(last updated May 2021)
Many of these FAQs are applicable to all types of acquisition deals, but this is primarily aimed at sellers of private companies who are unfamiliar with the company sale process. It’s hard to be comprehensive about M&A, which has more moving parts than the typical business deal, so these FAQs don’t address all issues that may come up. (Though I guess there’s a reason they call it FAQs and not AAQs.)
The usual stages for the sale of a company are as follows:
- Preliminary steps: determine valuation, prepare for responding to due diligence, identify buyer;
- Execute non-binding term sheet/letter of intent;
- Due diligence;
- Negotiate and execute acquisition agreement;
- Satisfy closing conditions; and
Often a buyer is already known to the seller, such as a competitor in the same industry. If a seller is starting from scratch, the typical move is to engage a business broker to match the seller with potential buyers. The broker is usually compensated with a commission of a percentage of the eventual sale price. In a situation where there are multiple potential buyers, the seller can conduct an auction, with the bidders submitting proposed purchase price and other deal terms.
The seller should engage an appropriate experienced firm to do a valuation, which may or may not be the seller’s usual accounting firm that does taxes. Valuation is both art and science, and as a result, the buyer may assign a much lower valuation to the target company than the seller. If the parties are at an impasse about this, one way to bridge the gap is to incorporate an “earnout” in the deal terms. In other words, the seller will get paid based on the lower valuation at the closing of the deal, and then the performance of the company after closing will be measured to see if the seller’s optimistic view pans out over time, in which case it will receive additional payments reflecting a higher value. The parties should consider, however, that earnouts can be the source of disputes – sellers can claim that the buyer didn’t run the business correctly during the earnout period, for example – and typically a seller doesn’t want to have to think about the sale process after closing too much if it can be avoided.
Additionally, the deal structure may involve a working capital adjustment, where the parties agree on a certain “target” amount of funds required to operate the business to be available to the buyer, and there is an adjustment after closing to the extent the actual number at closing turned out to diverge from the target.
M&A deals are typically kicked off with the negotiation of a short letter of intent or term sheet, which allows the parties to see if they can tentatively agree on the basic deal terms before continuing in earnest with the more time-consuming and expensive process of drafting definitive documents and doing full due diligence. The key deal terms in the term sheet are usually non-binding, though that doesn’t mean you shouldn’t care what’s in it. If you’re ultimately going to insist on something very different from what’s in the term sheet when you get to the definitive documentation stage, you’ll need to give a compelling reason for doing so, or the other party may conclude you’re negotiating in bad faith and break off negotiations. A few provisions in the term sheet are usually binding, such as confidentiality and exclusivity, which basically means that the seller agrees to negotiate exclusively with the buyer for a set period of time (say, 60 days) and see if they can complete a definitive agreement before giving up and perhaps trying with another potential buyer.
Almost all deals entail some level of due diligence investigation of the target company by the buyer. (And there can be the reverse, with the seller doing due diligence on the buyer, if the seller is receiving stock in the buyer as payment of the purchase price and needs to understand what it’s getting.) Typically, the buyer sends a broad request to the seller for documents relevant to the buyer, in categories such as financial, legal, intellectual property, tax returns, etc., and then the buyer and its legal and financial advisors do their review. The results of that review could ultimately lead to a renegotiation of the purchase price or a different structure for the deal. The representations and warranties by the seller in the acquisition agreement work hand in hand with the due diligence process by forcing the seller to confirm the accuracy of various statements about the target company, with financial consequences for being wrong.
In any deal, the buyer can take effective control of the target company’s business either by acquiring the stock or other equity interests in the target company or by purchasing the assets of the target company, leaving that company with no assets after closing other than the purchase price, which can then be distributed to the owners of the target company. Generally speaking, a buyer will prefer an asset deal, because it can agree to purchase the relevant assets without having to assume some of the liabilities of the target. If the buyer purchases the stock, it takes effective control of all the company’s assets and liabilities. However, even with a stock deal, the acquisition agreement will contain provisions to compensate the buyer for issues that arise as a result of the company’s liabilities, so there is less of a substantive difference between the two structures than it may seem. Also, there may be tax or other reasons to structure a transaction in one way or another.
