align the deal structure with your other objectives.
Due diligence and completion – guiding you through the due diligence process and navigating any challenges and obstacles that occur prior to completion.
Disclosure
Disclosure is a process that the sellers of a company go through with their lawyers during the later stages of a transaction. The objective is to disclose to the buyer any information that qualifies the warranties and indemnities contained within the Share Purchase Agreement. All of the disclosures are compiled in a disclosure letter, together with any supporting documentation.
For example, the Share Purchase Agreement may require the seller to warrant that the company is not the subject of any litigation. If in fact the company is currently going through litigation, details of the case would be included in the disclosure letter.
The disclosure process gives the seller an opportunity to set out all of the issues they are aware of that could be relevant to the warranties and indemnities, avoiding the need to add detailed qualification to the wording in the Share Purchase Agreement.
Discounted Cash Flow (DCF) Valuations
Discounted Cash Flow (DCF) valuation is a widely used method for valuing any type of investment, including the acquisition of a company.
The central principle is that the value of an acquisition target is equal to the value of all the cash flows that will be generated by that acquisition in the future.
A DCF valuation therefore requires a financial model that includes forecast cash flows for the next few years. The valuation also requires an assumption for what happens at the end of the forecast period. This will either be an estimate of the future sale price of the business, or an estimate of the growth rate that the business will achieve into the future.
Today’s value is then calculated by applying a discount rate to all the future cash flows, reflecting the fact that money received in the future is worth less than the same amount received today. The calculation a seller will use to arrive at a discount rate can be complicated. For simplicity, the discount rate can be thought of as the rate of return on the investment that the acquiror is aiming for.
DCF valuation is perhaps the most rigorous method of valuation that an acquiror can use. However, there are still a number of subjective inputs that mean DCF valuation is as much an art as a science. The accuracy of the valuation depends heavily on the accuracy of the target company’s financial projections, as well as the acquirors assumptions around the future growth or sale of the business beyond the forecasted period.
Because of these uncertainties, a DCF valuation will also usually include some sensitivity analysis, to show how the value of the business is affected by variances in the inputs and assumptions.
Due Diligence
Due Diligence is the comprehensive investigation and analysis of a target company that is carried out by the acquiring company. It takes place after the two sides have agreed and signed Heads of Terms.
As the seller of a business, the due diligence phase of the transaction process can place a lot of strain on you and your senior management team. It is an intense process requiring the collection and presentation of detailed information relating to every aspect of your business. And despite this heavy workload, you will also need to keep the business operating in line with your budget, to protect the sale price agreed at Heads of Terms.
The acquiror will typically appoint advisory firms to carry out financial due diligence, tax due diligence and legal due diligence. Depending on the nature of your business, there could also be additional specialist due diligence providers involved, covering areas such as technology, intellectual property, or environmental matters.
At Rockworth, we want our clients to go into the due diligence process with their eyes open, because there is no escaping that it can be exhausting. However, we also offer our clients extensive support and guidance, drawing on our experience to help clients strike the right balance with their provision of data in response to due diligence enquiries.
EBITDA
EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation.
In the world of M&A, it is the most commonly used measure of profitability for many types of business. This is because it is a quick measure of a company’s ability to generate cash from its operations.
Why exclude the costs of interest, tax, depreciation and amortisation?
Interest relates to the financing structure that a business has in place. An acquiror will usually make a ‘cash free debt free’ offer to buy the business, leaving the seller with responsibility for the debts and debt-like items within the company. The financing costs of the business are therefore of no interest to the buyer. That said, behind the scenes they will need to work out their own financing arrangements, which will be factored into the price they feel able to pay for the business.
Tax expenses will in some ways correlate with performance. However, tax is not an operational cost. And tax rules such as the carry forward of losses from historic periods can make the current year’s tax charge misleading.
Depreciation and amortisation are non-cash accounting adjustments which spread the cost of adding fixed and intangible assets over time. The cash flow relating to the purchase of the assets has already happened.
There are often further adjustments that need to be made to EBITDA, leading to an Adjusted EBITDA that fairly reflects the business’s operating performance.
