Tag Archive for: ExitPlanning

Real Estate

Separating Business Value from Real Estate Value

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Many privately held businesses own the property from which they operate. That ownership creates additional considerations when the owner prepares for a sale. The business and real estate represent separate assets, even when the same owner controls both. Therefore, evaluating real estate and business value requires understanding the economic relationship between the company and its property. The seller must first determine whether the real estate should transfer with the business or remain separately owned.

Determine How the Business Uses the Property

Some properties serve an essential operating purpose. Manufacturing facilities, warehouses, dealerships, and specialized buildings may contain improvements specifically designed for the company’s operations. Other businesses occupy conventional offices, retail locations, or industrial properties that another tenant could readily use.

The property’s role affects the alternatives available to the seller. Where operations depend heavily on the location, a buyer may prefer ownership or long-term control of the property. A more interchangeable facility may provide greater flexibility.

Evaluate the Real Estate Separately

When appropriate, the owner should evaluate the property independently from the operating company. A real estate appraisal considers factors different from those used to value a business. Location, comparable sales, market rents, capitalization rates, zoning, condition, and highest and best use may influence property value. The property’s current use does not necessarily represent its highest and best use.

From a property standpoint, redevelopment or alternative uses may support a different value than continued business occupancy. Environmental conditions, deferred maintenance, or specialized improvements may also affect marketability.

Normalize the Company’s Occupancy Cost

Real estate ownership often affects the company’s reported earnings. An owner may charge the business above-market rent, below-market rent, or no rent. Before evaluating the operating business, the financial statements should reflect a reasonable market occupancy cost. This adjustment helps separate real estate and business value and produces a more representative earnings base. Market rent also becomes particularly relevant when the seller retains the property after closing.

Consider the Transaction Alternatives

The seller generally has several alternatives when the business owns the real estate. The buyer may acquire both the operating company and property as part of the transaction. Alternatively, the seller may retain the property and enter a long-term lease with the buyer. The seller may also sell the property separately to another real estate investor. Depending on the structure, these alternatives may produce significantly different proceeds, income streams, financing requirements, and tax consequences.

Structure the Lease Carefully

When the seller retains the property, the lease becomes an important component of the transaction. Rent should reflect market conditions and the economics assumed in the business valuation. The parties should also negotiate lease term, renewal options, maintenance responsibilities, insurance, taxes, and future rent adjustments. A buyer also needs sufficient occupancy certainty to operate the acquired business. Likewise, lenders may review the lease when evaluating transaction financing.

Evaluate the Business and Property Together

Separating the valuations does not mean evaluating the assets independently from the transaction. The business requires a place to operate, and occupancy costs directly affect its earnings. The real estate also derives economic value from its location, use, tenant, and alternative opportunities.

An experienced M&A advisor will evaluate these relationships before marketing the company. Real estate, valuation, tax, and legal professionals may also provide specialized advice where appropriate. The objective is to understand both assets separately, then structure them together around the seller’s transaction objectives.

Babson College’s 2013 Middle Market/Small Business M&A Survey

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Babson College recently examined the conditions shaping mergers and acquisitions for small and middle market businesses. Professor Kevin J. Mulvaney directed the research with participation from M&A advisors, bankers, and other transaction professionals. The survey evaluated trends affecting buyers, sellers, financing, valuations, and transaction execution.

The 2013 Middle Market M&A Survey described a market that had improved considerably following the recession. However, economic uncertainty continued to influence transaction activity. For business owners considering a sale, several findings stood out.

First, the survey characterized the environment as a seller’s market for quality companies. Strong businesses could attract buyer interest, but preparation remained essential. The same conditions did not apply equally to underperforming companies. Buyers remained selective and placed greater emphasis on sustainable earnings, growth prospects, and business quality.

Deal execution also required patience. The survey reported that transactions commonly required six to nine months from serious negotiations through closing. Some respondents expected timelines to extend another month or two. Buyer due diligence contributed to these longer timelines. Buyers increasingly used experienced teams to examine financial performance, revenue trends, and future growth potential.

Another finding involved seller participation in smaller transaction. As company size decreased, buyers generally demanded greater seller assistance. That assistance could include earnouts, deferred consideration, employment, consulting, or other continuing involvement. At the time, deferred consideration averaged approximately 20 percent of the purchase price in surveyed transactions.

