Startup Founders, Here’s How to Succeed on Your Next M&A Deal

Imagine ABC Company developed proprietary technology for enterprises and is in talks to be acquired by D Company for a proposed price of $100 million. What does this really mean? And how can ABC Company’s founders position themselves to get the best deal possible?

Letter of Intent

The first step in an acquisition is generally to enter into a letter of intent, a (mostly) non-binding agreement setting out the basic terms of the deal. The LOI is where a seller has the most leverage.

Once the LOI is signed, a seller is locked in for a significant period and will have more difficulty taking tough stances during negotiations. Therefore, it’s in a seller’s best interest to include as many material terms in the LOI as possible before leverage erodes.

What types of terms should an LOI include?

Purchase price. While purchase price is important, it’s equally important to set and understand terms of how that price will be paid.

If the payment is cash, will it be paid over time or in a lump sum? If payment is made over time, that could create uncertainty over whether ABC Company will ever receive the expected $100 million.

If the payment is in equity, note whether the company is public or private.

If public, it’s much easier to get liquidity for shares. If the company is private, how are the shares being valued? Should you do your own due diligence if there is little available public information on the company?

Payment structure. If the deal consideration is fully payable at closing, that makes things easy. But that often isn’t the case—there likely will be various contingencies on payment.

Some deals have earnouts where part of the consideration is only payable if certain revenue targets or other milestones are met. It’s important to ensure protections are in place to help achieve these milestones.

Oftentimes, a buyer wants a holdback. Certain seller employees/founders subject merger consideration to new vesting contingent on continued employment. If that’s the case, what protections do those individuals have? If they are fired without cause, for example, does the holdback accelerate?

The buyer will likely hold back part of the purchase price to secure certain indemnification obligations of the sellers. The buyer typically will ask the seller to make broad representations about the state of the business being sold and its assets.

If these representations are breached, the seller will be obligated to “indemnify” the buyer for any losses. This is heavily negotiated—in particular, buyers usually agree to different caps on liability for different indemnification obligations.

Exclusivity. An exclusivity clause is typically a binding obligation whereby the seller doesn’t negotiate with other prospective buyers for a period. A shorter timeline is more beneficial for the seller.

The Process

The acquisition process involves initial discussions and negotiations, approvals, the due diligence phase, and finalizing the deal.

Founders must approach these initial conversations cautiously and be wary of an unacceptable offer. Putting too much upfront effort diminishes one’s negotiating power. Paramount to leverage is securing the deal terms in the LOI. Buyers typically appreciate short LOIs; sellers should require longer ones.

The acquisition process is costly and time-consuming. Before the process begins, founders should secure soft approvals from investors who may have veto rights over a sale. Although a seller can’t secure formal approvals until the deal’s signing stage, soft approvals signal that investors will formally sign off when the time comes.

Some buyers may explore deals in bad faith and use diligence to get intel on a competitor or potential competitor. Watch out for buyers who focus solely on diligence. Further, be careful about diligence that discloses to customers or vendors that you are in a merger and acquisition process. If the deal falls through, those relationships could change.

Once terms are outlined in the LOI, founders must balance managing the company with focusing on an expeditious closing. The purchase agreement can take months to negotiate, sign, and close—and each stage poses potential risks that could derail the deal.

Deal documentation must be drafted and finalized as diligence is ongoing. Flesh out everything in the LOI, including detailed company reps and warranties. Internal diligence can determine if the reps and warranties are true, which need to be revised, and what the seller needs to disclose against.

Founders should understand different exit structures to minimize risk, secure the best financial outcomes, and ensure legal compliance. Consider the choice between an asset sale and a stock sale, for example.

An asset sale puts the company as the seller, so tax would be at the company level. Once the funds are distributed to the stockholders via a dividend, the seller must pay dividend tax on the proceeds.

This essentially doubles taxation on asset sale proceeds unless the company has enough net operating losses carried forward to avoid taxes at the corporate level. Founders should seek the expertise of tax counsel and accountants, who can review the financials before they agree to an asset sale. Assuming they’ve held the stock for at least 12 months, stock sales generally give sellers long-term capital gains tax treatment.

This is just the tip of the iceberg. There are other types of structures, such as various merger structures, that have their own tax implications.

The acquisition process is complex and rife with opportunities to derail the process. By understanding the intricacies of each stage, founders can set themselves—and their companies—up for success.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Mital Makadia is partner at Grellas Shah, where she provides counsel on corporate and transactional matters and negotiates equity financings and M&A transactions.

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