M&A Dictionary of Common Terms
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One-half of our work is in the M&A space: buy- and sell-side searches, valuations, negotiations, due diligence, etc. So from time to time I’m going to slip some M&A articles in here. This is a good weekly article to skip if it doesn’t interest you, but for any of you who see this in your future, I think you might appreciate “normal language” definitions of key terms in the space. These are our definitions, and are not copied from anywhere else.
This glossary doesn’t define every term in the M&A space, but rather just the ones that you should understand when you hear them so that you aren’t embarrassed and/or someone takes advantage of you. Some of these are quite advanced, but most of them are very basic.
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Acquihire. Used to describe the purchase of a firm, but the actual transaction costs the buyer less than a traditional acquisition, and it delivers more than an absorption to the seller. It combines two terms, acquisition and hire. The purchased firm is usually “defective” in the sense that there has been some intractable challenge (usually new business) and the entrepreneur wishes to exist, and then thrive, in a larger, more protective environment. To the seller, an acquihire is better than all the staff members merely being hired by the buyer, but not as lucrative as a traditional sale to the buyer.
Asset Sale. The purchase of whatever another legal entity owns, but without actually purchasing the corporation that owns those things. An asset sale, for consideration, transfers things like furniture, fixtures, hardware, software, client lists, IP, and so on, but moves them from the seller’s corporation to the buyer’s corporation without incurring any risk that might accompany the actual shares of the selling firm, including tax liabilities or legal judgments.
Balance Sheet. The consolidated statement of the assets and liabilities of a corporate entity. Under assets, you might find cash, accounts receivable, fixed assets, etc. Under liabilities, you might find accounts payable, credit cards, installment loans, leases, unearned client deposits, etc.
By-Laws (or partnership agreement). The written document that governs how an organization functions and decisions are made by the entity. This document is agreed to, in writing, by all owners of that entity, and is then bound by the specifics in that document. It will ideally address how voting is conducted, how members are replaced, how shares are sold and at what price and terms, etc.
Cap Table. A spreadsheet, usually, that shows what percentage of the company is owned by which entities, as well as the nature of their shares (controlling, voting, non-voting, etc.).
Capital Call. Refers to the infusion of cash, from the shareholders, personally, to the corporation. This is usually booked on the financial statements as Paid In Capital to distinguish the reversal of the capital call as repayment of a loan, recognized as such or not, rather than a distribution. A capital call is usually structured to match the ownership percentages of the shareholders. So if there are two equal partners, each would contribute an equal amount.
Cash at Closing. The portion of the purchase price that is paid at the transaction boundary, when the buyer acquires part or all of a seller’s interest in the firm. Anything not included in “cash at closing” is usually subject to the seller hitting certain performance targets in the earnout. This is proposed in the LOI (letter of intent), and is confirmed in the purchase agreement, which is signed at that transaction event and after the due diligence period has concluded and when the purchase is consummated.
Conflict Strategy. The assurances you make to clients who might compete in the marketplace, but who rely on you for advice. A conflict strategy is sometimes required to allay any fears that one client might have if your positioning, by definition, attracts more than one firm competing in the same space. This written strategy lays out how you will serve their best interests strategically without compromising any of the competitive advantages they might hold because you are also working for one or more of their competitors.
Corporation Type. Corporations are merely legal entities that are formed for a specific purpose. They are formed by the owner(s), and then they assemble a team of people to carry out that purpose. Corporations are not all the same, though, and carry unique legal protections and taxation features. The buyer must determine if it is in their best interest to purchase that legal entity in a stock sale or just purchase some of what the corporation owns in an asset sale. A legal entity chooses its format when it is created, though that can often be changed later, and in the USA, a corporation is a state-based entity.
Cross-Selling. Sell a different service or product to an existing customer. After a transaction, the buyer might want to sell what they offer to your clients, or they might want you, the seller, to line up customers from their existing base to purchase what you are selling. Cross-selling takes advantage of the existing relationships of both parties.
Dissolution. The opposite of a founding. A dissolution is a specific action to close a firm and wind down its operations. An “orderly dissolution” is one undertaken of your own choosing, and not forced on it via, for example, an involuntary bankruptcy. An orderly dissolution is undertaken, usually, because no acquisition opportunity surfaced, or because the would-be seller is not open to any type of earnout and no buyer has surfaced who will pay 100% of the transaction price at closing. So instead, the owner pays its obligations from its assets and retains the remainder.