Financing conditions were also improving. The survey identified greater middle market lending availability and a rebound in SBA-guaranteed acquisition financing. Meanwhile, mezzanine debt yields had declined to approximately 12% – 14%. Historical averages had previously ranged from approximately 15% – 20%.

Taken as a whole, the 2013 Middle Market M&A Survey delivered a straightforward message for business owners. Favorable conditions alone did not guarantee a successful transaction. Quality companies still required careful preparation, realistic expectations, and experienced transaction guidance. Sellers also needed the information and responsiveness necessary to withstand increasingly thorough buyer due diligence.

For owners considering a future capital event, the survey supported planning well before entering the market. Preparation allowed sellers to evaluate alternatives and approach potential buyers from a stronger position.

What Drives EBITDA Multiples in Business Sales

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Business owners frequently hear that companies sell for a multiple of EBITDA. While generally true, the appropriate multiple may vary significantly between businesses. EBITDA measures earnings before interest, taxes, depreciation, and amortization. Buyers commonly use it to evaluate operating performance and compare acquisition opportunities. The basic calculation appears straightforward. A company generating $2 million of EBITDA at a 5.0x multiple indicates $10 million of enterprise value.

However, applying the multiple requires considerably more judgement. The multiple reflects how buyers view the quality, risk, and future potential of those earnings. For this reason, two companies generating identical EBITDA may command very different valuations. Understanding EBITDA multiples in M&A requires understanding what separates those businesses.

Several characteristics influence the multiple buyers are willing to pay:

  • Growth: Sustainable revenue and earnings growth may support greater buyer interest and stronger valuations.
  • Recurring Revenue: Predictable and repeatable revenue may provide buyers with greater confidence in future performance.
  • Customer Diversification: A diversified customer base reduces exposure to the loss of any single relationship.
  • Management Depth: An experienced management team may reduce dependence on the selling owner.
  • Competitive Advantages: Differentiated products, capabilities, brands, or market positions may strengthen future earnings expectations.
  • Size and Scale: Larger companies often possess greater management depth, diversification, resources, and financial stability.
  • Margins: Strong and sustainable margins may demonstrate pricing power, operating efficiency, or meaningful differentiation.

While these characteristics affect the business itself, the buyer may also influence the multiple. A strategic buyer may identify synergies unavailable to other acquirers. Cost savings, additional customers, new markets, or complementary capabilities may increase the acquisition’s economic value.

Buyer demand may further affect transaction pricing. When several qualified buyers pursue the same company, their different perspectives may produce different valuations. This dynamic makes a competitive sale process particularly valuable. Rather than relying on one buyer’s view, the seller may test value across the marketplace.

Broader market conditions also play a role. Financing availability, industry consolidation, economic conditions, and acquisition activity may influence EBITDA multiples in M&A. Accordingly, sellers should avoid applying a single industry multiple to their EBITDA and assuming they know the company’s value. A multiple provides a useful reference point, not a complete M&A valuation.

An M&A advisor will evaluate normalized EBITDA, company-specific value drivers, market evidence, and likely buyer interest. The advisor may then position those attributes within a competitive sale process. EBITDA provides the earnings base for many M&A valuations. The multiple reflects the marketplace’s assessment of the quality, risk, and future potential of those earnings.

Using Stock Appreciation Rights to Retain Key Employees

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Key employees represent a significant source of value in a privately held business. Their departure may also create create a substantial risk during a sale. Owners often need an incentive that rewards these employees without transferring actual ownership. A Stock Appreciation Rights Plan may provide one solution.

Stock Appreciation Rights, or SARs, generally provide employees with compensation tied to increases in company value. Participants receive economic benefits without purchasing or owning company stock. As company value increases, the potential value of the SARs also increases. This structure connects employee rewards directly with shareholder value creation. A properly designed Stock Appreciation Rights Plan may help owners accomplish several objectives:

  • Align Incentives: Employees benefit when their efforts contribute to increasing company value.
  • Retain Key Employees: Vesting schedules may encourage important employees to remain with the company.
  • Reward Performance: Owners may provide meaningful financial incentives without transferring actual equity.
  • Support Succession: SARs may encourage management continuity as an owner reduces day-to-day involvement.
  • Prepare for a Sale: Transaction provisions may define how participants receive benefits following a change in control.