Broadly speaking, the buyer can pay the sellers for the target company either by paying cash (not literally a suitcase of Benjamins, usually, but by wire transfer) or by issuing stock/ownership interests in the buyer itself. Some or all of the payment of the purchase price can be deferred to a time after closing, discussed in more detail below. Consult with your tax advisor, but being paid in stock makes it more likely that the transaction can be structured to be tax free, meaning that the seller doesn’t have to pay taxes on receipt of the stock in this transaction, though it will eventually have to do so upon sale of the stock it receives.
The name of the definitive agreement for the deal will depend on the structure. If it’s an asset deal, it will be called an Asset Purchase Agreement. If it’s a stock deal, there are different possibilities. If the buyer is directly purchasing the stock/membership interests from the sellers, it will be called a Stock Purchase Agreement or Membership Interest Purchase Agreement. If the deal is structured as a merger, it’s called a (you guessed it) Merger Agreement. There are usually other supplemental agreements and documents, such as a Bill of Sale in an asset deal or Employment Agreements for sellers continuing in the business post-closing, which the lawyers call “ancillary” documents.
Yes, often some portion of the purchase price is not paid at closing, but will be paid later. Sometimes, the buyer will deliver a promissory note to pay the purchase price to the seller over time, using the proceeds from the operation of the business after closing. This is known as seller financing, because effectively the seller is acting as a lender to the buyer to cover the purchase price. The seller will need to consider the risk that the buyer doesn’t do such a good job with the business and thereby defaults on the loan. This risk wouldn’t be present if the buyer can pay in full up front or can get financing from a bank or another third party. Another form of deferral of the purchase price is a holdback of a portion of the price to be placed in an escrow account to satisfy potential claims (more on that below).
While part of a seller’s motivation for unloading a company is to avoid having continued risk of losses associated with the business, it is customary for sellers to assume some potential liability for breaches in the representations and warranties that they make in the acquisition agreement, or breaches of covenants in the agreement, if the buyer identifies these breaches during a limited period after the closing. The potential liability is usually capped at a certain percentage of the sale proceeds received in the acquisition, though there are exceptions such as fraud committed by the seller, where there shouldn’t be a cap. Often a percentage of the purchase price is held back at closing and put in an escrow account for the period during which the buyer can bring a claim for a breach (known as the survival period). After the expiration of the survival period, if there have been no claims, the seller gets the funds. Alternatively, rather than forcing the seller to pay for any damage caused, the parties can arrange for representations and warranties insurance, where an insurer would pay out any claims, though of course this comes at a cost (the insurance premium).
Indemnification is the procedure by which post-closing claims are brought against the other party and the aggrieved party is compensated. Typically, an acquisition agreement will provide for reciprocal indemnification, meaning that each party must indemnify the other if particular circumstances are met, but indemnification by the seller is more likely to be relevant since it’s the seller is making the detailed representations and warranties about the target company’s operations in the agreement that the buyer is relying on in making its purchase.
Sometimes. Unless the acquisition agreement is drafted to have signing and closing occur simultaneously, the agreement will contain provisions that allow the agreement to be terminated prior to closing, either by mutual consent of the parties, or by one of the parties alone under particular circumstances. Every agreement that contemplates a later closing contains closing conditions, such as obtaining governmental approval of the transaction if applicable, or third party consents relating to the target company’s agreements. The agreement will, for example, provide that the buyer can terminate the agreement prior to closing if a closing condition that is in the seller’s control does not happen within a particular time frame.
Not a lot from the perspective of the non-lawyers, as the parties usually don’t schedule a closing unless they’re pretty comfortable that all the closing conditions set forth in the acquisition agreement have been satisfied. The days of in-person closings in a conference room with accordion-style racks of folders were pretty much gone, even before Covid. Instead, the parties work off of a closing checklist, and the attorneys send each other the remaining items required to be signed, such as a certificate by each party confirming that its representations and warranties made in the agreement remain true as of closing. And of course, if there is money to be exchanged at closing, there is a wire transfer. At that point, while I’d love to say there’s nothing to ever think about again regarding the deal, there’s the possibility of post-closing indemnification, earnout calculations, working capital adjustments, etc., as described above.