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FOUNDER’S GUIDE TO M&A AND FUND-RAISING TERMS

There’s lots of finance industry jargon out there. But entrepreneurs only need to know a fraction of it: the key terms that drive M&A and fund-raising deals. Why be a rube when you can be a savant?

To jump to definitions of our 55 terms, see the list below. Or scroll through them one by one for a relaxing tour of corporate transaction lingo.

Mergers, acquisitions and raises are complex, ever-changing undertakings. Check back here for list additions and modifications. And make your own suggestions!

338(h)(10)
Election

A term only a bureaucrat could love. It’s the name of the IRS code that allows buyers of S Corps to treat the transaction both as a purchase of assets and of equity. From the buyer’s perspective that’s the best of both worlds. Specifically, after purchase they can depreciate/amortize assets. That reduces profit and therefore taxes.

Then — as if they were buying control equity — they also avoid the hassle of renegotiating whatever contracts the seller may have. Like agreements with employees, suppliers, licensors and clients. But the downside is that sellers get taxed as if they sold assets, i.e., at regular income rates on their net gain on sale. They’d much rather sell equity at lower capital gain tax rates.

So whether the seller signs off on a 338(h)(10) Election may depend on whether the buyer can figure out a way to share the benefits for mutual gain. Or less charitably, conclude that the seller already has no better offer. See Bloomberg  for more detail.

Accretive Transaction

When a public company acquires a target for lower price/earnings (P/E) multiple than its own, the deal is considered “accretive.” That’s because when the target’s earnings are added to the acquirer’s, they increase the acquirer’s stock price more than it cost the acquirer to buy the stock. That’s the theory, anyway.

Adjusted EBITDA

Adjusting EBITDA means adding back non-recurring expenses and excess owner-operator compensation. It also means subtracting non-recurring gains like one on an isolated foreign exchange trade. The idea is to normalize or smooth out irregularities in EBITDA caused by events unrelated to operating the business going forward.

IBs (investment bankers) scrutinize such adjustments carefully. Any change in EBITDA can jack value up or down by the EBITDA multiple for which the company is selling. That’s commonly five times or more. Buyers also know that while specific expenses may not re-occur, unexpected or one-time expenses as a group do re-occur. See this Corporate Finance Institute article for more info on the art and science of adjusting EBITDA.

Angel Investor

Angel InvestorAngels are high net worth individuals (HNWs) who invest their own money in start-ups via “seed” rounds. Seed rounds follow initial investments made by the founders and their friends and family (F&F).

Assets Under Management (AUM)

AUM include the cash and market value of investments made by a venture capital firm (VC) or private equity group (PE group or PEG). See Investopedia for more about AUM.

PEGs call the cash portion of AUM available for investment “dry powder.” Both VCs and PEGs often limit the dry powder they invest in a single opportunity to 5% of their AUM.

If they reach this limit or otherwise feel uncomfortable committing more than a certain amount, yet remain excited about the opportunity, they may “lead” the round by recruiting others to join in investing.

Backlog

The value of orders that clients have placed but the company has not yet fulfilled. Buyers regard backlog as an important indicator of seller viability. Its size as a percentage of annual revenue offers them assurance of continuity.

Bolt-ons

Bolt-on acquisitions (aka add-on) provide advantages to a PEG’s “platform” company like access to new markets, technology, geography, production facilities, etc. They usually retain their own market identity as compared to “fold-ins” or “roll-ups” which the acquirer absorbs Borg-like. For a grab bag of miscellaneous M&A jargon like the above, see M&A Science’s searchable list.

Bootstrapped

A company that has sold equity only to its original owners or key employees. The term “bootstrapped” alludes to theBootstrapped fact that such companies financed their growth solely through cash flow and operators’ investment — as in “pulled themselves up by their bootstraps.”

Broker

A broker is an intermediary that represents the owners of smaller companies typically for the purpose of finding them buyers. Want to know more about business broker and investment banker job descriptions? See WHICH TO USE — INVESTMENT BANKER OR BUSINESS BROKER? and WHAT DO INVESTMENT BANKERS DO TO SELL A COMPANY?

Burn Rate

Burn rate is the amount of money that a company spends over a certain period of time net of whatever cash it may generate. Dividing cash on hand by monthly burn rate tells you how many months the company has left before it must at least reach cash flow break-even. Or raise more funds!

Buy-side

For investment bankers and brokers, a buy-side engagement in one where they seek acquisition targets for their client’s company. They’re working for the “buy-side.”

