What’s Really in an Acquisition Offer: A Basic Guide To M&A
When is a $10M acquisition offer not really a $10M acquisition offer? All the time. Almost never does a $10M acquisition mean you are going home with your pro rata share of $10M.
In addition, an M&A process is a major distraction to a business and takes precious founder time away from building compelling products, long-term customer relationships, and motivated teams. How can you be sure it’s the right thing for you?
What follows is a brief explanation as to why a $10M offer isn’t what it seems, as well as what to look out for before starting down the path with a potential acquirer. Part I deals with the key terms of an offer, Part II explains the liquidation waterfall, and Part III discusses the common pitfalls of M&A processes and how to avoid them.
Special thanks to Cooper Overcash for reviewing and improving this post from his perspective of an M&A lawyer. Cooper has an excellent blog on corporate topics here.
Part I: Key Terms
Company Consideration vs. Aggregate Employment Agreement
Oftentimes the headline number on an acquisition offer doesn’t reflect the actual consideration paid to shareholders; instead it could mean the total theoretical value of the employment agreements for the retained employees. For example, $10M could mean nothing for the company itself and $2.5M in cash and stock compensation over the next 4 years of anticipated employment (more commonly referred to as an “acqui-hire”). Acquirers generally prefer this approach as pushing purchase price into compensation allows them to realize a tax deduction on the employment piece.
Cash vs. Stock
Whether an acquirer offers cash or stock typically depends on which is more abundant. It’s also common to have a mix of both, for example $3M cash and $7M stock. The tricky thing about stock is it’s up to you to determine the absolute and relative value of another private company’s stock. This includes factoring in things like transfer restrictions and liquidation rights which can greatly impact the value of the received stock. In general, the acquirer tends to overestimate the value of their stock while underestimating the value of yours. Cash offers are more straightforward.
Upfront vs. Earn-out
Another way to slice an acquisition offer is by upfront vs. deferred consideration. Acquirers prefer as much consideration to be deferred as possible. This can take the form of an earn-out stipulating a key business metric to be achieved in a set amount of time in order for the consideration to be fully released to the shareholders, thereby motivating the key team members from the acquired company to continue contributing to the go-forward entity.
There’s another major consideration here for founders, which is what happens if you’re fired from the acquiring company and lose out on both your salary and portions of your earn-out. Sellers should try to have as much “control” over the metric set for the earn-out as possible, or at least agree on the accounting or internal method to calculate the metric ahead of time.
Part II: Liquidation Waterfall
Another set of reasons why a $10M acquisition offer doesn’t result in your pro rata share of $10M has to do with the liquidation waterfall of your company. As a founder holding common stock, you are typically last in line to get paid.
Creditors vs. Shareholders
First in line in any liquidation or change in control are creditors (and within the stack of creditors there’s a pecking order too). These include venture debt investors, non-converted convertible notes, and any founders or employees who have leant money to the business.
Preferred vs. Common
Next in line after creditors are the holders of preferred stock that haven’t converted into common. These are your VCs who usually have some form of a liquidation preference, meaning they get the greater of some multiple of their invested capital or their pro rata portion of the proceeds to common stock, or both.
Transaction fees: banker, escrow agent, etc.
If you have a banker involved they are usually paid a portion of the total purchase price. There’s others in here too such as escrow agents.
“Normal Working Capital”
Normal working capital often throws people for a loop who aren’t used to seeing it, and who correctly recognize it as an effective reduction in the agreed-to purchase price. Acquirers want to take over the business with enough cash to pay a normal level of expenses, therefore they often set a minimum amount of cash that needs to be in the accounts at the time of the transaction. Otherwise there’s an incentive for the sellers to chase receivables and push payables, leaving the acquirer without enough cash to sustain a normal level of operation. Obviously the higher the normal working capital requirement, the less effective consideration for the company so this is often a negotiated point.
Escrow and Expense Funds
Every deal has some amount of “hold back” that goes into an escrow and/or expense fund managed by an independent third party to be released when a certain amount of time has passed. This in a nutshell is to ensure the obligations of the merger are met. It’s also there to fund any prevailing claims against the deal or parties to it. If there’s no issues the escrow and expense funds will be released to the acquired company. But you don’t want an overly large portion of the proceeds you were promised to be sitting out there for long.
Part III: Common Pitfalls
Beyond the complexities of deal terms and the liquidation waterfall, there’s a unique set of business risks inherent to M&A discussions.
Non-binding LOIs
After initial conversations to establish a potential fit, the first official step of an M&A process is a non-binding LOI — analogous to a term sheet from an investor. LOIs are typically binding on the company in the form of an exclusivity period restricting the company from entertaining other acquisition or fundraising offers until the diligence process is complete. Aside from an NDA for information gathered during the process, they are not typically binding on the acquirer.
This means that, for an acquirer, there is no legal penalty for doing deep and time-consuming diligence, learning about a business (and potential competitor), and then walking away from the table for any reason. If an acquirer walks, the company can be left in a situation where the other bidders have moved on. Worse, the business can easily slow due to the distraction of diligence. This can allow acquirers to “recut” their acquisition price at the finish line since they know the dynamics will have shifted in their favor.
For larger deals there may also be breakup fees on the company, meaning if the company fails to complete the transaction they will owe money to the acquirer. Less commonly there may be reverse breakup fees that the acquirer pays to the company.
This is all to say companies should carefully diligence their potential acquirers in early conversations before the LOI stage. Likelihood of completing a deal should be weighed alongside likelihood of a high bid when choosing to move forward with one party.
Information Leaks
There’s also the risk of information leaking that you’re in acquisition discussions. This can bring you unwanted attention and compound your distractions. Competitors can seize on the information and use it to sell against you in competitive opportunities (“they are getting acquired and deprioritized while we are here to support you”). VCs may also react negatively if they think M&A discussions are a sign that they shouldn’t be buying if the insiders are selling.
The wider the process, the more bidders and associated parties, and the longer it takes, the greater the risk of a leak.
Shareholder Disputes
It goes without saying that the key company stakeholders should be on the same page about an acquisition. This requires an honest internal discussion on what constitutes a “win” for everyone involved. Keep in mind that a win for a founder or early investor may be a suboptimal outcome or even a failure for a later stage investor. In some cases a later stage investor may have the ability to block a sale that doesn’t provide them a win.
Alignment is also important because merger agreements (the final execution docs after the LOI) will require a certain high threshold of shareholder consent so as to minimize the chance that minority shareholders hold up the deal or come out of the woodwork to make claims against escrow.
Insolvency
Another thing to discuss is backup plans in case an M&A process doesn’t work as planned. If the company isn’t profitable, then it’s imperative to plan for cuts or bridge financings to avoid a doomsday situation where an acquirer walks and the company risks insolvency.
The stronger your financial position (a strong balance sheet, profitability, or both), the stronger your negotiating position, and the more likely you are to have a successful outcome.
In conclusion…
In M&A discussions it can be difficult to discern what is genuine interest and what is a fishing expedition for your proprietary information. As with most things in business, it pays to have a healthy level of skepticism (“only the paranoid survive”).
To reiterate, don’t jump at big numbers, don’t go too deep before doing your own diligence, make sure your investors are aligned with you (work toward a deal where everyone wins), and — importantly — always have a backup plan.
