M&A Vocabulary: The Terms You Need to Know When Selling Your Company
Because most business owners only go through the process of selling their business once, there can be many terms or phrases heard throughout the transaction process that are unfamiliar or used in a different context than sellers are used to. Below, we share the most common words you’ll encounter during a sale process:
An asset sale is one in which a buyer purchases the assets of your business directly from your company. The buyer also typically agrees to assume certain liabilities of your company (usually those related to the assets purchased, such as accounts payable or contractual obligations), though this is not required. Learn more about asset sales and what factors determine if this is the best legal structure for your business sale here.
Auction Sale (Formal Process)
The sale of a company organized by an investment bank that involves: the investment bank compiling a list of potential buyers, performing outreach to the buyers with confidential information memorandums (CIMs) or teasers to gather interest, collecting bids for the company within a specified time frame, potential buyers visiting the company, and eventually the selection of one buyer in the form of an exclusive Letter of Intent (LOI).
A basket represents a threshold amount that must be met before the buyer can make a claim for indemnification. This protects the seller from being nickel-and-dimed by the buyer for amounts below the agreed upon threshold. An experienced M&A attorney can advise as to market norms for setting the amount of the basket (typically, this bears a relationship to the size of the purchase price and can be influenced by other factors). The amount and terms of the basket are always documented in the purchase agreement and are sometimes included in the letter of intent.
A cap refers to a limit on the amount of a claim for indemnification. Often, representations and warranties are separated into different groups, and each group might have its own cap in the event of a breach by the seller and a corresponding indemnity claim by the buyer. The amount of the cap (or caps in the case of multiple categories of reps) is a negotiated point and is documented in the purchase agreement. The amount of the cap (or caps) may also be included in the letter of intent. An experienced M&A attorney can advise on market norms for setting the amount of the cap.
Closing / Closing Date
The date that the sale transaction will be complete, with all legal documentation signed and closing payment wired.
The amount of cash that will be wired to the seller at closing. This may or may not be the same as the purchase price, which can include earnouts, seller notes, or rolled equity.
Confidential Information Memorandum (CIM) / Confidential Information Presentation (CIP)
A description of the company including history, products or services, end markets, key employees, competitors, customers, financial statements, and growth plans. The CIM is distributed following confirmation of interest from a buyer and execution of a non-disclosure agreement (NDA).
Corporate Spinout / Corporate Carveout
Refers to the sale of a subsidiary or division by a larger parent company. A transaction in which a private equity firm backs a management team with the capital to acquire their division may be referred to as a corporate spinout, a corporate carveout, or a management buyout, but each refers to the same transaction.
A formal attachment to the purchase agreement that gives additional detail to, qualifies, or discloses known exceptions to the reps and warranties made by the seller in the purchase agreement.
Drop-down LLC Structure
A drop-down LLC structure refers to a transaction in which an S corporation seller forms a wholly owned LLC subsidiary and transfers all of the company’s assets and liabilities to the newly formed LLC. This technically happens prior to the sale, but in practice is done in conjunction with closing the transaction. The transfer of all of the assets and liabilities to the newly formed subsidiary LLC is a non-taxable event and positions the buyer to accomplish a step up in basis of assets in proportion to the buyer’s ownership position while the seller avoids triggering a taxable event on seller’s rollover equity without the constraints of meeting the requirements of a 338(h)(10) election or 336(e) election (see below for definitions).
The stage of a sale transaction in which the potential buyer will request internal data from the company to perform analysis and confirm their interest in investing in the company. Learn more about what to expect from due diligence here.
Earn Out / Contingent Payment
An additional payment, or series of payments, in addition to the closing payment, paid to the seller contingent upon the company meeting a specified performance target.
Earnings of a company before interest, taxes, depreciation, and amortization are deducted. EBITDA is used as a proxy for the level of cash generated by a company’s operations (without noise from non-operational factors) by normalizing for differences across companies in capital structure, tax structure, and non-cash accounting decisions such as depreciation and amortization schedules. EBITDA is a simplified approximation of a company’s cash flow from operations found on the cash flow statement without noise from short-term fluctuations in working capital. Learn more about EBITDA and why it’s important here.
