Understanding M&A Deal Structures: How Transactions Are Structured in Practice
Mergers and acquisitions (M&A) transactions can take many forms, with deal structure playing a critical role in shaping financial, tax, and operational outcomes for both buyers and sellers. While every transaction is unique, most deals follow common structuring frameworks that dictate how ownership is transferred, how consideration is paid, and how risk is allocated between the parties.
For sellers, understanding deal structures is not about choosing an ideal scenario but about preparing for what they are likely to encounter in a sale process. Buyers will structure transactions based on their own financial and strategic objectives, and sellers must navigate these frameworks to optimize their outcome. This article outlines the most common deal structures used in M&A, their key components, and what they mean for business owners considering a sale.
Asset vs. Stock Sales: The Foundation of Deal Structure
At the highest level, M&A deals are structured as either asset sales or stock sales, each with significant implications for tax treatment, liability assumption, and operational continuity.
- Asset Sale: The buyer purchases specific assets and assumes certain liabilities, while the seller retains the legal entity. This structure is more common in lower middle market deals, as it allows buyers to minimize risk and maximize tax advantages.
- Stock Sale: The buyer acquires the entire entity, including all assets and liabilities. This approach is generally preferred by sellers for its simplicity and capital gains tax treatment but is less common unless specific regulatory or contractual reasons necessitate it.
While the core components of the business transfer in either structure, the legal and financial implications differ significantly, shaping how the rest of the transaction is structured. Read more about the differences between asset and stock sales here.
Consideration: How Payment is Structured
One of the most critical aspects of an M&A transaction is how the purchase price is structured. The way consideration is paid has major implications for both buyers and sellers, influencing risk, liquidity, and potential upside. While many sellers prefer an all-cash transaction, the reality is that deals often include multiple forms of payment, each with its own advantages and drawbacks. Below are the most common structures sellers can expect to encounter in an M&A transaction.
Cash at Close
Cash at close is the most straightforward and preferred method of payment for sellers. In this structure, the buyer pays the full purchase price, or a significant portion of it, in cash at the time of closing. This provides the seller with immediate liquidity and eliminates concerns about future performance of the business under new ownership. However, cash deals require the buyer to have sufficient capital or financing in place, which may not always be feasible. Additionally, competitive deal processes often favor buyers who can provide more certainty through cash-heavy offers.
Rollover Equity
In many transactions, particularly those involving private equity buyers, sellers are asked to retain a portion of ownership in the business post-transaction. This is known as rollover equity. By rolling over a percentage of proceeds into the newly structured entity, sellers maintain a stake in the company’s future success and align their interests with the buyer. While this provides potential for future upside, it also means that some of the seller’s proceeds are tied up until a future liquidity event, which may be uncertain. Sellers should carefully evaluate the buyer’s growth strategy and the likelihood of a successful exit before agreeing to rollover equity.
Earnouts
Earnouts are often used to bridge valuation gaps between buyers and sellers. Under this structure, a portion of the purchase price is contingent on the business meeting specific financial or operational milestones over a defined period. Earnouts help mitigate risk for buyers while offering sellers the opportunity to achieve a higher total payout if the business performs well post-sale. However, sellers must recognize that earnouts introduce uncertainty—payments are not guaranteed, and disputes can arise over performance calculations. To protect their interests, sellers should negotiate clear, objective metrics and establish oversight mechanisms to ensure fair measurement of earnout conditions. Read more about structuring earnouts in M&A transactions here.
Seller Financing
Seller financing is an option whereby a seller provides a loan to the buyer for a portion of the purchase price. This structure is often used in lower middle market deals where traditional financing options may be limited. The seller receives periodic payments over time, typically with interest, rather than the full purchase price at closing. While seller financing can help facilitate a deal, it comes with risks—if the buyer encounters financial difficulties, the seller may struggle to collect payments. To mitigate this risk, sellers should conduct thorough due diligence on the buyer’s financial stability and negotiate protective loan terms, such as personal guarantees or collateral backing the note.
Contingent Liabilities and Indemnifications
One of the key risks in any M&A transaction is the potential for undisclosed liabilities or future claims that arise after the sale is completed. Buyers seek to protect themselves from these risks by negotiating indemnification provisions, while sellers aim to minimize post-closing liabilities and retain as much of the purchase price as possible. Understanding how these provisions work is critical for structuring a fair deal.
Indemnification Clauses
Indemnification clauses define which party is responsible for legal, tax, or financial liabilities that may surface after the sale. Buyers typically want broad indemnification protections to cover unknown risks, while sellers prefer to limit their exposure. Negotiating these clauses requires balancing risk allocation to ensure both parties are protected without derailing the deal.
Escrows and Holdbacks
Escrows and holdbacks are commonly used to enforce indemnification obligations. A portion of the purchase price is placed in escrow for a set period to cover potential claims, giving buyers a financial cushion if undisclosed liabilities emerge. Sellers should negotiate clear terms around escrow amounts, duration, and conditions for release to avoid unnecessary disputes.
Reps and Warranties Insurance
In larger deals, representations and warranties insurance (RWI) is an alternative to traditional indemnification. This insurance policy covers certain breaches of reps and warranties, reducing the seller’s post-closing exposure and limiting the need for large escrows. While RWI can streamline negotiations, it comes at a cost, and policies may have exclusions that require careful review.
Working Capital Adjustments
A critical component of many M&A transactions is the working capital adjustment, which ensures that the business is transferred with an appropriate level of short-term liquidity. Buyers want to ensure that after closing, they have sufficient working capital to continue operations without needing to inject additional funds, while sellers want to maximize their proceeds by optimizing working capital levels leading up to the sale.
Target Working Capital
The buyer and seller agree on a target level of working capital based on historical performance and operational needs. This target typically includes accounts receivable, inventory, and accounts payable. If the working capital delivered at closing differs from the agreed target, adjustments are made to the final purchase price.
Post-Closing Adjustments
After the deal closes, a reconciliation process occurs to compare actual working capital to the agreed-upon target. If working capital falls short, the purchase price may be reduced. Conversely, if it exceeds the target, the seller may receive an additional payment. Sellers should ensure that calculation methodologies and timelines for adjustments are clearly defined in the purchase agreement. Learn more about the role of working capital in M&A transactions here.
Seller Considerations
Managing working capital effectively in the months leading up to a sale can significantly impact the seller’s final proceeds. Sellers should be mindful of accounts receivable collection, inventory levels, and payables management to avoid unexpected downward adjustments post-closing. Engaging financial advisors to model potential working capital scenarios can help prevent surprises and ensure a smooth transition.
Conclusion
M&A deal structures are complex and shaped by financial, operational, and risk considerations. While sellers may not always have direct control over structuring elements, understanding the frameworks commonly used in transactions allows them to prepare effectively and negotiate with clarity.
Every deal is different, and sellers should work with experienced M&A advisors to ensure their interests are protected, whether structuring consideration, managing earnouts, or mitigating post-closing risks. By anticipating the structuring mechanics of a transaction, business owners can maximize their outcomes and achieve a smoother sale process.