Glossary of Mergers & Acquisitions (M&A) Terms
M&A is a specialized profession with its own terminology. As an “outsider” (a buyer or seller of a business that doesn’t have a lot of experience in the M&A arena), jargon can be annoying. We try hard as M&A brokers to not confuse our clients. That said, using certain terminology is unavoidable – it’s part of the process. And, sometimes it’s efficient to use specialized terms.
So, to let you behind the curtain, we put together the list of M&A terminology below. We tried hard to make these definitions simple (not brief since we want them to be something more than textbook definitions – to be helpful to you if you’re buying or selling a business, but not themselves filled with jargon).
A basket (also called a tipping deductible) is a threshold under which a party to an M&A transaction, usually the seller, is not required to pay for a loss (a “loss” is any type of expense, cost, claim, damage, etc.) that a buyer or seller (usually the buyer) incurs, where the loss is one the seller would typically need to pay. Think of a basket like a deductible. Your insurance company doesn’t pay the first $100 or $500 of damage to your car if it’s in an accident. It’s the same thing. Unlike a true deductible, however, once one or more losses exceed the limit of the basket (individually or when adding up multiple losses), the seller has to pay for all the buyer’s losses, from the first dollar. M&A lawyers coordinate the negotiations of basket at the time we’re negotiating a final purchase agreement. Baskets vary, although it’s common for us to see baskets in the general range of .25%-1% in the deals we work on in the Texas market (i.e., $2,500 – $10,000 on a $1 million M&A deal). The idea behind a basket when you’re buying or selling a business is that sophisticated parties who take a little risk buying a business shouldn’t be looking for small, immaterial breaches and sending a small invoice back to the seller isn’t very efficient.
What is a cap? A cap is a great friend to the selling business owner. It is a ceiling on the total amount of losses a seller could be required to pay/reimburse a buyer. The seller wants a low cap on the deal and they should ask their M&A lawyer to make the purchase agreement clear that any loss the buyer incurs that can be put back to the seller for payment should be limited to cap. The buyer’s attorney will generally want, at the very least, to carve out (make exceptions to the cap) for losses related to fraud or purposeful wrongdoing (intentional misconduct), although those aren’t easy things to prove. With a cap, the seller can rest easier at night after the closing. In Texas, it’s common to see caps in the main street part of the market (M&A deals for businesses selling for less than $2 million) in a range between 20% – 100% of the purchase price.
What is a data room? A data room is a physical room or a website that contains information, including documents, contracts, and financial statements, of the business being sold. When Brett (one of our owners) first started in the M&A industry in the 1990s, these were always physical rooms that were well-managed to be certain no information or documents ever left the room without the attorneys knowing. And, no one could come in without the seller’s knowledge. The seller is cautious of the information they let out into the world. Today, physical data rooms are fairly rare. Instead, data rooms are online. They’re often called virtual data rooms. They can be as simple as a secure network of folders on Dropbox or Box, which are online document storage providers. Or, there are more sophisticated software solutions in the market, including SaaS (Software-as-a-Service providers), Intralinks and Firmex. Online data rooms are able to track who views the documents and they may or may not allow documents to be freely downloaded or printed.
What is a deductible? A deductible is similar to a basket – it’s a threshold (minimum amount) applied to losses a buyer or seller incurs for which it believes the other owes them indemnification. Generally, it’s the seller (if anyone) who will owe the buyer reimbursement of an expense, defense of a lawsuit, etc. If a deductible is $25,000 and the buyer believes the seller breached one of the representations and warranties in the purchase agreement, but the breach resulted in damages to the buyer of only $20,000, the buyer is not able to require the seller to pay for that loss. Once the buyer experiences one loss or, if there are multiple losses, many losses together that exceed the deductible, the seller is obligated to pay for losses to the extent they exceed the deductible (unlike with a tipping basket, where the seller would need to pay for all the losses, from the very first dollar, once the basket is exceeded).
What are disclosure schedules (aka, seller disclosure schedules)? Seller disclosure schedules are another friend to a business owner who is selling their company. The disclosure schedules are a document that lists certain information and, in some cases, exceptions to the representations and warranties the seller gives to the buyer in the purchase agreement. When a seller lists an item as an exception, in most cases it functions like a free pass and enables the seller to shift any responsibility for the disclosed item to the buyer, hence why these are so helpful to a seller. A representation and warranty may generally state there is no litigation involving the business. If there is, the representation will refer to a schedule that lists the litigation. Like this:
Except as listed in Schedule 4.8 of the Disclosure Schedules, there are not now, and in the past five years there have not been any, suits, actions, proceedings, investigations, arbitrations, mediations, claims and orders made, filed or otherwise initiated in connection with Seller in the past five years and the resolution thereof. Seller is not subject to any judgment, order or decree of any Governmental Authority.