Often referred to interchangeably as the cash-free, debt-free purchase price, enterprise value represents the total value of the company (including the value of the equity and the debt, net of any cash). Typically, the seller will sweep the company’s cash at closing and any debt will be refinanced or paid off from proceeds at closing. For example, consider two companies, company A and company B. Both companies are valued at $50 million of enterprise value. Company A has no debt and no cash. Therefore, the value of the equity (i.e., the seller’s proceeds) equals $50 million. Company B has $20 million of debt and $1 million of cash. Company B’s seller’s proceeds will equal $31 million (i.e., $50 million enterprise value – $20 million debt payoff + $1 million of cash).
An account in which an agreed-upon portion of the purchase price is held back for a specific period of time in case the seller breaches a representation, warranty, or covenant.
A term commonly included in a Letter of Intent in which the seller commits to deal exclusively with the buyer during the buyer’s completion of the final stages of due diligence and legal documentation for a specified period of time (e.g., 45 days). The purpose of the exclusivity period is to incentivize the buyer to spend the significant amount of time and money, including third-party advisors, to complete the final stages of due diligence and legal documentation.
A Section 368(a)(1)(F) reorganization, or simply an F reorganization or F reorg, refers to a transaction in which an S corporation seller forms a new S corporation holding company and transfers the existing S corporation’s stock to the new S corporation. The reason this is done is to enable the company to make what’s called a QSub (or qualified subsidiary) election and take steps to convert its form to an LLC. The LLC structure allows for the buyer to accomplish a step up in basis of assets in proportion to the buyer’s ownership position while the seller avoids triggering a taxable event on the seller’s rollover equity without the constraints of meeting the requirements of a 338(h)(10) election or 336(e) election (definitions below).
Funds Flow Memorandum
A document that details the calculation of individual amounts and wire instructions for all wire transfers that need to be made at closing. These can include transfers from buyers or lenders to sellers, existing debt payoff amounts, escrow accounts, or other third-party vendors (such as payments to attorneys or investment bankers for transaction fees).
In the context of an M&A transaction, an indemnity refers to a provision in the purchase agreement by which the seller agrees to hold the buyer harmless against loss or expense caused by a specified event (typically, a breach by the seller of a representation or warranty made elsewhere in the purchase agreement). An indemnity may be unlimited, limited to a specified dollar amount, or have other conditions attached to it (see related definitions of basket and cap above).
Indication of Interest (IOI)
Initial written offer from a potential buyer to a seller. This letter typically includes a valuation range and general terms the buyer is proposing and is non-binding on both parties. The IOI is more limited in scope than a letter of intent and is presented earlier in the process prior to buyer having substantially completed due diligence.
Letter of Intent
An outline of the key terms of the transaction, including, at a minimum, purchase price and basic legal structure. The LOI is countersigned by the seller to indicate agreement as to key terms, after which the post-LOI due diligence phase can begin. The LOI is more comprehensive relative to the indication of interest. The LOI is also typically signed once the buyer has completed significant due diligence and is, therefore, more informed relative to when the indication of interest is presented. The LOI is used as the basis for drafting the definitive purchase agreement.
A type of sale transaction in which an outside investor provides capital for an existing management team to purchase the company from the owner (which could be a corporate parent, a founder, or another individual shareholder or group of shareholders).
Management Incentive Equity / Management Incentive Pool
A percentage of post-closing ownership reserved for existing or future management team members, granting a stake of ownership in the company as a form of compensation. In some transactions, the buyer may invite management teams to co-invest in the company at closing for an even larger post-closing stake in the company. As the company grows, the value of the incentive equity also grows, allowing for significant personal proceeds for management team members when the private equity firm exits the company.
Most commonly refers to the enterprise value as a multiple of the company’s EBITDA. Theoretically, the multiple could refer to the value of the company as a multiple of any number of accounting metrics. However, across most industries, the value of the company is most commonly expressed as a multiple of EBITDA.
