Session #2: Introduction to Business Buying
An Overview of M&A and the Players (the "Forest")
THE BUSINESS BUYING PROCESS
Introduction
So, you’re ready to buy a business? Ready to “take the plunge” into SMB ownership. When you close your eyes, you can already see those juicy cash flows hitting your account. You can taste the freedom from the corporate grind. You’ve read the HBS guide and “Buy then Build” … 2.5x to 5x SDE/EBITDA … to put it mildly, you’re pumped!
But not so fast, unless you’ve been through the business buying process before, or have dealt closely with M&A in a professional capacity, you’re probably wondering to yourself, “How does this business buying thing actually work?”
In today’s lesson, we’ll (1) provide a detailed overview of a typical M&A transaction and (2) introduce the major players in the M&A process.
Our goal in this session is to show you the metaphorical “forest” before we begin examining the “trees” in later sessions.
Welcome to the second session of this free M&A masterclass. Thanks for joining us!
Part One — An Overview of a Typical M&A Transaction:
As a starting point, let’s make one thing clear…
No two M&A transactions are alike.
The process of acquiring an existing operating entity (the discipline of Mergers and Acquisitions or “M&A”) can more accurately be described as an “art” rather than a “science.”
Although “the market” (our imaginary overlord which dictates the appropriate range of terms based on a compilation of historical data from similar transactions) has established an expected range within which most deals should remain, everything is negotiable, especially in SMB. And, negotiate you shall!
Additionally, facts and circumstances (including type, size, nature and tax consequences) will vary from transaction to transaction and company to company, requiring variances in the terms of the purchase agreement, scope of due diligence, material issues to be examined, etc.
However, most business buying transactions follow a fairly routine set of steps, which are described below:
Initial Outreach
The vast majority of business buying transactions are initiated in one of two ways:
(1) Buyer initiated - buyer approaches seller or target company management with an unsolicited proposal (in SMB, this typically comes in the form of an off-market or proprietary search), or
(2) Seller initiated - seller decides it’s time to sell and engages a business broker or investment banker to run a sale process (this is the most common path). The opportunity is then listed on the various marketplaces (like BizBuySell.com) and broadcasted out to prospective buyers through the broker network.
NDA
In nearly all transactions, the buyer and the seller will enter into a confidentiality agreement or non-disclosure agreement (“NDA”), which will seek to limit the scope of disclosure and use of the information obtained by the buyer in its due diligence of the target company.
NDAs can sometimes be mutual, typically if the buyer will be providing equity as a form of the purchase price or is otherwise making disclosures to the seller of information that needs to be protected (this is rare in SMB, however).
We will discuss NDAs in greater detail in a future session. However, as a starting point, you should remember to follow the golden rule: “Always read those NDAs!” There is a tendency to move fast in the deal sourcing process, but signing legal documents that you haven’t fully reviewed and that you don’t fully understand can have real consequences.
As a practical note, however, most SMB business brokers have a standard NDA and no appetite to negotiate them, so unless there is a truly egregious issue, like a non-compete, it’s probably best to be diplomatic at this stage!
The Letter of Intent (LOI)
The letter of intent is a non-binding document in which you’ll attempt to reach an understanding with the seller on all of the material terms of the transaction before spending additional time and money on negotiating full transaction documents and conducting a comprehensive due diligence review.
Deal points often covered in an LOI include the following:
Purchase Price and Terms — how much you’ll pay, when you’ll pay it, and in what form—e.g., cash, promissory note (seller financing) or otherwise.
Consulting Services — how much transition support the seller will provide after closing.
Non-Competition — how long the seller will be barred from competing with the buyer.
Exclusivity — how long the buyer will have the exclusive right to negotiate the business without threat that an alternative buyer will swoop in a steal the transaction.
Entering into the LOI is typically considered a major milestone and signals that the seller and buyer are ready to go from “dating” to “engaged” (so to speak).
Note that, except for a few key provisions (e.g., confidentiality) of the LOI, the LOI should be non-binding. Meaning neither the buyer nor the seller can sue the other to try and enforce the terms of the LOI. It’s simply a starting point for the transaction!
Due Diligence — Make Sure You Actually Like the Business!
The purpose of due diligence is to provide the buyer with the necessary information regarding the business, legal and financial affairs of the target company to determine whether to buy the target company and, if so, on what terms.
There are three key “buckets” of due diligence, which should be examined in this order:
Financial — examining the financial affairs of the target company (typically handled by the buyer, sometimes with the assistance of a Quality-of-Earnings or “QoE” provider);
Business — examining the operational components of the target company (again typically handled by the buyer); and
Legal - examining the target business for potential legal issues (typically handled by the buyer’s legal counsel).
The material information uncovered in due diligence will ultimately be used to negotiate the contractual protections in the purchase agreement and/or make adjustments to the purchase price or deal structure.