What is due diligence? Due diligence is the process of the buyer “kicking the tires and looking under the hood” to confirm what they think they’re buying is what they actually are buying. Due diligence, for the seller, can feel like a root canal. And sometimes it seems to go on and on. It starts with the seller giving the buyer access to its important documents – financials, corporate governance documents (e.g., articles of incorporation/certificates of formation, bylaws, operating agreements or other partner/founder agreements, meeting minutes and resolutions of the board of directors/shareholders/ managers in an LLC/etc.), key contracts, customer lists, leases, human resource policies and procedures, files regarding disputes and litigation, and more. This information and all the documents are delivered to the buyer in a secured manner through the data room. When you’re performing due diligence as the buyer, ask for everything you possibly need to see to say “yes” to closing the purchase. When you’re the seller, keep in mind that the buyer doesn’t really know much about your company. The buyer is taking a huge risk. Be organized, candid, and understanding. I promise, due diligence ends.
An earnout is a deal structure where the seller can earn future payments based on certain milestones or performance of the business being sold after the closing. These payments become part of the purchase price. Earnouts are used to share risk and sometimes to encourage sellers to remain engaged and working for the business after the closing for a long enough period to smoothly and successfully transition the business to the buyer. Earnouts can be based on time, including the seller or certain executives or owners of the seller – working for the buyer for a certain number of years after the closing. Often earnouts are based on earnings (sometimes this seller discretionary earnings (SDE) or earnings before interest, taxes, depreciation, or amortization (EBITDA) or revenue targets. Understandably, sellers generally want all their money at the closing table. If you’re a seller, though, consider the earnout a valuable tool to help bridge a difference of opinion about the value of your business. Sometimes an earnout is the only way to realize the full purchase price you’re seeking and, for certain businesses that carry significant risks (e.g., a large portion of revenue coming from one key customer, the business being highly dependent on a charismatic owner, etc.), sometimes structuring the deal with an earnout is the only way a buyer will purchase the business.
What is indemnification? Indemnification is a contractual obligation to pay for the losses and expenses of another party to a contract. “Losses” is usually broadly defined to include all sorts of losses, expenses, demands for payment, even often obligating the party who is required to provide indemnity to pay for the legal defense of an indemnified party who is named in a lawsuit. The obligation to provide indemnification is triggered in different ways. One is if a party breaches their representations and warranties. Another comes up in the context of “your watch, my watch,” which is the typical standard for an M&A deal structured as a sale of a company’s assets (as opposed to a sale of its stock or a merger). If a loss arises, even after the closing, but it relates to activity of the business pre-closing, the seller will likely be required to indemnify the buyer for the loss.
Knowledge is a key term in the M&A context, especially when it comes to the representations and warranties . Knowledge comes in two main varieties – actual knowledge and constructive knowledge. Constructive knowledge includes, not just what a party actually knew at the time they made a representation or warranty, but what they should have known if they were keeping your eyes open. Many representations and warranties are qualified by knowledge. For example, a representation and warranty in a stock purchase agreement from one of our recent deals reads:
To Seller’s Knowledge, Seller has all licenses and permits required to conduct its business under applicable Environmental Laws. All such licenses and permits are valid and current and are listed in Schedule 3.14, and no revocation, cancellation, or withdrawal therefrom has occurred or, to Seller’s Knowledge, been threatened. In the three years prior to the Closing Date, Seller has complied, in all material respects, with applicable Environmental Laws. There is no pending nor, to Seller’s Knowledge, threatened Environmental Claim against Seller or involving any Seller Real Property.