The M&A application deserves particular attention. Buyers often evaluate whether key employees will remain after the seller exits. Management departures may disrupt customer relationships, operations, institutional knowledge, and future performance. As a result, employee retention may directly affect buyer confidence. A SAR plan may help address this concern when owners establish appropriate terms well before a transaction. Those terms should clearly define vesting, valuation, payment timing, and treatment upon a sale. Change-in-control provisions deserve special consideration. The plan should specify whether a transaction accelerates vesting or triggers payment to participating employees.

Beyond retention, owners should coordinate SARs with employment agreements and other employee arrangements. Restrictive covenants may also require consideration where legally permissible and appropriate.

Before entering the market, sellers should review all existing incentive arrangements with their M&A advisor and legal counsel. Tax and accounting advisors should also evaluate the plan’s financial consequences. This review helps prevent unexpected obligations from emerging during due diligence. It also allows buyers to understand how the plan affects employees and transaction economics.

A well-designed Stock Appreciation Rights Plan may reward employees for helping create value while preserving the owner’s equity. When coordinated with exit planning, it may also support management continuity and a smoother ownership transition.

Bankability

What Makes a Business Transaction Bankable?

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Business owners encounter financing needs throughout the life cycle of their companies. An opportunity may involve an acquisition, ownership buyout, expansion, recapitalization, new facility, or significant capital investment. Each opportunity may make strategic and financial sense. However, the transaction must also support an appropriate financing structure. An attractive business opportunity does not necessarily represent a financeable transaction.

Transaction bankability depends largely on whether lenders believe the borrower will generate sufficient cash flow to repay the proposed debt. Lenders also evaluate the borrower, transaction structure, collateral, equity contribution, and risks surrounding future performance. For this reason, owners and buyers should consider financing early rather than after negotiating the major transaction terms.

Start With Cash Flow

Cash flow generally represents the foundation of business and acquisition financing. Lenders evaluate historical earnings and determine whether those earnings provide sufficient support for the proposed debt service. They may begin with EBITDA before considering other demands on the company’s available cash. Capital expenditures, working capital requirements, taxes, and other recurring obligations affect the amount available for debt repayment.

The lender also considers the company’s existing debt and any additional obligations created by the proposed transaction. Historical consistency matters as well. A company with stable earnings may present a different credit profile than one experiencing substantial year-to-year volatility. Significant changes in revenue, margins, expenses, or profitability may require additional explanation.

From a repayment perspective, lenders generally place greater weight on demonstrated performance than optimistic projections. Projections still matter, particularly when the transaction changes the company’s future operations. However, management should support those projections with reasonable assumptions and identifiable business drivers. A lender may also stress projected results to determine whether the company could service debt during weaker operating periods.

Understand Debt Service Coverage

Lenders frequently evaluate the relationship between available cash flow and required debt payments. The exact calculation and acceptable coverage level vary by lender, financing program, industry, and transaction. Accordingly, buyers should avoid assuming that one universal ratio determines whether financing will receive approval.

The lender may adjust reported earnings before calculating available cash flow. Nonrecurring expenses, owner compensation, related-party transactions, and other adjustments may receive scrutiny during underwriting. Lenders may accept certain adjustments while rejecting others. For acquisition financing, this analysis often overlaps with the buyer’s evaluation of normalized EBITDA. A transaction becomes more difficult to finance when the purchase price requires debt beyond the company’s sustainable repayment capacity.

Evaluate the Buyer

The lender evaluates more than the business being acquired. A buyer’s industry experience, management capabilities, liquidity, credit history, and financial resources may influence the underwriting decision. Lenders want confidence that the buyer possesses the experience and resources necessary to operate the company successfully. A buyer entering an unfamiliar industry may face greater scrutiny than an experienced industry operator.

Management depth also becomes relevant when the seller plays a significant role in daily operations. The lender should understand who will assume those responsibilities after closing. A transition agreement with the seller may support continuity during the ownership change. However, the buyer still needs a credible long-term management plan. At the ownership level, the lender may also evaluate the buyer’s personal financial resources and required equity contribution. A buyer committing meaningful capital to the transaction shares financial risk with the lender.

Structure the Transaction Around Available Financing

Purchase price alone does not determine transaction bankability. The form of consideration also affects the amount of financing required at closing. A transaction may include buyer equity, senior debt, seller financing, earnouts, rollover equity, or other consideration. The appropriate combination depends on the transaction and available financing sources.