Net Working Capital Mechanism / Working Capital Peg
Net working capital refers to the difference between current assets (excluding cash) and current liabilities (excluding debt). In an M&A transaction, the buyer and seller will typically agree on a level of normalized net working capital that is required for the company to sustain its current level of revenue and EBITDA (i.e., presumably upon which the purchase price was established). This agreed-upon level of net working capital is referred to as the net working capital peg or the net working capital target. The formula for calculating any adjustment to purchase price (either an increase to purchase price due to excess net working capital or a decrease to purchase price due to a deficiency in net working capital) is referred to as the net working capital mechanism.
A covenant within the purchase agreement by which the seller commits to not compete against the company for a specified period of time (non-compete) and commits to not solicit employees to leave the company for a specified period of time (non-solicitation).
Purchase Price Allocation Schedule
A document which outlines how much of the purchase price in an asset sale (and certain mergers) is assigned to each asset class. This can affect the taxes a seller will pay on the purchase price, as different asset classes are taxed at different tax rates. For example, for depreciated assets, if the amount allocated to a fixed asset exceeds your tax basis (which could be $0 if the fixed asset is fully depreciated), the difference could be taxed at a special tax rate called the depreciation recapture rate. After fair market value has been assigned to all tangible assets, typically the remainder of the purchase price will be allocated to “goodwill” and “intangibles”. These asset classes are taxed at the capital gains rate, which is generally lower than the ordinary income rate. For a transaction in which the majority of the purchase price is allocated to goodwill and intangibles, the tax treatment more closely resembles a stock sale structure.
Quality of Earnings Review
A report ordered from a third-party accounting firm by the buyer that confirms the accuracy of the company’s financial statements and highlights any deviations from generally accepted accounting principles (GAAP). The quality of earnings will also reconcile historical fluctuations in revenue, expenses, and margins, analyze risks to future earnings, for example, related to customer concentration or margin trends, and will analyze historical trends in net working capital.
Refers to a change in the company’s capital structure (i.e., the mix of debt and equity and/or the owners of equity), typically with the goal of providing partial liquidity to the owner of the company. Recaps can be majority or minority. In the former, the seller retains a partial ownership stake in the company; in a minority recap, the seller retains the majority stake while still receiving growth capital from the outside investor.
Representations and Warranties
Representations (often referred to as simply “reps”) and warranties are statements of facts and assurances from the seller to the buyer about the company’s business, assets, liabilities, and operations. These can refer to the company’s past or current business and are meant to inform and protect the buyer from the seller knowingly withholding material information about the company. What is included in reps and warranties and any rights or damages resulting from a breach are negotiated during the legal documentation phase and included in the final purchase agreement. Experienced legal counsel will be able to advise as to which reps and warranties are market norms vs. which may be idiosyncratic or uncustomary.
Reps and Warranties Insurance
An insurance policy that protects the seller against post-closing indemnity claims made by the buyer (typically in connection with a breach of a representation by the seller). In the event of a breach, the buyer will seek reimbursement for damages from the insurance carrier rather than from the seller. The cost of the reps and warranties insurance policy is typically based on a percentage of the purchase price. The primary benefit to the seller is that the buyer will often agree to a materially lower escrow amount when there is a reps and warranties insurance policy backstopping potential breaches of reps. The lower escrow amount results in greater cash proceeds at closing for the seller.
Rolled / Rollover Equity
The amount of ownership a seller retains during a majority recapitalization. This amount is included in the purchase price but is not part of the closing payment, as it represents a “reinvestment” in the company by the seller. For example, if a founder sells his/her cash-free, debt-free company for $20 million in a transaction in which the buyer is funding the purchase with $10 million of debt and $10 million of equity, the seller may want to retain a 20% stake in the company by “rolling” $2 million (i.e., $2 million ÷ $10 million of new equity = 20%). The founder’s cash proceeds would be $18 million ($20 million – $2M of rolled equity). Typically, the rollover equity can be structured to avoid triggering a taxable event for the seller at the time of the transaction.
A portion of the purchase price paid to the seller in the form of an interest-bearing note rather than cash. The seller note often reflects a relatively small portion of the purchase price (i.e., typically less than 25%) and may incentivize the buyer to stretch slightly on purchase price as compared to an all-cash transaction.