Practice Tip: Material areas of emphasis in your legal due diligence should be (1) the transferability of the assets or stock, (2) hidden or unexpected liabilities, (3) third-party consents or approvals that are required to close the transaction, (4) third-party rights that may be triggered by the transaction, and (5) restrictions on the target company and/or the buyer’s business.
In broad strokes, due diligence typically proceeds in the following order:
Pre-LOI Preliminary Due Diligence - Buyer receives a confidential information memorandum (CIM) containing information on the target company prepared by the seller and/or the seller’s broker. Buyer conducts preliminary due diligence to determine whether the target business meets the buyer’s requisite investment criteria. This process concludes with either the buyer deciding to submit an LOI to seller or opting to pass on the opportunity.
Post-LOI Due Diligence - Buyer coordinates with a QoE provider and legal counsel to conduct more fulsome due diligence of the target business, starting by providing the seller with a targeted due diligence request list. We typically advise that buyers complete their QoE evaluation before turning to the legal diligence in order to avoid incurring material legal spend if financial diligence is going to kill the deal, but this is determined at the discretion of the buyer. At this stage, a virtual data room (VDR) is sometimes opened up by seller or broker (which may be as simple as a shared DropBox or Google Drive folder), where the seller or broker will deposit extensive documentation in response to the due diligence request list. This stage of due diligence can be iterative, and buyer and its counsel may progressively request more and more targeted documentation (via supplemental request lists) as the process advances. Post-LOI due diligence concludes with either the buyer obtaining enough information to get comfortable with acquiring the target company or opting to walk away from the deal.
Practice Tip: When conducting due diligence, always remember to have a well-defined scope of the transaction, including, what is the structure of the deal (stock or asset acquisition)? What is the legal and accounting budget? What are the critical deadlines (e.g., expiration of exclusivity)? Etc.
Obtaining the Money to Buy the Business
Debt Financing
If debt financing is required to close the transaction, the buyer should start having discussions with prospective lenders and negotiating financing terms very early in the process. As a buyer, your goal is to have your financing commitment in hand from your lenders before you begin spending money on legal or other assistance, including the drafting of the purchase agreement, to prevent “busted deal fees.”
Most SMB transactions are financed through the Small Business Administration’s (SBA) 7(a) Loan Program. A 7(a) loan is a terrific loan program only made possible via government subsidy, making it covenant light debt and easier to obtain than conventional financing. However, the SBA also requires the borrower to sign a personal guarantee, so it comes with equivalent risk. It’s also a government process so I usually describe the process as “getting a mortgage from the DMV—a pain in the ass!”
Later in the course, we’ll do a deep dive on the 7(a) loan program and get input from expert SBA lenders on this process.
Equity Investors
Before advancing from the due diligence and financing stage to the purchase agreement stage, you should reach a “meeting of the minds” and obtain a commitment from your equity investors, if there will be any in your deal.
Negotiating Agreements
After the parties have entered into an LOI, and concurrently with or after the consummation of the post-LOI due diligence, the parties (along with their counsel) will negotiate a definitive purchase agreement.
We’ll cover purchase agreements in greater detail later in the course, but in broad strokes, the purchase agreement will cover a number of legal concepts that were initially addressed in the LOI, but in much greater detail, including representations and warranties, covenants, closing conditions, indemnification, termination, working capital and other legal boiler plate.
Practice Tip: Although you should try to be thorough, it is not practical to cover off everything in an LOI that will be included in the purchase agreement. A number of areas will require more in-depth negotiations that aren’t practical at the LOI stage due to the time and cost required.
Timeline
A sample timeline for a typical private business buying transaction with SBA financing is below. Note that this timeline is being provided for illustrative purposes and could vary significantly, depending on the nuances of any given transaction.
Week 1 - Parties sign an NDA and buyer receives the CIM
Weeks 1-2 - Parties commence negotiations, have seller calls, begin preliminary due diligence. Buyer seeks preliminary input from lender and advisors.
Week 2 - Parties sign non-binding letter of intent. Buyer begins the process to receive formal approval from lender and equity investors and begins QoE.
Weeks 3-6 - Buyer conducts financial due diligence, including QoE, engages in discussions with equity investors and thoroughly examines the business. Due diligence continues.
Weeks 6-9 - Buyer and Seller negotiate the purchase agreement and other related ancillary legal documents.
Weeks 9-10 - Parties sign purchase agreement and finalize ancillary agreements.
Week 12+ - Parties close transaction.
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Part Two — M&A Players:
It’s no secret in the law firm world that junior lawyers know virtually nothing. Their job is basically that of a glorified secretary: take notes, gather documents and materials and keep them organized, prepare initial drafts of basic documentation, and learn.