A buyer should understand likely financing capacity before committing to a structure in the Letter of Intent. Otherwise, the parties may negotiate a transaction that available lenders will not support. The capital structure should also leave sufficient flexibility for the company after closing. A business still needs working capital, equipment, employees, and resources to pursue growth.

Excessive leverage may restrict those investments even when the company technically meets its debt obligations. Within the capital structure, the objective should extend beyond funding the purchase price. The business needs a financing structure that supports both repayment and continued operations.

Consider Seller Financing

Seller financing may complement senior bank financing in certain transactions. The seller accepts a portion of the purchase price over time rather than receiving the entire amount at closing. This structure reduces the buyer’s immediate cash requirement and may help bridge a financing gap. It may also demonstrate the seller’s confidence in the company’s future performance. However, seller financing introduces additional credit risk for the seller.

The parties should carefully negotiate interest, maturity, payment schedules, security, and default provisions. Senior lenders may also require the seller note to remain subordinated to bank debt. Payment restrictions may apply when the company fails to satisfy specified financial requirements. Therefore, sellers should understand that a seller note does not provide the same certainty as cash received at closing.

Understand Collateral and Guarantees

Collateral remains relevant even when cash flow supports the proposed loan. Lenders may evaluate accounts receivable, inventory, equipment, real estate, and other assets available to secure financing. The quality and liquidity of those assets influence their value from a lending perspective. Accounts receivable from strong customers may provide better collateral than obsolete inventory or specialized equipment.

Asset-light companies present a different financing profile. A professional services company may generate substantial earnings while owning relatively few tangible assets. In those situations, the lender may rely more heavily on cash flow and the strength of the borrower. The financing structure may also require additional buyer equity or other forms of credit support. Personal guarantees may apply depending on the lender, financing program, and transaction structure.

Evaluate Real Estate Separately

Real estate may provide additional financing alternatives when a transaction includes business property. The buyer may acquire the operating company and real estate together. Alternatively, the seller may retain the property and lease it to the buyer. A third-party real estate investor may also acquire the property under an appropriate structure. Each approach affects the buyer’s financing requirements and the company’s future occupancy costs.

Separating the real estate may reduce the capital required to acquire the operating business. However, the resulting rent becomes an ongoing expense that affects cash flow and debt service capacity. The lender will therefore evaluate the lease terms and market rent when underwriting the transaction. Real estate financing may also involve different terms and amortization periods from business acquisition financing.

Maintain a Strong Banking Relationship

A banking relationship should not begin when the company urgently needs financing. Management should help its lender understand the company’s business model, financial performance, ownership, and future plans. Regular communication provides the lender with context when financial results change.

The company should also understand what information its lender expects and which financial requirements apply to existing loans. If performance falls outside expectations, early communication usually provides more options than silence. Management should explain what changed, why it changed, and what actions the company has taken. Between transactions, this communication helps establish credibility and gives the lender greater familiarity with the business. A strong relationship does not guarantee financing. However, informed lenders are better positioned to evaluate new opportunities efficiently.

Prepare Reliable Financial Information

Strong financial reporting improves the financing process. Lenders need reliable historical financial statements, tax returns, interim results, and supporting schedules. They may also request financial projections, debt schedules, customer information, and working capital analysis. The information should reconcile across documents and clearly explain unusual or nonrecurring items.

Balance sheet accounts deserve particular attention. Accounts receivable, inventory, accounts payable, accrued expenses, and existing debt may directly affect underwriting. Poorly managed records may raise questions beyond the individual accounting issue. They may cause lenders to question management controls and the reliability of other financial information. When underwriting begins, organized financial records allow the lender to focus on the economics of the transaction.

Match Financing to the Opportunity

Not every transaction requires the same financing source. Traditional commercial bank financing may work well for established companies with predictable cash flow and sufficient collateral. Other transactions may require different capital sources or a combination of financing alternatives. Available options may include senior debt, seller financing, subordinated debt, equity capital, or asset-based lending. Certain qualifying business acquisitions may also use SBA-guaranteed financing.

The appropriate financing depends on company size, cash flow, assets, transaction structure, and buyer resources. Management should compare more than interest rates when evaluating financing alternatives. Amortization, covenants, collateral requirements, guarantees, prepayment provisions, and payment flexibility also affect the economics.