Senior debt refers to a loan or loans that are first in line in priority of payment, and if the loan is secured by certain assets, the senior loan would have a first lien against those assets. As a result of its senior priority of payment, senior debt carries the lowest interest rate. Most traditional bank loans are senior debt.
A stock sale (in the case of a corporation) or membership interest sale (for LLCs) is one in which a buyer purchases the ownership of the legal entity of your business. From a legal perspective, nothing about your company changes except for the owner. Learn more about stock sales and what factors determine if this is the best legal structure for your business sale here.
Structure (Economic Structure)
For a transaction that includes any consideration other than 100% cash as part of the purchase price, economic structure refers to the breakdown of how the non-cash portion of the purchase price will be paid to the seller. This can include contingent payments, seller notes, or any other form of payment that is not cash at closing.
Structure (Transaction Structure)
The legal structure of a transaction, which determines the mechanics of how the company (or portion of the company) changes ownership. Most M&A transactions will be legally structured as an asset sale, stock or equity sale, or merger. Read more about these legal structures and how each can affect you and your company here.
Subordinated Debt / Mezzanine Debt
Subordinated debt (also referred to as sub debt, mezzanine debt, or junior debt) is a loan or loans that sit behind senior debt in priority of payment. Often, subordinated debt is unsecured by the company’s assets. However, in the event that subordinated debt is secured by specific assets, it carries a second or junior lien subordinated in priority to the senior lender. Because subordinated debt sits behind senior debt in priority of payment, subordinated debt carries a higher interest rate relative to senior debt. Typically, subordinated debt is non-amortizing (i.e., interest only) with principal paid upon maturity whereas senior debt will receive principal payments. In middle-market M&A, most subordinated debt is supplied by private credit funds (not by banks).
Any written consents needed from a party other than the buyer or seller in order for a transaction to close. Typically, these are contractually required, such as a change of control clause in a customer or supplier contract, or landlord consents for facility leases.
For owners of S Corporations selling their company through a stock sale structure, a 338(h)(10) election is a special tax election that allows the stock sale to be treated as an asset sale for tax purposes. This can create a win-win solution for a transaction in which most of the purchase price is allocated to goodwill or intangibles, as in these cases the seller’s tax treatment closely resembles a stock sale (making the tax treatment a neutral point – see purchase price allocation schedule above). For the buyer, treatment as an asset sale allows the buyer to “step up” the tax basis of the purchased assets (including goodwill and intangibles) to fair market value. This higher, or “stepped up” basis, positions the company for larger depreciation and amortization tax deductions going forward. To make a 338(h)(10) election, the buyer must be a corporation (see 336(e) election below for an alternative in a situation in which the buyer is not a corporation). A 338(h)(10) election requires certain conditions are met, including greater than or equal to 80% of the stock being sold. Therefore, in a transaction in which the seller desires to roll greater than 20% of seller’s proceeds and/or wishes to defer tax on the seller’s rollover equity, see Drop-down LLC Structure and F Reorganization above as potential alternatives. Note, a 338(h)(10) election will result in a fully taxable transaction for the seller, including any rolled equity, and can result in entity-level tax liabilities in certain states (e.g., California); therefore, we recommend consulting a tax advisor early in the process to understand tax implications for your specific transaction.
A 336(e) election is similar to a 338(h)(10) election (defined above), except that it allows less rigid requirements in terms of how both parties are legally structured in order to make the election. For a 338(h)(10) election, the buyer must be a corporation; for a 336(e) election, the buyer can be a partnership, LLC, or corporation. The 336(e) election requires certain conditions are met, including greater than or equal to 80% of the stock being sold. Therefore, in a transaction in which the seller desires to roll greater than 20% of seller’s proceeds and/or wishes to defer tax on the seller’s rollover equity, see Drop-down LLC Structure and F Reorganization above as potential alternatives. Note, a 336(e) election will result in a fully taxable transaction for the seller, including any rolled equity, and can result in entity-level tax liabilities in certain states (e.g., California); therefore, we recommend consulting a tax advisor early in the process to understand tax implications for your specific transaction.