Deal structure plays a pivotal role in business purchase transactions, serving as the architectural framework that defines the terms, conditions, and financial intricacies of the deal. Deal structure involves determining how the purchase price (enterprise value) will be paid, whether through cash, rollover equity, or a combination of both, and establishing the timeline for payment.
The deal structure also addresses the allocation of risks and responsibilities between the buyer and the seller, often utilizing mechanisms such as holdbacks/ escrow accounts and earnouts and transition service agreements to ensure a smooth transition and safeguard both parties’ interests.
Moreover, deal structure can be tailored to take into account tax implications, aiming to optimize the financial outcome for both the buyer and the seller. Crafting a well-balanced deal structure requires a nuanced understanding of the businesses involved, their financial positions, and the broader market conditions, ultimately contributing to the success and sustainability of the acquisition.
Sample M&A Deal Structure
Here is a sample deal structure that may be received on an LOI for a business transaction. In this hypothetical scenario, the buyer is paying a multiple of adjusted EBITDA.
Most LOIs are 2-3 pages and lay out the purchase structure and key considerations. However, the more structure in the deal, the longer and more arduous the drafting and finalization of the purchase agreement is. It is not uncommon to have 5 pages of escrow agreements, 10-15 pages to outline the terms of a seller note and 20+ pages to detail an earnout.
While most of the purchase price is paid in cash at the time of closing, below are some key deal structure points along with commentary from the experts at Raincatcher.
A holdback in a business transaction involves withholding a portion of the purchase price for a specified period (often-times 1 year). This is typically to cover potential liabilities or unforeseen issues that may arise after the deal is completed.
The withheld amount, often held in escrow, serves as a form of insurance, ensuring that the buyer has recourse if post-closing concerns emerge, such as undisclosed liabilities or breaches of representations and warranties by the seller.
Holdbacks provide a financial safeguard for the buyer, encouraging the seller to address any outstanding issues promptly and protect the buyer from unexpected financial risks associated with the acquired business.
Raincatcher’s thoughts on holdbacks:
Holdbacks (often just called escrows) are very common and included in 90% of full buyout deals.
The only deals that don’t involve a holdback are deals where there are other financial assets that a buyer could claw back for the seller’s wrongdoing, such as rollover equity or seller notes.
2. Seller Note (seller financing)
Seller financing is a transaction arrangement where the seller of the business provides debt financing to the buyer.
In this scenario, the buyer makes principal and interest payments directly to the seller over time, in addition to or instead of obtaining a traditional loan from a third-party lender.
Seller financing is often used when buyers may face challenges securing conventional financing or when the seller wants to make the deal more attractive by offering flexible payment terms.
Seller financing can benefit both parties by facilitating the sale of the business and providing the buyer with an alternative financing option. However, because the seller’s paper is subordinate to other, senior lenders, it carries some risk.
Raincatcher’s thoughts on seller financing:
For competitive deals, it is uncommon for our sellers to accept a deal that has any seller financing. However, there may be a buyer who is willing to pay a premium for a company if the seller is able to finance a portion of it.
If you’re looking into deal structures, you may be interested in our business valuation calculator. It’s a great way to share your information with us and hear from our professionals on the value of your company.
3. Rollover Equity
Rollover equity, also sometimes referred to as retained equity is a strategic approach in mergers and acquisitions where existing owners elect to retain a portion of their ownership stake in the the company. Since the buyer is forming a new company, they are essentially exchanging their shares (or partnership units) in the old company for shares/units in the new company. This act is called rolling over.
This financial arrangement is designed to maintain a sense of continuity, as the original stakeholders continue to hold a vested interest in the ongoing success and performance of the combined entity.
Raincatcher’s thoughts on rollover equity:
Rollover equity is used commonly used in two different scenarios:
- The seller(s) are staying in place and continuing to run the company. They sell either a majority or minority of the business to diversify their wealth and bring on an investor as a partner.
- The seller is exiting the business completely, but greatly believes in the direction of the business moving forward and wants to take part in the growth that the buyer will enjoy.
An earnout is a payment arrangement in business sales where a portion of the purchase price is contingent on achieving future milestones. These milestones can be a cliff, where the seller gets all or none of the contingent payment based on achieving this, or a step, where there are various payouts for various outcomes.
This aligns the interests of the buyer and seller, especially in uncertain growth scenarios or when the seller is staying in place to operate the company through a period of time with a high-growth forecast.
Raincatcher’s thoughts on earnouts:
Earnouts can be helpful to bridge a perceived gap in valuation between a buyer and a seller. If the seller has a high level of belief in the future success of the business, they may be willing to take a portion of that payment contingent on future outcomes of the company’s operations.
Earnouts are often used in cases of high-growth companies and/or when the buyer is paying an above-market valuation multiple.
When Is Deal Structure Used in M&A
We provided our thoughts on when each type of structure is used above in the “Raincatcher thoughts” section. To summerize those thoughts, deal structure is used to reconcile a gap in valuation held by a buyer and seller and to align their go-forward interests.
It is also common for deals in soft markets to have more structure (less cash paid at close) than deals in strong, seller markets. This is because buyers have more leverage in purchase negotiations.