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.
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.
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 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 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.