Drag Along Clause. This is a mechanism whereby minority shareholders are obligated to follow the choices of majority shareholders. They can disagree and dialogue, but in the end they have no legal standing to kill a decision made by the majority shareholders. Say, for example, that there’s a 5% shareholder and the remaining 95% of the firm is owned by one entity, and that majority shareholder decides to sell the firm to an outsider. The 5% shareholder cannot kill the deal, though in practice they might have some non-legal leverage because the buyer might not want an unwilling participant, who is typically relevant to the selling firm’s operations or they would not have been granted 5% of the shares in the first place.
Due Diligence. The examination that a buyer conducts, after the LOI (letter of intent) is signed, but before the sale is consummated when a purchase agreement is executed. This allows the buyer to verify any assumptions they have made, discover important elements of the firm they are intending to purchase, and possibly revise the offer based on what they find. It is usually conducted by the buyer’s agents, including legal, tax, and advisory experts. There is no set period for due diligence, but often an LOI will suggest a closing date, before which the due diligence would be completed. Typically due diligence will last from one to four months, depending on the complexity of the transaction, and the seller will be required to sign a no-shop clause.
Earnout. Any of the purchase price that is a) not paid in cash at closing and b) subject to certain performance targets. The requirement could be as simple as maintaining employment in good standing, or as complex as hitting very specific profit targets over multiple years. The targets might be something besides profit, too, like retaining a client, developing a service, etc.
EBITDA. This abbreviation refers to “earnings before interest, taxes, depreciation, and amortization.” These four things, typically included in expenses before net profit is calculated, are actually pulled from expenses, thereby raising the profit number. The profit that doesn’t account for these four expenses is referred to as EBITDA.
Employment Agreement. The legal document that specifies the employment arrangements undertaken between the new firm, after an acquisition, and a key executive of the firm that is being purchased. This establishes a pay level, benefits, the length of the employment, the duties expected of the person, and how employment can come to an end, initiated by either party. In an acquisition, an employment agreement helps the seller understand how much influence they will have on hitting the targets that will be earned during the earnout period.
ESOP. A specific tax-advantaged process in which a company transfers its shares to an employee pool, also specifying how the company will run its affairs and deal with later transactions as ownership interests shift. A seller might opt for an ESOP, selling all or part of their shares, the purchase of which is often funded by a third entity, using the sold shares as collateral. A later, less complicated variant of this process, is accomplished through the establishment of an ownership cooperative.
Goodwill. Represents the portion of a purchase price beyond the actual value of the fixed, tangible assets owned by a corporation. This term refers to the intangible value that both a buyer and seller agree on in a transaction.
Gross Profit. While this is defined in many different ways, it is usually defined in the professional services space as all the revenue that remains after the direct costs of goods sold are deducted. These COGS are pass-through items that can be tied directly to a specific client, in whose absence such a purchase would not have been made. This excludes any overhead costs that are utilized in servicing all clients, generally. So gross profit would account for the cost of a product or service purchased specifically to be resold to a client, excluding internal labor. In some cases, gross profit is also referred to as fee billings. Gross profit is distinguished from net profit in that net profit recognizes all expenses, and not just the expenses of products or services resold to specific clients.
Income Statement. A financial report that summarizes the profit or loss incurred over a specific period of time. It recognizes the income and expense, as well as the gains and losses, in that specific period. Managers use an income statement to make important decisions about the profit contribution of an enterprise to the shareholders of that enterprise. An income statement can be built on an accrual or cash basis, but accrual is always the preferred method because it properly recognizes more elements, and because it tracks performance closer to the events that have occurred.
Intellectual Property. Also referred to as IP, this refers to the intangible creations that a company holds, developed by its members or purchased from an outside party, usually utilized to provide an advantage over its competitors.
Investor. An outside entity who infuses cash in exchange for a percentage ownership, expecting a return on that investment, either from profit distributions and/or later resale at a higher price per share.
LOI. Letter of intent, written by a potential buyer and offered to a seller, that lays out the specific intent to purchase some portion of a buyer’s interest, spelling out that purchase in specific terms, subject to any discoveries they make during a due diligence period. An LOI is typically non-binding, though it might require the seller to enter into an exclusive “no-shop” period. Larger transactions might provide for a break-up fee should the buyer not move forward with the purchase, offsetting the time and money that a seller incurred during the process.
Merger. The combination of two or more legal entities who will redistribute ownership interests and begin to operate as a single entity. A merger is simply a transaction where there is no clear buyer or seller. Instead of a one-way purchase price, from buyer to seller, there is an exchange of assets for specified equity.
