COMMON TERMS IN SALES OF MIDDLE MARKET COMPANIES
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Middle market companies occupy a unique niche in our economy. According to
Thomson Reuters, global mid-market M&A activity was valued at $736 billion in 2013,
with North America contributing $267.3 billion of deal activity (36.3%
share of the market).
There is no uniform definition of middle market companies; however, a common
measuring stick is $10 million to $500 million in revenue, or $2 billion
to $10 billion in market value. Mergers and acquisitions of mid-market
companies are similar to those of both small businesses and large cap
companies; however, they often have their own issues due to the company’s
stage of development.
Most negotiations for the sale of mid-market companies understandably concentrate
on the purchase price. The acquirer wants to minimize the risk of paying
for a business that could later underperform. The seller has a valuable
asset that it wants to monetize at the highest possible price. Somewhere
between these two extremes, a deal can usually be done.
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In addition to the purchase price, there can also be negotiations around
post-closing operations, post-acquisition employment, and indemnification
for certain issues.
This article discusses some of the more common terms in the acquisition
and sale of mid-market companies.
Contingent value rights – Contingent value rights (CVRs) allow the seller to profit from
certain later occurring events which are defined, for instance, a later
sale of the company by the purchaser. In this case, CVRs would allow a
seller to have some continued upside if the purchaser is able to later
sell the company at a profit. CVRs are especially common in transactions
with private equity firms. They allow the purchaser to complete an acquisition
yet reduce the amount paid upfront. For instance, the purchaser and seller
could agree that a 100% acquisition of the target is valued at $500 million.
Instead of paying $500 million upfront, the purchaser could pay $400 million
and grant the seller a CVR of 20% of any later gains to compensate for
the $100 million reduction in purchase price (in reality, the CVR percentage
is usually increased in order to reflect the risk that the seller is incurring;
as a result, in this example, the CVR would more likely be 25%). Note
that the CVR is not a partial acquisition with the seller retaining part
of the stock; rather, the purchaser acquires the full 100% held by the
seller. If the triggering conditions are met (in this case, the purchaser
being able to later sell the company at a profit), the seller would be
able to profit from the difference. However, if the triggering event is not met (e.g., the second sale is break-even or at a loss), then the seller’s
CVR would be worthless. Note also that the CVR is
not debt; if the company is later sold for less, the CVR holder gets nothing.
Earnouts – In earnouts, the purchaser and seller agree on a series of milestones
that will result in additional compensation to the seller. Earnouts are
usually used when the seller/founder will continue to work for the company
post-acquisition, but it can also be used in circumstances where valuation
is difficult because of a new product line that has launched, ongoing
restructuring, a recent acquisition, etc. Earnouts allow the parties to
share both the risk and reward that the company’s future operations
will be profitable.
Holdbacks – Holdbacks deal with the purchaser retaining (holding back) some
of the agreed-upon purchase price in order to deal with post-closing issues
(usually indemnification for certain claims). For instance, if the company
is involved in certain litigation which will likely result in a payment
to the adverse party, but the amount cannot yet be measured, the parties
could agree on a purchase price of $500 million with $10 million to be
held back to cover the litigation. Any damages (and sometimes legal fees)
are paid out of the held back amount first. If the claim is resolved for
less than the held back amount, then the remainder is paid to the seller.
If the amount to resolve the claim is greater than the held back amount,
then either the seller or the purchaser will pay the difference (depending
on the indemnification provisions agreed upon as part of the deal).
Employment and/or consulting agreements – If the purchaser does not have abundant experience in the acquired
company’s industry, then it may desire to have the company’s
management stay on to help run the company, at least until new management
can be found. Whether the services are rendered as an employee or consultant
depends on the desired tax treatment for the parties, the control to be
exercised over the services, and the length and extent of the services,
among other things.
Covenants not to compete – A purchaser understandably wants to protect the goodwill of the
company that it has purchased by preventing the seller from taking the
money from the sale of the company and opening a competing business. The
seller on the other hand wants to be able to capitalize on its knowledge
and contacts within the industry and move on to its next business venture.
Covenants not to compete (non-competes) work to balance these conflicting
concerns. Non-competes are subject to rigorous legal review if they are
too broad or too long and can be subject to different analyses depending
on the state whose laws are being applied.
Representations and warranties – The seller usually makes a series of representations and warranties
regarding the company’s operations, financial condition, assets,
etc. In private company M&A, these representations and warranties
survive closing, which means that a breach of these representations and
warranties can lead to a claim against the seller. In public company M&A (i.e., where the target is a public company), these representations and warranties
do not survive closing because there is no one to stand behind the representations
and warranties post-closing (i.e., the purchaser would have to sue every stockholder of the public company,
which is not feasible). In public company M&A, therefore, the representations
and warranties serve as conditions precedent to the purchaser’s
obligation to consummate the acquisition.
Indemnification – Indemnification deals with covering claims by third parties asserted
after the acquisition closes. Indemnification includes damages payments,
tax payments, and legal fees (usually). Generally, the seller must indemnify
claims asserted against the purchaser for matters arising before the closing,
for instance, a lawsuit filed after the closing for an accident occurring
before the closing date. The purchaser, on the other hand, will generally
indemnify the seller for claims arising after the closing date; for instance,
a suit filed against the seller due to an accident occurring after the
closing (this could happen if the plaintiff does not know about the sale
or if it is simply looking to expand the number of potential contributors
to pay damages). The parties may also agree that any claims for indemnification
will be brought within a certain time (i.e., private statute of limitations). These representations and warranties
may also have triggering points or deductibles.
The above is only a short description of some of the common terms arising
in the sale of middle market companies. Each company and each deal stands
on its own merit and has its own issues. As a result, the involvement
of knowledgeable accountants, investment bankers, attorneys, and other
experts is paramount.
For seasoned counsel, call our Houston securities law attorney—(888) 252-8277.