Develop the Financing Strategy Early

Buyers should evaluate financing before negotiating a transaction structure they cannot fund. An M&A advisor should begin assessing transaction bankability while evaluating the economics of the proposed transaction. Early lender discussions may provide useful insight into debt capacity, buyer equity requirements, and potential structural limitations. That information becomes particularly valuable before signing a Letter of Intent.

The advisor should also evaluate how financing assumptions affect purchase price, consideration, working capital, and closing conditions. Accountants should analyze historical performance, projections, and tax considerations. Attorneys should address loan documents, guarantees, security interests, subordination, and other legal requirements. Lenders then evaluate the complete transaction within their underwriting standards. Before commitments become difficult to change, the transaction team should understand how the purchase will actually be financed.

Make the Transaction Work After Closing

Financing should accomplish more than getting the parties to closing. The resulting capital structure must allow the company to operate successfully after ownership changes. The business may need additional working capital, equipment, employees, technology, or facilities. Unexpected challenges may also require financial flexibility.

A transaction structured at the limits of available cash flow leaves little room for these demands. The buyer should therefore evaluate the downside scenarios before accepting significant leverage. The strongest financing structure balances purchase price, debt repayment, operating requirements, and future growth. A good transaction becomes bankable when sustainable cash flow, a qualified buyer, and a workable capital structure support repayment.

How Tax Structure Shapes the Economics of a Business Sale

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A business sale involves more than negotiating the purchase price. The transaction structure significantly affects the economics for both buyer and seller. Accordingly, tax considerations in M&A should enter the discussion early. Decisions made during negotiations may directly influence each party’s after-tax outcome.

Buyers and sellers often approach these decisions from different perspectives. What creates a tax benefit for one party may create additional costs for the other. The choice between an asset sale and an equity sale illustrates this difference.

Buyers often prefer asset purchases because they can receive a new tax basis in the acquired assets. This basis may generate future depreciation and amortization deductions. Sellers may prefer an equity sale, particularly when proceeds qualify for capital gain treatment. The seller’s entity structure may also substantially affect this analysis. C corporations, S corporations, partnerships, and LLCs can produce different tax consequences. Therefore, the parties must evaluate structure within the specific circumstances of the transaction.

Once the parties determine the transaction structure, purchase price allocation becomes another consideration. In an asset sale, the allocation assigns value among the acquired assets. These allocations may affect the seller’s character of gain and the buyer’s future deductions. As a result, allocation often becomes an economic negotiating point rather than simply a tax exercise.

The form of consideration can create additional tax consequences. Cash, seller notes, rollover equity, and buyer stock may affect the timing and character of taxable income.

Other tax considerations in M&A may also influence the transaction. These can include:

  • Tax Elections: Sections 338(h)(10) and 754 may provide different tax treatment when applicable.
  • Tax Attributes: Net operating losses and tax credits may have value, although limitations may restrict their use.
  • Built-In Gains: Certain S corporations may face additional tax exposure following a prior conversion from C corporation status.
  • Transfer Taxes: Real estate, sales, and other transfer taxes may create additional transaction costs.

These issues demonstrate why headline purchase price tells only part of the story. A higher offer may produce lower after-tax proceeds depending on its structure. For this reason, sellers should evaluate competing offers on both a gross and after-tax basis. Buyers should likewise consider tax benefits when evaluating their total acquisition cost.

The M&A advisor should coordinate this analysis with experienced tax and legal professionals. The M&A team can evaluate structure, allocations, consideration, elections, and other material provisions before they become difficult to change.

Addressing tax considerations in M&A early gives both parties greater flexibility during negotiations. More significantly, thoughtful planning helps ensure the transaction structure supports the seller’s broader financial objectives.

Protecting Confidentiality During the Business Sale Process

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Selling a privately held business requires sharing sensitive information with prospective buyers. However, sellers should control when and how they disclose that information. Maintaining confidentiality in M&A protects the company while allowing qualified buyers to evaluate the acquisition opportunity.

Premature disclosure can create significant problems. Employees may become concerned about their jobs, while customers may question the company’s future. Competitors could also use confidential information to their advantage. Meanwhile, suppliers and other stakeholders may react before a transaction becomes certain.

For these reasons, an M&A advisor typically approaches prospective buyers without initially identifying the seller. The advisor may use a carefully prepared teaser or executive summary during the initial contact. This document provides enough information to determine whether a buyer has legitimate interest.