One of the very first tasks a junior lawyer will be charged with is compiling a working group list for the transaction. Unless the junior lawyer has a background in M&A or finance, they’ll invariably look at the long list of names and organizations on the working group list and think, “Who are all these people, and what do they do?”
The following is an introduction to the various major players in most M&A transactions.
*Note that in this course we’ll do our best to bring you the very best, most experienced, most prolific thought leaders and practitioners from each category for a deep dive into their respective disciplines.*
Buyers. If you’re a searcher, this one is simple. You’re obviously the buyer! However, in M&A transactions, buyers can range from large public companies to small privately held companies and individuals. Buyers who are looking to expand or improve their business are typically referred to as strategic buyers (or “strategics” for short). In contrast, other buyers (including private equity funds and financial institutions) who buy and sell companies strictly to generate a financial return are often referred to as financial buyers.
Target Companies. The target company is the subject of the transaction.
Seller(s). The owners of the equity of the target company are the sellers. Depending on its nature, the target company may have a large diversified body of equity owners (such as with a public company), may be wholly owned by a single individual, or something in between. The following are a few important distinctions based on transaction type:
Stock Sale - the seller(s) sell(s) their equity to the buyer.
Merger - the seller(s) approve(s) a transaction to merge the target company into a buyer entity, then receives merger consideration at closing. Note that this is rare in SMB!
Asset Sale - the target company sells its assets to the buyer, and the seller(s) receive the sale consideration as a distribution from the target company.
Practice Tip: One of the first questions every prospective business buyer should ask a seller (or their broker) is who owns the equity of the target company. The last thing you want to have happen is to negotiate a transaction (or worse, close a transaction) only to find out that there is another owner who is either not on board with your agreement or is otherwise unaware of it.
Target Management. If the target company has management that is separate from its ownership, the target company’s management may play a role in the M&A transaction. This is common in larger-scale corporate deals and less common in SMB.
Brokers. In SMB transactions, the seller will often engage a business broker to help market and sell the target company. In many transactions, the broker will play a significant role in vetting and guiding discussions with the buyer. In SMB, it’s not uncommon for the broker to facilitate all of the communication between buyer and seller.
Practice Tip: Every buyer should pay careful attention to the broker’s disclaimers in the NDA and the incentives they create. In most cases, the broker requires that you waive all liability against the broker for inaccuracies in the marketing materials upon which you base your offer. Always remember, caveat emptor (buyer beware)!
Investment Bankers. In larger transactions, the seller may engage an investment banker (in lieu of a broker). The investment bankers play largely the same role that business brokers play in SMB transactions. However, investment bankers may at times provide additional services, such as providing a fairness opinion addressing valuation and the sale price.
Lawyers. Lawyers play a significant role in guiding the transaction for both the buyer and seller. Lawyers will assist with due diligence and drafting the various agreements, including the purchase agreement. Lawyers may also provide tax and other specialty advice in areas such as securities, IP, environmental, employment, real estate, finance, among others.
Practice Tip: It is absolutely critical to the success of your transaction that you hire legal counsel experienced with M&A. Your existing counsel that has done other non-deal work for you may be in over their head in this situation. They will never admit to this! Inexperienced lawyers have been known to kill otherwise good deals or generate unnecessarily large bills. Don’t let this happen to you!
Accounting Firms. Buyers may choose to retain an accounting firm for assistance with diligence efforts, including conducting a Quality-of-Earnings or QoE report (i.e., an assessment of how a company accumulates its revenues, which is sometimes required by the SBA lending process).
Other Experts. Depending on the scope and nature of the transaction, other experts may be involved, including economists, proxy solicitors, public relations firms, consultants, etc.
Disclaimers
Now for a few required disclaimers. Sorry in advance!
This course is being presented strictly for educational and informational purposes, and not for the purpose of marketing any legal services or seeking legal employment and is not motivated by pecuniary gain.
The opinions stated in this course from the authors represent the opinions of such individual author and not the opinions of any other person or organization.
Nothing contained in this course or otherwise from the authors hereof is to be interpreted as legal, financial, tax, investment and/or any other form of advice. Please consult your own legal, financial, tax, investment and/or other advisors.
The authors are not your lawyer, and no information provided in the course of this class or otherwise has the affect of forming an attorney-client relationship between you and the authors. In short, get your own lawyer!
This course is being presented by The SMB Center LLC and has no affiliation or relationship SMB Law Group LLP.
About the Authors
The authors have worked for some of the world’s most elite law firms in the world.
During their time in BigLaw, they regularly worked on transactions in the hundreds of millions to billion dollar plus range for some of the most recognizable companies in the world and have extensive experience with M&A.
The authors have since begun investing in select SMB acquisitions and have co-founded an SMB-focused law firm where they’ve collectively worked on hundreds of millions of dollars in SMB-focused M&A.