Letter of Intent
What is a letter of intent? Letters of intent (LOIs for short) are also called Term Sheet or Heads of Terms, although generally in mergers and acquisitions, it’s simply an LOI. The LOI is a document that lays out the key terms of the deal – the purchase price, what the buyer will purchase (e.g., the stock of the business, the assets of the business, etc.), if the seller will be employed by the buyer after closing, the closing date, any key conditions to the closing, etc. LOIs are typically non-binding except for a few key sections, including confidentiality and exclusivity. Confidentiality may already be handled by a nondisclosure agreement, although, if there isn’t a signed NDA or sometimes just as what we call “belt and suspenders,” the buyer and the seller add language that says the buyer will not disclosure any confidential information the seller provides to the buyer during due diligence. The exclusivity clause is extremely important to the buyer. The exclusivity clause prohibits the seller from shopping the deal around and talking to other possible buyers for a certain amount of time (generally 90 days). The buyer almost always requires this before they start investing significant time, money, and energy in due diligence and work toward closing an M&A transaction.
Lower Middle Market
The Lower middle market refers to M&A deals of approximately $2 million (“main street”) to $50 million. As with the term, main street, different M&A professionals (lawyers and business brokers) use slightly different numbers to define the lower middle market, although this is a common range. Generally speaking, main street deals are handled by business brokers, whereas investment bankers work on larger deals. However, the categories and cutoffs are not bright lines, and, for example, a stock purchase for $49 million is handled no differently than the same deal for $51 million. The distinctions between how main street deals get done vs. deals in the upper part of the lower middle market is more pronounced, although to some extent, a deal is a deal.
Main street refers to M&A deals of $2 million and under. M&A advisors, business brokers, investment bankers, M&A and corporate lawyers may use a different cutoff amount, although in our experience $2 million is common.
Non-disclosure Agreement (NDA)
What is an nondisclosure agreement (NDA)? An NDA is a Confidentiality Agreement, which is generally signed before the seller provides detailed, sensitive information about its business to a prospective buyer. The NDA prohibits the buyer from sharing confidential information of the seller except with its professional advisors who need to know the information for purposes of evaluating and closing an M&A transaction. The NDA typically terminates in connection with, or is superseded by, the purchase agreement.
What is a non-compete? A non-compete is an agreement given by the seller and any executives/owners of a seller in favor of the buyer. It prohibits the selling parties from competing with the buyer after the closing. To be enforceable, a non-compete agreement needs to be limited in three ways – by time, geography, and scope of activity. What is a reasonable limit in each of the three categories will vary depending on the business. The general theory behind restricting a non-compete agreement is that the buyer doesn’t have a reasonable justification to prevent the seller from working anywhere in the world on any type of business, but rather only competing with the specific business the seller sold to the buyer and in whatever geographic areas where the business operates. In the U.S., we like free trade. We don’t like it to be restricted. But, courts recognize that a purchaser who buys a business is buying certain goodwill and customer relationships. If the seller could turn around the day after the closing and steal all the customers back, there would be a lot fewer M&A deals done! For a single location restaurant, competition will be compartmentalized to a small geographic area – maybe within 25 miles of the restaurant location or something like that. For a software-as-a-service (SaaS) company that sells its solutions worldwide, a court might enforce a worldwide restriction on competition for some amount of time. In Texas, it’s common to see 2-5 years on the time restriction. We’ve seen as high as 10 years, although we wouldn’t expect most courts in Texas to enforce that length of time, absent some very unique facts.
What is a purchase agreement? An M&A purchase agreement is the contract that lays out all the specifics of the transaction and the rights and obligations of the buyer and the seller. It has all the details of the deal – from the purchase price to what’s being sold to what’s not being sold to the representations and warranties on which the buyer is relying to agreements of the buyer and the seller post-closing. Purchase agreements are more specifically named after the structure of the deal — asset purchase agreement, stock (or share) purchase agreement, or merger agreement. In our experience, in the main street and lower middle market portions of the M&A arena, asset purchases are most common.
Representations and Warranties
What are representations and warranties? Representations and warranties (also called just “reps & warranties”) are statements of fact – past or present, typically written into an asset purchase agreement, stock purchase agreement, or merger agreement to inform the buyer or seller about the status and condition of their business and its operations, employees, and assets. Most of the reps & warranties in a purchase agreement are statements from the seller to the buyer about the status of the company being sold (e.g., there is no litigation, the seller owns all the intellectual property necessary to operate the business). Reps & warranties are highly negotiated sections of M&A transaction documents because a buyer’s ability to make a claim against the seller after the closing are based, at least in part, on the exact wording of the representations and warranties.
If you don’t understand a definition above or we didn’t define a term you’re running into, reach out to us at 512.910.2700. We’re happy to help. Braaten Woods is an M&A broker, helping sellers of technology businesses and service businesses maximize their sale prices. We work throughout the United States, although most our deals are in Texas. Our main office is in Austin.