Generally, the teaser describes the business without revealing its identity. It may include:

  • Company Overview: A general description of the business and its capabilities.
  • Products and Services: The principal offerings and markets served.
  • Geographic Reach: General information about customers and sales territories.
  • Financial Highlights: Selected revenue, EBITDA, growth, and other relevant financial information.
  • Investment Highlights: Characteristics that may make the company attractive to prospective buyers.
  • Transaction Overview: General information regarding the contemplated sale.

Once a buyer expresses sufficient interest, the advisor typically requests a Non-Disclosure Agreement, or NDA. Some parties may also refer to this document as the Confidentiality Agreement, or CA. The agreement establishes rules governing the buyer’s use and disclosure of confidential information. It may also address permitted recipients, information security, return or destruction of materials, and other protections.

Certain provisions may require negotiation, particularly with private equity firms or strategic buyers. The M&A advisor and transaction attorney should manage these discussions without unnecessarily delaying the sale process. After executing the agreement, the seller may provide more detailed information. This information often begins with the Confidential Information Memorandum (“CIM”) and progresses through later stages of due diligence.

Still, signing an NDA does not eliminate confidentiality risk. Sellers should continue controlling access to sensitive information throughout the transaction. For example, highly sensitive customer or employee information may remain restricted until later in the process. The seller may also redact certain documents or limit access within the Virtual Data Room.

Effective confidentiality in M&A therefore requires more than an NDA. It requires a disciplined process for identifying buyers, controlling disclosure, and releasing information as buyer interest becomes more serious. An experienced M&A advisor will manage this progression while protecting the sellers identity and sensitive information. This approach allows buyers to evaluate the opportunity without creating unnecessary exposure for the business.

Why Valuation and M&A Transaction Value May Differ

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Business owners often expect a business valuation to predict the price their company will receive in a sale. In practice, valuation and transaction value may differ. A business valuation in M&A provides an analytical framework for understanding value. The marketplace determines what an actual buyer will pay.

Both analysis begin with many of the same fundamentals,. Historical earnings, expected cash flows, growth, risk, and industry conditions all influence value. A valuation professional may apply income, market, and asset-based approaches. These approaches may include discounted cash flow analysis, capitalization methods, and comparable transaction multiples. However, valuation methodology represents only part of the analysis. The applicable standard of value also influences the conclusion.

Fair market value generally considers a hypothetical willing buyer and seller under defined assumptions. Neither party faces compulsion, and both possess reasonable knowledge of relevant facts. Fair value represents a different standard and depends heavily on the purpose and applicable legal or accounting framework. It frequently arises in shareholder disputes, financial reporting, and other specific circumstances.

Neither standard necessarily predicts the price available from a particular buyer in an M&A transaction. That distinction brings investment value into the analysis. Investment value reflects the value of a business to a specific buyer based on that buyer’s circumstances. Different buyers may therefore place different values on the same company.

A strategic buyer may identify cost savings, new customers, expanded geography, or complementary capabilities. A financial buyer may focus more heavily on growth, leverage, and expected investment returns. Buyer-specific opportunities may support a transaction value above other indications of value. However, the seller does not automatically receive that additional economic benefit.

The M&A process determines how much value the seller can capture. 

An experienced M&A advisor identifies buyers with compelling reasons to pursue the company. The advisor then communicates the company’s financial performance, value drivers, and strategic opportunities. From there, a competitive sale process allows multiple qualified buyers to evaluate the opportunity. Each buyer approaches the company with different motivations and economics. Competition can reveal values that a standalone valuation may not anticipate. It may also strengthen the seller’s negotiating position on price, structure, and other transaction terms.

For this reason, business valuation in M&A should provide a reference point rather than create an artificial ceiling. It helps establish expectations and provides context for evaluating offers. Business valuation also provides a reasoned indication of value under defined assumptions. A competitive M&A process tests those assumptions and determines what the marketplace will actually pay.

Protecting the Seller in an Earnout Agreement

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An earnout may help buyers and sellers overcome differences in their expectations about future business performance. However, agreeing on the earnout amount represents only the beginning. After closing, the seller typically gives the buyer control over the business. That changes creates significant risk for contingent consideration. For this reason, seller earnout protection should address both the payment formula and the buyer’s post-closing operation of the company.

