Friday, October 2, 2009

Deal Strategies from an Attorney's Perspective

It has been a challenging year on many levels. In the business transaction marketplace the deal advisors have had to dig deep into their reservoir of experiences to put and keep deals together. In a normal market, creativity is a primary factor in helping buyers and selling and that is especially true in this economy.
I recently had the opportunity to speak with Markus May, an attorney with Eckhart Kolak, who specializes in Mergers and acquisitions. Markus shared some interesting insights about the current market and potential strategies to get deals done.

Interview with Markus May from Eckhart Kolak:

Q: What kinds of deals are typical for you and your firm?
A: As a small boutique business law firm in the Chicago Loop, we see a wide range of deals. We have helped numerous “main street” businesses with a sales price of less than $1,000,000 and up to $40,000,000. Our sweet spot tends to be businesses selling in the $750,000 to $5,000,000 range.

Q: What has the M&A market been like in 2009?
A: It has been an interesting year from a mergers and acquisitions perspective. We have seen a large tightening of the credit markets and financing has really dried up in the first three quarters of 2009. Our firm remained quite busy, but we have heard that numerous other firms are suffering at this time.
It appears that due to the slow economy, business valuations are down this year. Because of this downturn in business values, some sellers are not placing their businesses on the market and are waiting for business values to increase. With the layoffs in management, there are a large number of buyers in the market. However, because of the lack of available financing, they have not been able to close on deals.
I believe the SBA’s relaxing of the goodwill rules (effective October 1, 2009) will help provide lending on the under $2MM loan size deals. In summary, the sellers tend to be on the market a little longer than they were in the last few years while waiting for a buyer with the proper resources to become available.

Q: Are there any other market conditions worth mentioning?
A: The other market condition we are seeing is a decrease in business valuations due to the overall economy and fear in the marketplace. While a company has, in the past, been able to base its selling price on historical revenues and EBITDA (earnings before interest, taxes, depreciation and amortization), current buyers are not agreeing with those valuation methods due to concerns related to the economy and its effect upon the business.

Q: How are sellers and buyers bridging this potential valuation gap?
A: We are seeing a large increase in performance based pricing using tools such as earnouts, equity ownership or profit sharing in order to try to bridge the valuation gap. Really, this becomes some form of deferred purchase price.

Q: Can you describe an earnout in further detail and provide an example?
A: An earnout is a purchase price component based upon meeting certain milestones. In the past, earnouts were typically used to address the “hockey stick” situation where a seller tells the buyer, “If you do A, B, and C, then your revenues/income will go up and therefore you should pay me more for the company.” The buyers of course asked why the seller had not done A, B, and C in order to increase the value of the business and were unwilling to pay for what the seller perceived as being a higher value for the company. This difference in value was often bridged by creating an “earnout” which provided that if certain parameters (revenue or income goals) were met, the buyer would pay an additional amount of money to the seller. For example, if a company was earning $500,000 per year in EBITDA and there was an agreement the value of the company was $2MM based upon that EBITDA, but the seller wanted an increased sales price due to things the purchaser could do to increase the value of the business, a buyer may agree to pay $2MM plus X% of EBITDA for the next two years, with a cap of $400,000 in earnout payments.

Q: How has the earnout situation changed in today’s environment?
A: In today’s economy, what we are seeing is more of a “reverse hockey stick” where fear is driving valuations. Buyers are unsure that even if a company has a solid five year track record, whether the earnings and profitability will continue in the future. Due to this fear, buyers are less willing to pay full value and are asking sellers to share in the economic risk. Further, this is another way to bridge the financing hurdle if a bank is not willing to lend on a deal. For example, if the buyer in the above example thinks the business is only worth $1.5MM, an earnout could be structured to provide that the buyer will pay an additional $500,000 for the business if EBITDA continues at the same level it was prior to the sale.

Q: Are there any issues with respect to how earnouts are determined?
A: One of the issues that often arises in these types of situations is a discussion as to whether an earnout should be based upon top or bottom line numbers. A seller prefers the earnout to be based on top line numbers, such as revenues. The buyer prefers bottom line numbers such as net income. In practice, this issue can be fairly heavily negotiated and there should be safeguards in the agreement that allow the seller to at least audit the numbers presented by the buyer to verify that the proper amount of earnout is paid to the seller.

Q: What other form(s) of deferred pricing are being negotiated?
A: Seller equity ownership in the new company is another option when a seller is hesitant to give full control to a buyer. Rather than just receiving earnout payments, a seller may require some ownership in the company and a board position in order to exercise some control over the company going forward. A deal may be structured so the seller retains some equity in the old company if the transaction is processed as a stock deal. If it is an asset deal, the seller may take an equity interest in the buyer’s company. Often the buyer may want an option to purchase the seller’s stock at some time. For example, there may be an option which forces the seller to sell its equity interest to the buyer once certain parameters are met; e.g., once seller has received $XXX in dividends, the seller is required to sell the stock back to the buyer. These are just a few ways to bridge the valuation gap.

There are, of course, tax implications to all of these different strategies and it is important to properly structure any type of deferred purchase price or performance pricing parameter.

Q: Do you have any other advice for buyers and sellers in this market?
A: We are still seeing deals getting done. It just takes a little more creativity than in the past and the people who succeed are still the ones who take the time to do things right. I closed a deal a couple weeks ago where I was able to save the client approximately $23,000 in the course of two hours at the closing table. If the client had not hired a deal attorney, this is money that would have been lost. Its important to surround yourself with a good deal team of a broker, attorney, accountant, and others who can help you succeed. This is not like a house closing or a general business contract where most attorneys are able to serve you fairly well.

Markus May backgrounder
Markus May is an attorney with Eckhart Kolak LLC - a boutique business law firm located in the Chicago Loop which provides its clients with high quality legal representation in business areas. Mr. May is a client focused business attorney with knowledge in a broad range of industries. He helps clients with transactions, including mergers and acquisitions and drafting and negotiating contracts, shareholder agreements, leases, and other documents. Markus is a frequent speaker on the legal aspects of buying and selling businesses and other business law related topics. He represents business clients as well as clients who desire to start, buy or sell businesses. Mr. May is a member of the Illinois State Bar Association Corporations, Securities & Business Law Section Council (Vice Chair 2009), the Chicago Bar Association Corporation and Business Law Committee (Chair 2009), the DuPage County Bar Association Business Law Committee, and the Midwest Business Brokers and Intermediaries (Board of Directors 2008 – present). He has published numerous articles on topics related to business sales and the operation of businesses. He can be reached via phone at 312-236-0646 or 630-864-1004 or via e-mail at or

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