It is also worth noting that EBITDA is not always the most appropriate profit measure to consider. For example, for companies with high levels of capital expenditure, depreciation is more relevant. The acquiror may look at EBITA instead, or build their offer around the value of the assets on the balance sheet.
EBITDA multiples
The value of a business is often expressed as a multiple of EBITDA, and it is common for business owners to wonder what multiple will apply to their company when they come to sell.
There are many variables that determine the appropriate EBITDA multiple for a business. To pick just a few examples, the EBITDA multiple for a given company will be affected by: the size of the business; the strength of the management team; the reliance on any departing shareholders; the strength and diversification of customer relationships; intellectual property; barriers to entry; profit margins; market trends; credible expectations of future growth; and the visibility of future revenues.
In short, multiples are dragged down by risks and uncertainties and pushed up by opportunities and strengths.
Business owners often ask us what multiple applies to their industry. Although average EBITDA multiples (based on real transactions) for different industries can be found online, it is overly simplistic to assume they apply to any given business within that industry. An average of 5x may conceal a range from, say, 2x to 10x. What a company really needs to know is where it sits within that range, which will depend on variables like those described above.
That said, it is true that the intrinsic nature of certain industries means that companies can command higher multiples. For example, Software-as-a-Service businesses have recurring revenue models and ‘sticky’ customer relationships. This makes future revenues more predictable and creates a solid platform for growth, driving up valuation multiples.
Earnout
The value of a business depends on its ability to generate cash for the acquiror in the future. So the total price that an acquiror pays for a business will factor in the future expected performance of the business.
To manage the risk that the business does not perform as expected after the acquisition, acquirors often aim to split the cost of the business between initial consideration (paid at completion and sometimes referred to as ‘day one cash’) and an amount to be paid at a future date, linked to the post-transaction performance of the business. This future payment is known as an earnout.
Sellers prefer to maximise day one cash and not have a portion of their sale proceeds vulnerable to future underperformance. But a carefully negotiated earnout can align the buyer’s and seller’s interests. By staying with the business to deliver the projected profits, the buyer has an opportunity to realise the full value of the company. Meanwhile, the buyer has the comfort that the seller is highly motivated to achieve the growth projections their offer was based on, and the protection of paying a reduced total price if the company falls short of those projects.
Excess cash
Successful, cash-generative businesses often build up cash reserves on their balance sheet over time.
Most deals are completed on a cash free debt free basis, allowing the seller to benefit from those cash reserves. During negotiations, the acquiror and the vendor will agree a cash balance that needs to remain within the business to service day-to-day operating expenditure. The remainder of the cash balance is known as excess cash, and can be added to the total consideration for the transaction.
Fireside Chat
Like all the best industry jargon, the use of ‘Fireside Chat’ persists because the phrase is intuitive. It simply refers to an informal meeting between a vendor and a potential acquiror. Fireside chats are an opportunity to talk at a high level and assess the potential strategic and cultural fit, before progressing to a more formal management presentation.
Heads of Terms
In an M&A context, the Head of Terms (sometimes simply called the Heads) is a document which sets out the key terms of an offer to acquire a business. The document is prepared by the acquiror and then subject to negotiation prior to signature by both parties.
The Heads of Terms do not legally commit the buyer to going through with the transaction, or prevent them from revising the terms of their offer later on in the process. Rather, the document makes sure that the two sides have a shared understanding of all the key issues relevant to the transaction.
As well as standard legal issues (such as confidentiality and governing jurisdictions), common areas agreed in the Heads include:
- Purchase price, including the amounts and conditions attached to any earnouts or deferred payments.
- The exclusivity period, during which the seller agrees to cease discussions with other interested parties.
- The scope and duration of the acquiror’s planned due diligence process.
- Any ‘conditions precedent’ that need to be fulfilled for the acquisition to complete. This could include regulatory approvals, resolution of legal or tax issues, etc.
- An outline of the approach to warranties and indemnities.
- An outline of any ‘restrictive covenants’ that will restrict the seller’s ability to start or join a competitive business in the period following the transaction.
