There are several terms and definitions you should know if you are evaluating a businesses for sale . In order to buy or sell a company, it is critical that you understand the rationale for each legal document as well as terms that are commonly used.
- Non-Disclosure Agreements (NDAs) – a confidentiality agreement between two parties. This basically prevents one of the parties from disclosing the information specified in the agreement. This helps to ensure proprietary and sensitive material is kept confidential.
- Engagement Letter– outlines the scope of work that a service provider / vendor will provide to the client, including the type of work that will be performed, how much work will be performed, the payment method for the work (hourly vs. fixed fee), and the timing of the payments. In addition, an engagement letter defines the deliverables that the client wants to receive.
- Indication of Interest (IOI) – this is a letter that the Buyer sends to a purchaser. It basically gives an offer range for the business as well as ownership percentage the buyer is seeking.
- Term Sheet– This is basically a one or two-page document that provides a little more detail to supplement an Indication of Interest (IOI).
- Letter of Intent (LOI) – A letter of intent is the preliminary agreement entered into between a buyer and a seller. This document summarizes the transaction terms and conditions that have in principle been agreed to by both parties.
- Stock Purchase Agreement (SPA) – agreement by which the owners of a company sell their shares of stock to a buyer. Basically, a SPA details the terms of the transaction (who receives what, how much and when; legal conditions and/or issues). Here’s a more detailed explanation of a Stock Purchase Agreement.
- Asset Purchase Agreement (APA) – agreement by which the assets of a company are sold to a buyer. Basically, an APA details the terms of the transaction – who receives what, how much and when; legal conditions and/or issues. Here’s a more detailed explanation of an Asset Purchase Agreement.
- Escrow Agreement – ensures parties fulfill contractual obligations and helps mitigate disagreements. For example, a buyer typically escrows part of the purchase price to protect itself in a transaction. The escrow is typically released after one and/or two audit cycles. Basically, a buyer wants to make sure it is buying a sound business. Here’s a more detailed explanation of an Escrow Agreement.
- Senior Management Agreements (SMAs) – an employment contract between a company and its key executives. This formalized a Company’s relationship with its senior managers. SMAs outline such things as base and incentive compensation, employees’ roles and severance terms. Basically, this spells out the terms of employment for a respective employee.
- Stock Option Plans – stock option plans govern employees receiving ownership (or right to exercise option for ownership) in a company. Business owners use stock option plans to retain and motivate workers because options allow workers to participate in the upside. We believe Google employees are quite happy it had a stock option plan! In addition, business owners receive tax savings, which helps cash flow. There are two types (i) incentive stock option pans and (ii) non-qualified stock option plans.
Some Common Terms
- Deal Fees– Generally related to a financial advisor and outlines the scope of work that a financial advisor will perform for the client and specifies how the financial advisor will be compensated. For example, financial advisors typically earn a fee that is equal to 2%-5% of the total deal price. This fee may be more or less depending on certain characteristics (nature of the deal, complexity, etc).
- Earnouts – payment(s) contingent on some future financial or measurable target. For example, a buyer may agree to pay the owner of a business an additional $5 million the year following an acquisition if earnings grow by at least 20%. Depending on the complexity on a transaction, earnouts can be either straightforward and easy to understand or very complicated and hard to quantify the real value. Some examples will help you to better understand how earnouts work.
Some Deal Terms – (more to come)
- Price – how much are you paying / receiving?
- Timing of Payments – when are payments paid or received?
- Conditional Payments – are any payments contingent (commonly referred to has earnout payments). For example, is part of the compensation based on company achieving a certain amount of revenue by the end of next year? two years from now?
- Management Roles / Retention – is the transaction contingent on the an individual being given certain duties or being retained prior to the closing?