Buyout

A type of acquisition where the buyer purchases control of the seller’s company

CAPEX

Capital Expenditure is the amount of money spent on depreciable assets like production machinery or intangible, amortizable assets like patents. It’s not initially an expense since it lands on the balance sheet. Then it slowly wastes away, draining through the income statement as a non-cash expense.

Cap (Capital) Table

A chart that lists a company’s equity and options holders, how many shares and what types of shares they own. It also tracks what dilution (reduction in percentage of equity ownership) would occur if the holders of options or convertible debt exercise their rights to purchase additional shares.

Investors or buyers generally eschew complex cap tables since many small shareholders can make achieving consensus on moving ahead difficult.

Cash-Free/Debt-Free Transaction

A purchase structure commonly used by private equity groups (PEGs) whereby they buy all the seller’s equity or key assets but take none of its excess cash or excess debt.

While a simple concept, the devil’s in the details – specifically what constitutes “excess” cash and debt may provoke buyer-seller debate. For a more complete description of what this sort of deal structure means, why it’s used and how to apply it, see this WallStreet Prep article.

CIM

The Confidential Information Memorandum is a detailed description of a company for sale that sell-side IBs distribute to buyers who have signed an NDA. CIMs describe the target’s history, cap table, market, clients, operations, organization, historical and projected financial performance, reason for sale, and perhaps preferred deal structure.

IBs originally printed CIMs in bulky leatherbound and individually numbered books (which explains why some people still call them that), But today’s CIMs are electronic documents increasingly formatted like slideshow presentations with backup detail available in an online data room.

Data Room

Like CIMS, data rooms were originally physical, even windowless locations where companies for sale stored sensitive information like employee and client files for controlled access by buyers. In the last 20 years, sellers have converted all such data into electronic form available online.

Today’s data room operates 24/7, allows access to authorized users located anywhere the Internet is available, tracks usage patterns, and updates content in real-time.

You’d think such improvements in economy and speed would accelerate the DD process (see). But in fact its greatest impact has been on the amount of DD material gathered and delivered.

Dilution

Reductions in a shareholder’s percentage of company ownership caused by the issuance of additional shares.

Drag-along Rights

Rights held by controlling shareholders that compel other shareholders to sell their stock if a purchaser wants more than what the controlling shareholders own. Drag-along rights are an antidote to cap tables teeming with dozens of small and perhaps inexperienced shareholders.

Due Diligence

Acquirors invariably conduct thorough due diligence (DD) on potential acquisition targets, a process that follows the signing of a Letter of Intent (LOI) and that consumes months. While every target undergoes this inquisition, not all are found innocent.Due Diligence

Most DD covers every aspect of the company’s operations, market, legal and tax standing, customer relations, intellectual property, “quality of earnings,” competition, organization chart, etc. going back as far as five
years. For examples of when DD can get so tedious as to threaten the deal, see HOW BUYERS KILL M&A DEALS.

DD hardly ever results in buyers increasing their offer but can result in their reducing it. A competent sell-side IB will identify potential DD problems before going to market and help the seller cure them or otherwise reduce their impact on value in advance of DD.

For lists of DD issues and their cures see HOW TO INCREASE YOU COMPANY’S VALUE: A CURB APPEAL CHECKLIST and HOW TO INCREASE YOUR COMPANY’S VALUE: A RENOVATION CHECKLIST.

For both DD and other reasons why sellers can run into trouble while trying to close the sale of their company, see HOW SELLERS KILL M&A DEALS.

EBITDA

Earnings Before Interest, income Taxes, Depreciation and Amortization. Analysts commonly multiply EBITDA by some number when estimating a company’s worth. As in “Acorn Private Equity values Aero Corp at 5x trailing twelve-month EBITDA.”

Despite its ubiquity, we think using EBITDA does a poor job of valuing a business. Buffet even considers it “meaningless.” That’s because it strips away non-operating expenses like taxes and interest in an effort to get at “core” earnings. But non-operating expenses are as real as operating ones.

To omit them artificially inflates something that looks like cash flow but isn’t. Acquirers must still pay non-operating costs even if the amounts they pay differ from what the seller used to pay. For a truer picture of a company’s value, use present value. It examines actual cash flow. Cash flow of course includes CAPEX, interest, taxes and any other non-operating expenses or even gains that the acquirer could realize going forward.

Having said that, because it’s so commonplace, EBITDA is still useful as a standard gauge of relative value. It’s a convenient way to compare a company with its peers.