Signing Heads of Terms is a major milestone in the sale process, which will be followed by due diligence.
Alternatives to Heads of Terms include Memorandums of Understanding, Letters of Intent and Non-Binding offers, all of which serve similar purposes.
Information Memorandum
The Information Memorandum (sometimes called the Confidential Information Memorandum) is a detailed document usually prepared by a seller’s corporate finance advisor. The document is shared with potential acquirors during the transaction process, in order to give them a thorough understanding of the target business.
Common components of the Information Memorandum include:
- Executive summary: A concise introduction to the company and the acquisition opportunity.
- Business description: A detailed description of the company’s products and services, market position, competitive advantages, key differentiators and potential for growth.
- Financial information: Summary historical profit & loss accounts, balance sheets and cash flow statements, as well as projected financial performance (usually for the next two or three financial periods).
- Market analysis: More information on the market dynamics of the industry the company operates in, including factors such as market size, growth trends, customer demographics, competition and market share.
- Management team: The skills, experience, track record and roles of the senior leadership team.
- Legal and regulatory matters: This section could include information about intellectual property, licenses, permits, regulatory permissions, and contracts, as well as covering any history of litigation or potential legal risks and uncertainties.
The downside of using Information Memorandums as part of the sale process is that you will inevitably share detailed and sensitive commercial information with a number of parties who do not eventually become the buyer of your business.
At Rockworth, we favour an approach to selling businesses that does not involve production of an Information Memorandum. If you would like to know how we do this, please get in touch.
Indemnities
See warranties and indemnities.
Letter of Intent
See Heads of Terms
Locked Box
When an acquirer makes a formal offer to buy your business, the price is always linked in some way to your company’s financial performance. Whether the valuation has been based on the Net Asset Value shown on your balance sheet, or a multiple of your EBITDA, your accounts are the starting point for agreeing a price.
But once you have accepted a formal offer, the due diligence and completion process will take several months. During that time, your company will continue to trade and its financial position will change.
The end result is that the value of your business at completion will be different to the value at the time you received the original offer.
This creates some risks and uncertainties for both buyers and sellers.
One common way to manage this challenge is to use a ‘Locked Box’ mechanism (the other common solution is to use completion accounts).
A locked box offer is based on the target company’s financial position as at the date of the offer, factoring in an accurate assessment of all line items on the P&L and Balance Sheet, including cash, debt and working capital.
After the offer is signed, the business continues to trade (and remunerate its employees and shareholders) in the normal way. But the performance of the business between signing the offer and the completion date will not alter the agreed sale price, which is written as a fixed amount in the SPA.
This mechanism means that the buyer bears the risk of a downturn in performance, but also stands to benefit from any additional value that may be created prior to completion. The buyer will protect its position by adding ‘leakage’ clauses to the SPA, designed to prevent the seller from releasing money to themselves outside the normal course of business.
A locked box agreement is often combined with a ‘profit ticker’ to keep track of the profits between Heads of Terms and completion.
Memorandum of Understanding
See Heads of Terms
Non-Binding Offer
See Heads of Terms
Post-Completion Plan
A post-completion plan is a buyer’s strategy for handling the integration of the acquired business during the crucial early months following the transaction. See 100-Day Plan for more information.
Profit Ticker
A profit ticker keeps track of the profit generated by your business between agreeing Heads of Terms and completion of the sale. It is often used together with a locked box mechanism.
The ticker is best thought of as an additional payment, which shifts back to the seller the benefit of profits generated between signing an offer and completing the deal.
Depending on the nature of the business, tickers can be calculated using management accounts to arrive at a profit-after-tax or cash generated figure. Alternatively, it may be appropriate to simply agree a daily amount that is added to the purchase price every day until completion.
Buyers are generally happy to agree a profit ticker, since it keeps the sellers motivated to maximise the performance of the business prior to the completion date.
The Share Purchase Agreement is the legal contract between the acquiror of a business and the vendor. Like any contract, it sets out the rights and obligations of the parties to the agreement.
