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M&A 101: Where to Start
If your company has decided the best way to grow is to expand your ownership boundaries, you are probably considering either a merger or an acquisition.
Both are convenient, quick ways to grow, and they both have advantages and disadvantages. But the legalities and tax outcomes of these two transactions are very different.
First, here are the basic differences between the two types of transactions:
Mergers generally involve taking control of another corporation’s business by issuing stock to the target company’s shareholders. Then, they wind up owning part of the combined company. You can often structure a merger as a tax-free transaction for both parties.
Acquisitions generally involve buying the target’s stock or assets in a taxable transaction for cash, debt, or a combination. Your company won’t owe income taxes, but the target or its shareholders might.
While the consideration provided to the seller in a merger is simply shares of the combined entity, there are a number of alternatives that can be utilized when assembling an acquisition offer.
Cash. Whether sourced from cash on hand or from lenders, cash at closing is typically the preferred form of consideration from the sellers’ perspective. This is especially true for selling shareholders who will not be involved with the business post-closing.
Stock. Many buyers will provide some portion of the purchase price in the form of stock in the combined entity, which aligns interests in building strategic value going forward and gives the selling shareholders the opportunity to have a “second bite of the apple” if the combined entity is later sold.
Earn-Out. When there is a valuation gap between buyer and seller that is driven by different opinions about the expected near-term performance of the target, earn-outs can be an elegant solution to reach agreement. Earn-outs provide additional purchase price should the target achieve agreed upon performance benchmarks post-closing. Earn-outs embody the idiom “the devil is in the details” – make sure to thoroughly document how the metrics will be measured and how the business will be managed during the measurement period.
Seller Note. Non-contingent deferred purchase price, known as seller notes, can enable you to stretch on price beyond the capital that you have available at closing. Sellers may provide more attractive rates and terms than a third-party lender, given their involvement in the transaction and their comfort level in the combined entity’s future. As an added benefit, the interest paid on seller notes may be tax deductible.
Operating Agreements. Additional consideration beyond the purchase price can be provided to sellers through operating agreements that provide for payment of above-market rates, such as consulting or employment contracts or facility leases (if the sellers own and are retaining the real estate).
In addition to weighing the transaction structure and purchase price consideration options, don’t forget to focus on the big picture: What do you hope to achieve by combining your operations with those of another company? Among the goals commonly considered are:
Gaining an immediate foothold. Your company can instantly step into an appealing geographic market, gain access to coveted customer accounts, or start a new line of business without the uncertainty, expense, and time involved in starting from scratch.
Capturing revenue-enhancing synergies. To the degree that there is minimal overlap between the target’s customer base and yours, significant opportunities exist to cross-sell each business’s offering to the accounts of the other. Conversely, if both businesses serve many of the same customers, the combined entity will become a more important vendor to those accounts with a broader suite of services under one roof.
Exploiting a niche. Your company can exploit a market niche that is compatible with your existing business. This can allow both businesses to grow faster and generate more sales with less effort and marketing expense.
Reaping economies of scale. The combined entity will most likely not require the same level of operating infrastructure as the two businesses did separately. Redundant indirect costs, such as corporate overhead, office space, and third-party services, can be consolidated, enhancing profitability.
Reducing competition. You acquire a regional or local competitor and effectively eliminate it, gaining greater pricing power. That translates into higher profits.
Benefiting from size. Larger companies find it easier to obtain favorable financing, attract new equity investors, and craft more-advantageous deals with vendors and suppliers. Some people simply take larger businesses more seriously. Being bigger also levels the playing field with competitors and gives a company more margin for error during economic downturns.
Jonathan Brabrand is a Managing Director at The Fahrenheit Group and brings a unique skill set to the firm based on his 20-year career in middle market investment banking. Having represented dozens of companies in successful sale processes during his tenures at premier firms such as Harris Williams & Co. and BB&T Capital Markets, he now provides independent pre-transaction advisory services to entrepreneurs, business owners, and Boards of Directors to help them evaluate and prepare for future liquidity events, including M&A transactions, leveraged recapitalizations, or capital raises. He also works with executives to hone their business plans, develop acquisition strategies, and refine their company’s core value proposition. His experience-based advice on liquidity alternatives, timing, valuation, and overall transaction readiness focuses solely on the owner’s best interests and lacks the inherent bias from business brokers and investment bankers whose ultimate goal is to secure an advisory mandate.