Enterprise Value (EV)

EV is roughly what you’d pay if you bought a company outright. That is, if you purchased all its shares (its “market cap” or market capitalization), assumed its debt and took its cash.

Actually, you’d have to pay a higher price for the shares (a “premium”) because otherwise why would their owners sell? See here for more about how and why to use EV.

Meanwhile, what’s all this got to do selling your private, mid-market company?

One way a buyer can value your company is by looking at the average and median EV/EBITDA and EV/Sales multiples of public companies in the same business as yours. They then apply those multiples to your company. But first they discount the multiples somewhere between 25% and 35%.

They do that to account for the lower share illiquidity, size, brand visibility and accounting standards of private versus public companies. Like any valuation technique, using EV multiples to value a private company is less than precise. Choosing the right discount rate can be a bit like raising a wet finger in the wind.

Expression of Interest (EOI) or Indication of Interest (IOI)

A buyer’s Letter of Intent (for description see below) strives for quantitative precision regards consideration paid, close date, etc. In contrast, EOIs and IOIs lay out ranges. Example: consideration to be paid is between $50 and $65 million.

Sell-side IBs use EOIs/IOIs to weed out uncompetitive bidders or tire kickers to avoid wasting time cultivating them. For more on this see Divestopedia’s article.

Financial Buyer

VCs and PEGS are called financial buyers because mostly what they bring to an acquisition is money. “Strategic” buyers theoretically bring not only money but the promise of operating synergies. The acquisition styles of both types of buyers differ as do their plans for the target’s future. Competent sell-side IBs understand these differences, make sure their client does too, and manages them accordingly.

Financial Model

Financial models are “digital twins” of a company’s business’s transactions as captured in its income statements and balance sheets (and by their interaction in the form of cash flow). After examining the history of a company, the modeler identifies key metrics that drive dollars (“drivers”), then extends those metrics into the future by considering historical sales growth, economies of scale, future market demand, inflation, cost-cutting, changes in the post-close balance sheet and prospective timing and value of an exit (whew).

Model Building

The idea is to:

1) Produce a cash-flow driven net present value (NPV) that the analyst can compare to M&A and public company multiples when valuing the business both as-is and after instituting various enhancements;

2) Optimize the balance between debt and equity to maximize ROE at an acceptable level of risk;

3) Stress-test outcomes under multiple scenarios to determine how sensitive the company’s performance is to external developments like rising interest rates or recession.

The IBs of both buyers and sellers create such models for the same reason – to determine what a company is — and could be — worth.

Forward/Backward/Horizontal Integration

Forward integration is a rationale used to acquire a company that brings the buyer closer to end-using clients, or closer to the last stages of the value-add chain.

Backward integration is a rationale used to acquire a company that brings the buyer closer to the beginning of the value-add chain. Example: a steel factory buying an iron ore miner.

Horizontal integration is a rationale used to acquire a company that brings greater scale or more intellectual property to the buyer’s current operations.

Golden Parachute

Employment contracts that guarantee extensive benefits to key executives atGolden Parachute the selling company should the new owner fire or “constructively terminate” them post-close. Parachutes motivate these execs to stick around and assist in the company’s sale without excessive concern for their financial future.

Sellers may also grant bonuses to them for contributing to a sale that meets certain value, timing or other criteria.

Goodwill

The degree by which an acquirer’s purchase price is greater than the fair market value of the target’s net assets. The new owner amortizes goodwill ratably over 10 years unless it’s “impaired” (worth even less).

Intermediary

An intermediary, or middleman, brings together – intermediates — between a buyer and seller or between parties joining together for a common commercial purpose.

Both investment bankers (IBs) and business brokers are M&A intermediaries though the former specializes in initiating complex financial transactions while brokers tend to focus on selling smaller companies.

For a more complete description of the differences see WHICH TO USE — INVESTMENT BANKER OR BUSINESS BROKER?

Letter of Intent (LOI)

Sellers want to see an outline of the buyer’s purchase terms before committing to the arduous DD process (see above). LOIs – two to three pages long — typically:

  1. Describe the buyer’s source of funds;
  2. Deal structure (asset versus equity purchase)
  3. What’s being purchased (how much equity, which assets or liabilities);
  4. Amount of consideration paid and in what form (cash versus Newco equity versus earn-out versus debt, etc.);
  5. Anticipated close date and;
  6. If relevant where in the buyer’s corporate structure the target fits.