Multiple. The amount by which the EBITDA of a purchase target is multiplied to arrive at a purchase price. If the EBITDA of a target company is $1M and the multiple is 4x, the purchase price is expressed as $4M. There are standard multiple ranges for each vertical industry, and then terms are applied to note how and when and on what basis the purchase price is actually paid.
Net Profit. See gross profit above.
Non-Disclosure Agreement. An executed legal agreement whereby one party agrees to keep the information they will learn confidential and out of the public eye. This is usually limited to information that’s not already known to the public, and a mutual NDA binds both parties and not just one party. These are executed when one party needs to access confidential information in order to determine how to proceed, and the party with that information wants to limit how it is circulated. Executed NDAs usually allow you to consult with your advisors.
No-Shop Clause. A period of time when you will not actively look for another buyer, and when you will tell the potential buyer if another buyer approaches you with the intent to purchase your firm, setting up a competitive situation where the potential buyer who asks you to sign the NDA does not want to invest time or money without some advantage in the process. You would not want to sign such an agreement if you want to search for other buyers in an attempt to surface other bids.
Orderly Dissolution. See dissolution, above.
Profit/Loss (or P/L). See income statement, above.
Partner. Someone who actually owns a percentage of the firm, however large or small. While individuals are sometimes called “partner” without any equity attached, here we are referring to someone with actual equity. This excludes anyone who is merely a participant in profit-sharing, options, profit-interests, etc.
Partnership agreement (or by-laws). See by-laws, above.
Private Equity (PE). This is the capital that is raised from others (individuals and entities) by PE firms, then used to invest in private companies (not those listed on publicly traded exchanges). PE investments are made with an investment horizon in mind, at which time they expect to resell those holdings for a profit, which is then redistributed back to the original investors in a fund.
Purchase Agreement. The legal document that represents all the final details of a proposed transaction, signed at closing by the buyer and seller, after due diligence is complete, which is conducted after a proposed buyer delivers an LOI to a proposed seller. This document is prepared by the buyer’s attorney, approved in advance by the seller’s attorney, and is often separate from the employment agreement that is also signed concurrently.
Retained Equity. The portion a seller retains rather than selling that to the buyer. So a buyer might purchase 51% of a firm, leaving the seller with 49% retained equity. The later sale price and terms of that retained equity are usually addressed in a purchase agreement. This is separate from rollover equity (see below).
Rollover Equity. The portion of a purchase price not actually paid for at closing, but essentially reinvested into the larger buyer’s entity. The seller might be given what is sometimes referred to as a “second bite of the apple.” Say that the purchase agreement specifies that 10% of a seller’s position is “rolled over” into the equity of the seller. That 10% would represent a much smaller percentage of the buyer’s firm or other ownership interest, and the seller is paid for that rollover equity later, in a subsequent transaction, that might or might not happen. It allows the buyer to align their interests with the seller because both parties are aiming for a favorable later sale of that entity, of which the seller now owns a small portion. This is separate from retained equity (see above).
Roll-Up. The process whereby a buyer initiates multiple purchases of similar or related firms, for the purpose of selling the combined entity later at a higher price than the firms would have sold for individually. The lead buyer purchases each firm, over time, and may ask the sellers of each firm to accept rollover equity in exchange for some portion of their shares. In some cases, the book value of the purchased firms is used to purchase subsequent firms, and in other cases the transactions are funded with debt.
SPAC. Special purpose acquisition vehicle, or essentially a shell corporation that begins trading on a stock exchange, and only then uses its assets to purchase a private company. This allows a private company’s shares to essentially be traded on a public exchange without going through the actual process of being listed on such an exchange. Some roll-ups (see above) attempt to exit their investment in this manner, though a SPAC cannot legally be formed with the intent of acquiring a specific company.
Stock Sale. See asset sale, above.
Strategic Purchase. Any purchase that commands a price higher than a strict mathematical valuation. In other words, any purchase motivated by something other than buying a stream of profit.
Terms. The arrangements upon which a purchase price is paid. Some of the purchase price might be paid in cash at closing and some may be subject to hitting certain performance targets in an earnout. In still other cases, there might be a seller note, guaranteed or not, that specifies certain installment arrangements. See “valuation,” below.
Valuation. The process of determining what an entity is worth. This is more commonly relevant to a private company that’s not traded on a public exchange, since a publicly traded company’s value is essentially all its outstanding stock times the share price. Valuations are conducted by experts in a particular vertical category, and can take many things into account, including book value, a multiple of EBITDA, free cashflow, discretionary earnings, normalized shareholder compensation, etc. A specific valuation methodology is usually favored based on how a company’s operation and growth is funded. See “terms,” above.