Before accepting an earnout, sellers should first evaluate the buyer. Financial strength matters because an earnout has little value without the ability to pay. Operating capabilities deserve similar attention. A buyer that cannot successfully manage the acquired company may reduce the probability of achieving performance targets. Sellers should also understand the buyer’s plans for the business. Changes involving employees, customers, pricing, suppliers, or investments could materially affect future results. Once comfortable with the buyer, the seller should focus carefully on the earnout provisions. Several areas deserve particular attention:

  • Performance Measures: Define revenue, EBITDA, gross profit, or other measurements precisely.
  • Accounting Policies: Establish consistent accounting methods for calculating performance throughout the earnout period.
  • Operating Covenants: Address significant actions that could unfairly reduce or shift the company’s reported performance.
  • Information Rights: Give the seller appropriate access to financial information supporting earnout calculations.
  • Payment Terms: Clearly establish measurement dates, payment dates, and procedures for calculating amounts owed.
  • Dispute Resolution: Establish a practical process for resolving disagreements, including independent accounting review when appropriate.
  • Buyer Creditworthiness: Consider available protections when future payment depends materially on the buyer’s financial condition.

The measurement period also requires careful consideration. Longer periods increase uncertainty because business conditions and buyer strategies can change. Even strong contractual provisions will not eliminate every risk. Therefore, sellers should evaluate earnout consideration differently from cash received at closing. More fundamentally, the earnout should align the economic interests of both parties. A buyer should not benefit from preventing the seller from achieving reasonable performance objectives.

Effective seller earnout protection begins during negotiations, not after a disagreement develops. The M&A advisor should coordinate closely with legal, accounting, and tax professionals when evaluating the provisions. Earnouts may help bridge valuation gaps and complete transactions that might otherwise fail. However, their value depends on the seller’s ability to earn, verify, and collect the promised consideration.

Turning Business Weaknesses Into M&A Opportunities

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Every business has weaknesses. During an M&A transaction, the question is whether the seller addresses them before the buyer discovers them. Addressing business weaknesses before a sale allows the seller to explain potential concerns within the proper context. It also provides time to correct problems that could otherwise affect value.

Buyers will examine the company carefully during due diligence. Problems discovered unexpectedly may undermine confidence in management and raise questions about other undisclosed issues. For this reason, sellers should identify material weaknesses before entering the market. Common examples include:

  • Customer or supplier concentration
  • Uncollectible accounts receivable
  • Obsolete or slow-moving inventory
  • Expiring leases
  • Nontransferable contracts or licenses
  • Unprotected intellectual property
  • Pending litigation or contractual disputes
  • Unprofitable customer contracts
  • Unclear ownership of key assets
  • Significant dependence on the owner

Once identified, management should determine which weaknesses can be corrected before a sale. Some problems may require months or years to resolve. Other weaknesses may remain when the company enters the market. In those situations, thoughtful positioning becomes essential. The Confidential Information Memorandum (“CIM”) should present material issues accurately and within the broader business story. Appropriate disclosure allows buyers to evaluate both the risk and potential opportunity. For instance, customer concentration represents risk. Yet a buyer with broader customer relationships may see opportunities to diversify the acquired company’s revenue. Similarly, weak sales infrastructure may limit current growth. A strategic buyer with an established sales organization could identify meaningful expansion opportunities.

The seller should not disguise a weakness as an opportunity. Instead, the M&A advisor should explain the issue and demonstrate how a buyer could address it. This approach strengthens credibility while allowing buyers to consider opportunities unavailable to the current owner.

Timing also matters. Addressing business weaknesses before a sale gives sellers greater negotiating leverage while multiple prospective buyers remain interested. Before signing a Letter of Intent, competition may help sellers negotiate identified risks within the broader transaction economics. After exclusivity begins, that leverage generally decreases.

An experienced M&A advisor should identify likely buyer concerns before launching the sale process. The advisor may then determine what to correct, disclose, and position appropriately. Strong M&A positioning does not require a perfect company. It requires understanding the weaknesses, addressing them proactively, and presenting the opportunity with credibility.

Allston Advisory Group is an experienced boutique M&A advisory firm providing a variety of services to lower middle market companies. See our footer for contact information.

(502) 742-2933
[email protected]
P.O. Box 21266, Louisville, KY 40221

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