LOIs don’t bind the buyer beyond an obligation to pursue in good faith a timely close as per the terms proposed. In fact, buyers have the right to walk if in their opinion DD reveals material weaknesses in the target company or misrepresentations made by its management.

On the other hand, the seller is prohibited from contact with other buyers for the duration of a specified LOI “lock-up” or “exclusivity” or “no-shop” period lasting several months. It’s during that time that DD and negotiations over terms proceed.

Leveraged buyout (LBO)

LBOs are a type of company purchase where third-party lenders fund part of the cost of acquisition, perhaps 20% or more. Such lenders typically put liens on the assets of the acquired company as collateral.

From the seller’s perspective, an LBO is riskier for two reasons: 1) closing the sale is contingent on the lender coming through; 2) heavy debt post-close can threaten the financial integrity of the company, bad news for a seller that holds equity or debt in the company or that expects future payments from it.

On the other hand, an LBO structure may fund a higher purchase price than any all-cash offer the seller will see.

Long-Term Capital Gain

If you sell an asset you’ve owned for at least a year at a price greater than your basis (cost minus depreciation), you’ve got a long-term capital gain. It’s taxed at a lower rate (currently 20%) than short-term capital gains which the IRS treats as regular income.

Founders selling their company generally prefer to sell its equity rather than its individual assets because stock sales qualify for long-term capital gains treatment. Yet buyers may prefer the opposite – the chance to write up the seller’s assets then depreciate them as a tax shield down the road. So goes the art of the deal.

Material Adverse Change (MAC)

The mack-daddy of bad news. MACs reduce buyers’ risk during the period between when a purchase agreement is executed and the deal closes, meaning when consideration actually changes hands. (Surprising to some, that period can be a month, even more while the parties arrange finances and other matters.)

MACs do so by defining the conditions under which the buyer may cancel the deal without penalty. Such changes are usually related to a dramatically negative development that “materially” affects the seller’s business and therefore its value.

Conversely, if a buyer bails for unconvincing reasons or for reasons unrelated to the seller during that period, the seller may have earlier negotiated a break-up fee due from the buyer. We see break-up fees ranging from 10% to 15% of deal value.

Mergers and Acquisitions (M&A)

M&A covers everything from a company’s sale of minority equity (called a raise) to control equity
(anything over 50% of voting rights). When the consideration paid for control is cash at close, (maybe combined with future cash from an earn-out or seller’s note), we call it an acquisition.

When the consideration paid is in the form of shares traded between two companies it’s called a merger. Rarely are mergers between equals. Much more common are mergers where one company’s shares are worth more than 50% of the other’s.

Mergers are more complicated than acquisitions because the IB must determine the value of both party’s equity, not just that of the client.

Newco

For the purposes of this glossary, Newco is the temporary name of a company that a PEG buyer creates in order to protect itself from the acquired target’s liabilities. It does that either by merging the target into Newco (“reverse triangular merger”) or by merging Newco into the target (“forward triangular merger”).

These transactions are called “triangular” because they involve three business entities — seller, PEG and Newco.

When offering all-cash consideration, PEGS prefer using the reverse triangular structure. It not only protects the PEG from Newco liabilities but also makes the deal tax-free. But wait, there’s more. It also allows the PEG to assume the seller’s contracts without having to re-negotiate them with suppliers, clients and employees.

For a fuller explanation of these rather complicated but money-saving arrangements, see Investopedia’s article.

Pipeline Data

It’s more than a list of prospects that salespeople are working to convert into customers. Proper sales pipelines categorize prospects by stages ranging from mere identification all the way to a scheduled order date. Each stage carries anSales Pipeline estimated probability of close multiplied by order value.

Example: Stage 4 carries an 80% probability of close and the order is worth $100,000. Ergo, that order’s expected value is $80,000.

Adding all prospective orders together produces future estimated monthly revenue. The bigger that number is compared to historical performance, the less risk that the business is going south. And so the more valuable buyers consider it to be.

Platform Company

Platforms are portfolio companies that a PEG considers to be a leader in its industry. It has available infrastructure capacity and strong management, meaning the PEG is motivated to invest in it further by buying add-ons and roll-ups (see).

Portfolio Company

A company in which a PEG or VC has invested. In the case of PEGs, this usually mean they own controlling interest. In the case of individual VCs, they rarely do. Both VCs and PEGs advertise their current and former portfolio companies on their websites.

