Deal Structure Basics: What Sellers Need to Know

Did you know that only 20% of the businesses listed for sale actually sell? It’s a startling figure to consider when you’re a business owner thinking about selling. While this rate can be attributed to numerous factors, such as the valuation gap, one common point remains: deal structure is absolutely critical to the success of a prospective M&A transaction. Both the buyer and the seller need to be on board with the deal structure for a deal to be successful. 

In this article , you’ll learn about the fundamentals of deal structures and how they impact mergers and acquisitions. You’ll also discover some common ways deals might be structured and why this part of the selling process is so crucial. 

Fundamentals of Deal Structures

Acquisition deal structure is precisely what the term implies. It is the structure, or framework, that will support the many components of a deal. It can be helpful to think of every deal as a puzzle with numerous pieces, all of which are unique to the goals of both buyer and seller. The deal structure will determine how those pieces fit together.

Basic deal structure can be broadly referenced during initial discussions with a buyer. The most important elements are then outlined by the acquirer in a Letter of Intent (LOI) to purchase the business. The LOI then becomes the foundation for buyer’s and seller’s legal counsel to create the Definitive Agreement. As such, it is critical to get this first pass at deal structure in the LOI right. Requests to modify the deal structure later can erode trust, sour negotiations, and potentially scuttle the deal entirely.

To prevent this scenario, all parties need to be upfront about the deal structure and what they are expecting. This includes: 

  • Their stance on certain issues, such as how long the seller will stay involved with the company post-sale  
  • Their expectations for the negotiation, including progress milestones and deadlines 
  • What they are willing to compromise on 
  • Conditions that will prevent the deal from being completed 

A deal structure also broadly addresses the following components: 

  • The business valuation, purchase price, earnouts (contingent payments), and financing means 
  • Promissory notes for the seller 
  • Current market conditions 
  • Accounting policies of both parties 
  • Employment or consulting agreements 
  • Non-compete agreements
  • Working capital peg (amount left in the business) 

Working through each one of these details takes time. For instance, consider a few of the things that go into the financing of the deal. The buyer and seller must determine how much of the purchase price will be paid in cash at closing. Both parties must also analyze cash flow from operations, and the amount of working capital to remain after the deal is complete. Lastly, it must be decided how funds will be dispersed and the time period in which this will occur. 

Before advisors and attorneys move details from the LOI to the final deal, both parties must first agree to a general deal structure. The structure they choose will strongly determine how the rest of the sale will go.

Common Deal Structures

If you’re a small business going through the deal structuring process, there are three options that are frequently used for the proposed deal

  1. Asset purchase
  2. Stock purchase 
  3. Merger 

The M&A process has evolved and become a bit more complex over the past few years. Ultimately, your advisor and attorney will come up with a structuring strategy that is most likely to result in the sale of your business while also protecting your best interests. Let’s take a closer look at the most common deal structures you might consider when selling your company. 

1. Asset Purchase

Under an asset sale, the buyer agrees to buy certain assets from the target company. This can include tangible assets, such as inventory, equipment, and receivables, as well as intangible assets, such as goodwill and intellectual property

This model can be particularly attractive to buyers because the target company remains a legal entity, keeping its own corporate status. As a result, the target company still remains responsible for liabilities on its books. 

The buyer is not necessarily obligated to purchase all of a company’s assets. If the buyer chooses to hand-select which assets they’d like to purchase, it will heavily influence the structure of the deal. Working through the availability of assets can take a considerable period of time. Attorneys must also figure out whether leases, contracts and warranties transfer during the small business due diligence process

2. Stock Purchase

Under a stock sale, the buyer purchases shares that are currently in the hands of stockholders. This is a common method for publicly-traded companies, but is not as common for small to midsize businesses. 

Unlike an asset sale, where buyers can pick and choose what they wish to purchase, buyers do not get to hand-select what they buy under a stock purchase. They automatically assume all assets, liabilities, and contracts held previously by the target company. This puts sellers at a tremendous advantage. 

Stock purchases typically come with tax advantages for the seller, as the entire purchase price is taxed at the state and federal capital gains rate (versus ordinary income).

3. Merger

Less common in the lower middle market is a merger. Under this structure, two unique entities combine to form one corporate entity. Sellers typically give assets and intellectual property in exchange for stocks, cash, or both. 

This structure tends to result in a deal that occurs more quickly. However, buyers can find themselves at a disadvantage because many liabilities may not emerge until after the sale as a result of the accelerated deal. 

Examples in the lower-middle market would include product liability claims or employment disputes against the target company. Some of these issues are not evident until after the merger has occurred, even with a thorough due diligence process.

Why Deal Structures Are Important in the Selling Process

Deal structure: business people shaking hands

Deal structure clearly defines what will occur during and after the sale of your business. You have put years of hard work into building your company. The deal structure outlines how the merger or acquisition will occur, how much cash you can expect to receive as a result, and when you will receive those funds. 

It will also determine the role you will have (if any) in the company moving forward and your obligations toward your existing debts and liabilities. Furthermore, the chosen structure has significant tax implications for both buyers and sellers. The structure defines how both entities are treated by the IRS after the deal is complete. 

Because of this, it’s essential to hire experienced advisors and attorneys to help with the M&A transaction. Professionals in this field have experience with various types of deal structures and they can help determine which is best for you. 

Remember that the merger and acquisition process is a negotiation between a buyer and a seller. The deal structure and terms may not be perfect, and you may have to compromise on some issues. But you should not lose out on the deal either. 

Do Your Due Diligence When Structuring Your Merger or Acquisition

When going through the M&A process, there are numerous details to determine, from figuring out how much cash the seller will receive upfront to how much working capital is left in the business, or whether they need to sign a consulting agreement to complete the transaction. 

The deal structure is one of the most critical components needed to complete the sale. Experienced advisors and attorneys can help determine which type of deal structure is ideal for your situation. 

You can have an asset sale, stock sale, merger, or a structure completely unique to your situation. Unlike real estate, there is no standardized method for selling a business: Every deal is different. Hiring experienced professionals to help you through the M&A process can help protect you and the company you’ve worked so hard to build.

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