Deal Terms: Advantage, Buyer

A new study shows acquirers have their choice of target companies, and deal agreements are more buyer friendly.
Vincent RyanNovember 4, 2011

Want to sell the company? Make sure revenue is growing and cash flow is positive or near so; prepare yourself to be flexible on deal terms, especially if you’re glued to a selling price; and don’t make plans to fade into the sunset once the deal is signed.

A new study from Shareholder Representative Services (SRS) shows that acquirers in private-target transactions are largely winning buyer-friendly terms in the deals they complete and are setting higher standards for revenue and earnings because they have their pick of companies to buy.

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The SRS, which manages the postclosing process for selling shareholders, said its study of the deals it has worked on shows buyers are prioritizing their purchases — buying mostly mature companies with proven track records. In the past two years, a greater percentage of target firms had revenue and positive EBITDA (earnings before interest, taxes, depreciation, and amortization), for example. And sellers had more rounds of preferred-stock financing prior to being acquired — 3.57 on average in 2011, versus 2.81 in 2008.

Mark Vogel, a managing director of the SRS, says the numbers, which mostly come from venture-capital-backed exits, make sense. In 2007 and 2008, “it was difficult for these VC-backed companies to get bought, so the sponsors had to put more capital in to protect their best companies,” he explains. And because of the additional time, “companies that would have been bought pre–net income in the past instead became profitable.”

Some of the deal terms in private-target M&A transactions have also shifted in the past year. A majority of the changes benefit the acquirer, but not all. Changes occurred in three areas in particular:

Earnouts. An earnout is a provision stating that the target’s shareholders will get additional consideration if the selling company reaches certain milestones. Using this tool, buyers are hedging their bets and transferring some risk back to the selling shareholders in about 25% of deals, says the SRS. The number of deals using earnings or EBITDA as the metric for an earnout increased fivefold in 2011.

But it’s not necessarily bad news for sellers. The average “earnout period” — the time during which the seller has to meet the earnings and revenue targets and thus collect additional money — rose to 43 months in 2011, from 35 months last year. “If there is going to be an earnout, the sellers want the earnout period to be as long as possible,” Vogel says. Earnouts are being used to bridge the difference between the seller’s desired price and the buyer’s bid, he says. “[The buyer says] we will give you $100 million now, but for each year the company’s revenue or net income exceeds a certain amount, we will pay you additional consideration later,” says Vogel.

Escrows. An escrow is a holdback of what’s being paid for the target. It’s used to indemnify the buyer if it discovers a problem after the deal closes. Buyers want holdbacks for “collection convenience,” says Vogel. “If after the deal closes the seller is audited and there’s a $2 million tax liability, the buyer has to go back and collect [a portion of] that $2 million from each of the shareholders.”

The SRS’s study shows buyers are negotiating more time to make a loss claim: the average escrow period rose from 15.9 months in 2009 to 18.3 months in 2011. “The buyers have more time to identify errors or losses and get back some of the merger consideration to compensate them for the flaws,” Vogel says.

But that doesn’t mean longer holdback times are being crammed down sellers’ throats, he says: “It’s a negotiation. Sellers are often willing to increase the escrow period or raise the amount of escrow in exchange for losses being capped.”

Management carveouts. These plans are arranged to incentivize a management team or employees to stay with the company until it is sold. The incentive is the direct allocation of a portion of the purchase price to the employee. The use of carveout plans declined in 2011: 25% of deals had them versus 33% last year, according to the SRS.

Why did usage go down? Vogel says it’s not because shareholders are placing less value on existing management and employees in the preclosing period. Instead, “as companies mature they have more income, so they are able to negotiate a sales price that is higher,” he says. “Management is able to make most of the incentive through the purchase price of the deal — they don’t have to be paid separately to make the deal happen.”

All these additional terms can produce something of a headache for buyers and sellers. The postclosing process of many M&A deals is indeed much more complex, says Vogel. “It used to be more things were done at closing,” he says. “Now contingencies and deferrals are being pushed out further so that the shareholders have a longer period [in which] they have continuing rights and obligations.”

Vogel says CFOs shouldn’t use the individual deal-term numbers from the study as an absolute benchmark. “Every [deal] term has metrics, but you need to know the trade-offs of your deal,” he says. “You may be willing to do a longer escrow, on the high side, in exchange for something else you’re getting. You have to look at the deal as a whole; you can’t look at any individual term to know whether it’s good or bad.”

Most of the deals the SRS collected data on were made in the past 12 months. One-quarter of them were valued at $200 million or above, 22% at $100 million to $200 million, and 21% at $50 million to $100 million.