Present Value (PV) and Net Present Value (NPV)

The holy grail of valuation, present value first looks at a company’s stream of cash flow going forward. Then it discounts that back to the present based on how much risk and time is involved in getting the money. Net present value takes into account what you spend to acquire the flow. For fuller descriptions of both see HOW TO VALUE A START-UP.

Proprietary Advantage

Any competitive advantage that’s gained by using intellectual property — technology, data, know-how or other processes and assets unique to the firm. It’s the job of the sell-side IB to uncover and promote these advantages.

Return on Equity

ROE is one measure of a company’s financial performance. It’s calculated by dividing net income by shareholders’ equity to produce a percentage. Example: an ROE of 25% means in four years the company will generate profit equivalent to Year 0 equity.

Some other useful measures of financial performance are:

  • COGS (Cost of Goods)
  • ROA (Return on Assets)
  • ROS (Return on Sales)
  • GM (Gross Margin, i.e., sales minus COGS)
  • B/E (Operating Breakeven)
  • SGA/Sales (Administrative Overhead)
  • Inventory Turnover (COGS/Inventory)
  • Sales Growth (Yr 2 – Yr 1)/Yr 1)

Sell-side

For investment bankers and brokers, a sell-side engagement in one where they seek a buyer for their client’s company.

Series A, B and C Fund Raises

All are types of funding rounds financed by VCs. Series A typically follows friend and family, angel or seed rounds and it consists of the sale of preferred stock. Proceeds finance the conversion of an interesting idea into a working business. So far in 2023, the average Series A round raises about $22 million.

Series B funds the roll out of a business that has demonstrated commercial viability and may benefit from economies of scale.

Series C — usually the last private round — fuels the expansion of an already successful business. The money goes toward new product development, entry into new markets, etc. Series C round companies are typically mature enough that they attract not only VCs but hedge funds, PEGs, etc. For more detail on funding series, see this Investopedia piece.

Target Criteria

Working with their sell-side clients, IBs create target criteria to define their company’s ideal buyer or seller. As a random example: Seller X prefers buyers that will:

  • Pay all cash;
  • Allow the founder to exit within six months of close, and;
  • Retain the current CFO for three years.

For further refinement, IB and client may assign different weights to each criterion then total them to rank a buyer.

Teaser

A brief (one or two-page) description of an anonymous company for sale that sell-side IBs circulate to potential buyers. They want to pique buyer interest so that they sign an NDA to get a CIM (see).

Pari Passu

A term referring to the equal treatment of two or more parties in an agreement. It’s Latin for “with even step.” For example, an investor may want certain rights that are pari passu (identical) to those granted to earlier investors.

Pre-money/Post-money Valuations

The value of a company before investors put money into it versus its value after they do so.

Preferred Stock

Stock that gives its holders certain rights, preferences and privileges over holders of common stock and other securities.

Proforma Shares Outstanding

The total number of shares anticipated to be outstanding after the company issues and sells new shares.

Purchase Price Allocation

The division of purchase price into two buckets — net assets and goodwill. Buyer and seller must agree on this allocation because how much goes into each bucket affects either:

  1. The seller’s regular income tax liability or;
  2. The buyer’s tax shield via depreciation.

 

Recapitalization (or Recap)

Usually, a reduction of a company’s debt relative to equity in order to stabilize its financial condition. Or a partial sale of a company’s equity to a PEG. That generates a liquidity event for the seller. At the same time it allows him/her to participate in future equity value gains.

SandbaggingSandbagging

A bidder may claim that a sell-side IB is sandbagging them while waiting for a better offer — stalling for time.

Synergies

Cost savings and revenue enhancements that a buyer expects will come about in a merger/acquisition. Expectations are often unmet.

Tag-along Rights

Rights that enable the holder to participate in a sale of stock by another shareholder to a third party.

Valuation

The act of estimating what a company is worth. For established companies, analysts use three methods to do this and hope the values converge:

  1. Present value of future cash flows;
  2. Comparable company acquisitions and;
  3. Comparable public company values.

 

For early-stage companies with little or no revenue, analysts must use proxies for cash like “eyeballs,” or milestone achievements. To learn more about both approaches see HOW TO VALUE A START-UP and HOW TO VALUE A GOING BUSINESS.

Warrants

A security that includes the right to buy shares (usually common stock) from the issuer at a certain price and time period. IBs may earn warrants as part of their success fee.

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Ryan Kuhn

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09/05/23

“Ryan Kuhn is the founder of Kuhn Capital (bio). This article is not the product of AI. AI is a product of this article.