The Share Purchase Agreement is the focus of negotiations following Heads of Terms. The document is passed back and forth between both sides’ lawyers, and will normally go through multiple ‘turns’ before a final version is agreed. Your corporate finance advisor should be closely involved in the negotiation of the Share Purchase Agreement, particularly in relation to any clauses that relate to the consideration and the deal structure.
Share Purchase Agreements are long documents covering every aspect of the sale agreement including:
Purchase price – details of the price agreed for the shares, including any adjustments (such as working capital adjustments) and the conditions and timing of any deferred consideration (such as earnouts).
Warranties – assertions about the present state of the company which, if they prove to be untrue, would allow the buyer to make a claim against the seller.
Covenants – commitments made by the buyer and the seller, covering matters such as the operation of the business prior to completion of the transaction, non-competition clauses, and confidentiality clauses.
Indemnification – the Share Purchase Agreement outlines the procedures, responsibilities and liability limits that will apply to any losses that may arise after the transaction completes. The goal is to allocate the risks of both known and unknown liabilities between the buyer and the seller.
Completion and post-completion obligations – clauses governing the mechanism for the transfer of shares, the payment of the purchase price, and any other post-closing obligations such as the delivery of specified documents.
A teaser is short document that provides an overview of a business, usually without naming the company. It normally includes a description of products, services, markets, customer base, financial performance and growth opportunities.
Some corporate finance advisors send teaser documents to potential acquirors of businesses they are trying to sell. The objective is to see if the acquiror is interested enough in the opportunity to sign a Non Disclosure Agreement (NDA) and receive more information.
At Rockworth, we believe there are some potential downsides to teasers, so we avoid using them whenever possible. The main problem is that potential acquirors who know the relevant industry well may be able to guess the identity of the business, even though the information in the teaser is limited. This could lead to news or speculation that the business is for sale filtering through to competitors, customers and suppliers.
Instead of sharing teasers, we preserve confidentiality for our clients by having exploratory conversations with potential acquirors. Our objective is to understand the extent to which our client’s business fits with the acquiror’s appetite and strategy for acquisitions. We then only proceed to the NDA stage with acquirors who have given us good reasons to believe they are sincerely interested in the opportunity.
Warranties
Warranties & Indemnities
One of the purposes of the Share Purchase Agreement is for the buyer to make sure that the seller is responsible for the state of the business at the point of completion and to protect against the risk of future liabilities as much as possible. This is achieved using warranties and indemnities.
Warranties are statements agreed to by the seller regarding the state of the company at the point of completion. The buyer may require warranties relating to every aspect of the business, including tax, litigation, employee issues, stock, customer relationships and more.
Indemnities are provisions that are designed to allocate the risk of post-transaction losses between the buyer and the seller. The seller will be required to commit to covering the costs of certain future losses that could occur through no fault of the buyer. For example, the seller may indemnify the buyer against losses resulting from any litigation that relates the company’s conduct in the pre-completion period.
The Share Purchase Agreement will normally include a number of warranties and indemnities that the seller cannot easily agree to. This is resolved through the disclosure process.
Working Capital Adjustment
A company’s working capital position is crucial to its ability to finance its day-to-day activities. In accounting terms, it is defined current assets less current liabilities.
Common current assets include stock, debtors and prepayments (cash is also a current asset on the balance sheet, but it is often treated separately from the working capital calculation in a Mergers & Acquisitions context). The most common current liabilities are creditors and accruals for expenses incurred but not yet paid.
When a business is acquired, the vendor will expect the working capital left in the business to be sufficient for the continued normal operation of the business. In the course of negotiations, the buyer and the seller will agree a working capital target for completion day. The basis for this target will vary depending on the nature of the business, but it is often based on the average month-end working capital for the past 12 months.
On completion day, the consideration will be increased by the amount of any uplift in working capital above the agreed target, or decreased by the amount of any reduction.
This gives the buyer confidence that the business will have the necessary level of working capital after the transaction completes. It also means that the seller is not incentivised to run the business in an abnormal way leading up to completion. For example, without a working capital adjustment, the seller could be motivated to artificially build cash reserves by reducing stock levels.