M&A Monday: Breakdown of a Closed Deal (Part I)

Anatomy of a Closed Deal. This is the structure and learning points from a closed deal.

I have closed dozens of deals this past year. Each is unique and has lessons for other deals. Here is a breakdown of the deal and issues we faced. I am leaving out certain identifying information.

This was a sponsor from an unconventional background (non-financial services). He was seeking a business that needed his initial involvement, but could sustain a professional management team. He wanted to be in control of his time, be there for his kids, and create a generational asset. This sponsor was one of the the best I have worked with. He left his ego at the door, was calm and non-threatening under pressure, and focused on solving each problem that arose. He had a quite professional persona and I grew to like him a lot throughout the deal.

Offer and Purchase Price Structure.

Asset v. Stock. The first issue was the acquisition structure. Ordinarily, buyer prefers an asset purchase in order to leave most of the old business’s legacy liabilities behind and to get a full “step up” in the tax basis of the assets for the buyer (very important and for another post). In this business there were licenses and contracts that could not be assigned in an asset purchase, so we had to do a stock purchase. However, the target was an S-corp and buyer had investors, so we needed to do an F-Reorg on the seller entity. This converts the S-corp to a single-member LLC. Thus, the transaction would be treated as an asset purchase for tax purposes (giving the buyer a full “step up”), but the business keeps the same EIN and the licenses, contracts, and employees do not get disrupted. The downside is that the liabilities of the business are still inherited by the buyer. In the LOI, the buyer agreed to pay the cost of legal for the F-Reorg.

Purchase Price Structure.

The EBITDA for trailing 12 was above $3 million and after significant negotiations on the LOI, seller agreed to an enterprise value at a multiple of around 3x EBITDA. The multiple was lower than average for a few reasons. First, the business did was in a very competitive industry usually commanding much higher multiples, but a portion of the business was new construction. Second, it was in a secluded geography that deterred some bidders. Third, the sellers really liked the buyer. He had deep roots in that geography and sellers felt he was the best fit for their employees and legacy. Sellers emphasized many times that their business was a staple of the community. They employed many people from church and sponsored the Little League team. Sellers were very focused on this continuing and turned down higher offers from private equity.

Thus, Sellers accepted his offer over other higher offers.

We structured the purchase price as follows because of certain considerations:

Because of legacy liabilities and the need for seller involvement, we wanted a significant promissory note. We settled on 14% of the purchase price in Notes (How to Get a Seller Comfortable with Promissory Note).

Promissory Note #1 could be used to offset any indemnification issues (if something goes wrong after closing, we could reduce the promissory note for that loss: What If Something Goes Wrong After Closing?)

Buyer wanted to go with an SBA 7(a) loan to fund this acquisition (even though independent sponsor financing options were also available). While conventional SBA lenders max out at $5m, some lenders will add their own loan on top of the SBA loan to get higher. This is called Pari Passu and for this deal, I sent it over to Bruce Marks at First Bank of the Lake who is an expert on getting Pari Passu loans closed. We have closed many together and I have full confidence in him and his team. For this deal the SBA loan was around $5m plus the Pari Passu portion of more than $2m. The business's EBITDA could more than sustain these loans.

For the portion of the purchase price that Buyers were not funding through the loan, buyers were raising equity from investors (to be discussed in Part II). According to the SBA regulations, a promissory note can be considered part of buyer’s required equity injection if it is on “standby”; while interest can accrue, buyer cannot make any payments or adjustments on the promissory note for the term of the loan (and recently, no balloon payments). Sellers did not want all of the Note on “standby”, but agreed to a portion of it 2% to be on standby.

The buyer also agreed to pay for the seller’s F-Reorg ($5,000) and the business broker. So, in reality, this should be added to the enterprise value of the business and impact the multiple.

The final piece of the purchase price was the net working capital (NWC). There was significant disagreement over this point. To digress briefly, NWC is defined as Current Assets minus Current Liabilities that must be left in the business at closing. This is the amount of money needed to sustain the performance of the business after closing (think of this as when buying a car, it is the gas needed to get to the next gas station). In the LOI, it was agreed the NWC would be a certain amount. However, the Quality of Earnings provider said the NWC average over the past 12 months was $500,00 more. We came to understand that the seller’s cash retention and collection of AR may have accounted for the higher-than-expected NWC number. We finally came to an agreement on this prior to signing the purchase agreement in exchange for the seller’s making a certain investment in the business after closing.

At closing the actual net working capital came in slightly above, so there was $50k owed back to the seller after the closing adjustment.

A few more points to mention. The buyer had a great relationship with the sellers. He maintained that relationship throughout the transaction, even when there were difficulties. The buyer always stayed calm, left his ego at the door, and focused on solving the problems.

Because this was a purchase of membership interests where liabilities came over, we had to be extra thorough on legal due diligence.

We structured this as a Sign Then Close (Sign Then Close). This was very important because after signing the purchase agreement we could proceed with employee offer letters and initiating the F-Reorg. Additionally, the business started performing better between signing and closing and knowing we had a purchase agreement in place gave us added comfort.

Finally, it is hard to say if this deal would have closed without a sophisticated bank’s counsel, Scott Oliver. Many bank’s counsel do not understand how an F-Reorg works and they botch it. Scott and I have closed a handful of deals this year with F-Reorgs and the process is always smooth. In this deal we learned that the F-Reorg cannot be done right before closing (like we do in PE deals), but the F-Reorg has to be complete before the bank can start their closing process. Noted for next time.

The buyer ended up owning more than 80% of this business with $50k of his own money in the deal. In Part II, I will review the Preferred Investor structure.