Hi Reader

Well, I just closed my 50th M&A deal and the journey unfolds with more insights to share. In this part 2 of our 3-part series (here's the link to part 1 if you missed it) we dive deeper into the world of business acquisitions. If the first installment set the stage, think of this as the next chapter, where complexities grow, and the lessons become more profound.

Buying businesses is no walk in the park; it's a nuanced process with numerous moving parts, each demanding attention. With each deal, I've gathered practical lessons – tips, strategies, and street-smart insights. Now, let's dissect these real-world experiences together, shedding light on the practical wisdom that can guide you in your journey as an astute acquisition entrepreneur.

These lessons aren't abstract theories; they're refined through hands-on experience in the realm of high-stakes acquisitions. While the learning curve might seem steep, my aim is to distill these experiences into practical knowledge. Let’s delve into the heart of the matter, where insights become a reliable compass in the uncharted territories of deal-making.

So, gear up – the adventure continues, and there's much more to discover. Welcome to part two of our series, where the acquisitions journey gains even more clarity and practicality.

50 Deals, Lessons Learned - Part 2

1. Crafting a Tailored LOI: What should be in it (and what shouldn't)?

Setting the Scene: When it comes to crafting a Letter of Intent (LOI), think of it like tailoring a suit – it needs to fit just right for both you and the seller.

Too vague and you risk later negotiations failing (and killing the deal) or needed terms being viewed as "re-trading" (and also killing the deal.

Too specific and you risk belabored LOI negotiations or (cringe) involvement of a sell-side lawyer too early!

Sure, there are the non-negotiables like the deal structure and purchase price. But there are also plenty of optional provisions, like indemnity caps & baskets, post-closing true-up language, detailed contingencies, specific indemnities that you might want to add. Again be cautious here. When you've got a good rapport with seller and they're advised by a savvy broker, these optional provisions may be welcome and might help the deal go smoother. But don't add them if they'll delay the LOI or overwhelm the seller!

IMPORTANT NOTE: in your LOI, make sure to include EVERYTHING regarding deal terms that the seller may regard as a "negative" like escrows, note offsets, Net Working Capital from seller and the like. If they're not in the LOI and you bring it up later in the deal, it almost never turns out well.

2. Unmasking Hidden Risks in S Corp Stock Acquisitions

Navigating the Tax Terrain: If you're buying a business through a stock acquisition, and the business is taxed as an S corp (IMPORTANT: it can either be a corporation or LLC taxed as an S corp) watch out! We're diving into the nitty-gritty of tax rules – not the most thrilling, but crucial. The key is that the acquisition target must have complied with all S corp rules - or you're potentially on the hook. These S corp rules? Here are the most important ones to watch: Ownership restrictions (must be individually owned not through entities), bans on ownership by non-resident aliens, and the one-class-of-equity rule. The last of these is especially tricky. Even if all the seller did was make distributions unevenly between shareholders or somehow adopt an agreement that had the effect of directing or resulting in such an uneven distribution. That's known as a "defacto second class" and similarly results in a breaking of the S corp rules.

What happens if the target breaks S corp rules? Bad things. IRS audits, penalties, back taxes, and since you bought the company's stock, you're on the hook.

Do your homework; make sure you know what you’re getting into, and if there’s any doubt, clear the tax decks with an F Reorganization (or consider Reps and Warranties Insurance).

3. Net Working Capital: Fueling Your Acquisition Engine

Ensuring Financial Vigor: Net Working Capital (NWC) is the gas in your acquisition tank – you can’t move forward without it. The problem comes about if there hasn't been enough or communication at the beginning of the deal and either you close without enough, or you think you're getting it from somewhere (like from the seller) and it doesn't materialize.

There are many sources of NWC: bank financing (part of your 7a loan or a separate line of credit), your equity injection, or directly from the seller. HINT: today’s buyer’s market means sellers are often open to helping out with NWC. Just make sure everyone’s on board about where that NWC is coming from. There's nothing worse than springing a need for NWC on a seller later on in a deal when nothing was mentioned in the LOI. Accusations of re-trading fly and the deal will be at risk.

4. Decoding the Psychology of Seller Notes

Navigating Seller Financing: Seller notes can be a tricky part of the deal. With wrong messaging the seller can feel like you're "wanting to buy their business with their own money" - something that doesn't really make sense. Or their overly risk-averse advisors can scare them about the prospects of not being paid. Either way, it comes down to understanding and applying some simple psychology to make seller notes make sense and not feel risky.

Here are my best tips:

a) Don't let seller think it's a "loan" or "seller financing." Instead, make sure they understand that it's a necessary part of the offer and is what allows you to make the offer you're making. Think "deferred payment" (that even comes with tax advantages) instead of "financing."

b) Make sure that the seller knows you're "all-in." Share how much you've invested in search and due-diligence and the fact that you've personally guaranteed the (huge) SBA loan for the acquisition. Sure, the repayment of their note depends on your successful operation of their business, but nobody could be more motivated than you to do so.

c) Whenever you can, (tactfully) reiterate to the seller that if they feel like they're taking a chance on your operation skills to successfully run the business and pay them back, you're just as much taking a chance on the fact that their business is what the seller says it is and won't crumble to the ground when they leave. It's a shared risk and the seller note is where you share it.

5. Licensing Continuity in SBA-Financed Trades

Securing License Stability: In SBA-financed acquisition of trades businesses, having a clear, realistic, and SBA-approved plan to keep licenses intact is crucial. This is both for your good as well as the lender. Licensing continuity is absolutely critical for the business to continue operating, and for your lender to get paid.

The tricky part is that a continuity plan that meets your operational needs may not meet SBA rules. Plus, different lenders interpret SBA rules differently (and may have their own preferences).

My best recommendations here:

a) Have a multiple-redundant plan. Usually this might start with the seller being license-holder for a period of time (with one or more backup employees who can also hold the license if needed), and then transitioning to one or more of the employees, and then transitioning to you (if you are able to qualify) or an operator that you bring on.

b) Document this plan in writing and get early and affirmative approval in writing from your lender. You don't want any last minute surprises.

c) Be careful about using the seller personally as license-holder. Some lenders interpret SBA rules as prohibiting this. Even if your lender is OK with it, plan to have their involvement be short. Despite best plans, sellers quickly get tired of running their own companies under new management after they've been paid their purchase price.

That's it for part 2!

As we continue our journey through the intricacies of acquisitions, I'll be sharing more insights from real-world deals to give you the tools to navigate the complexities of your own acquisition journey. Stay tuned for more tips in the final chapter of our series (direct to your inbox in two weeks), where we unravel the remaining layers of the acquisition puzzle.

Until then, happy hunting and deal-making!

Eric Hsu. M&A Lawyer

Editor, Freedom Through Acquisition Newsletter

DISCLAIMER:

I am a lawyer but not your lawyer (unless we so happen to be working a deal together pursuant to a written engagement agreement). This newsletter is for educational and informational purposes only and nothing in this or any other issues is intended as legal or financial advice and cannot be relied on as such. Do your own diligence and consult with your own lawyer or financial advisor before taking any action on your deals. Nothing in this newsletter is intended to solicit your business in any way and should not be interpreted in any way as legal advertising.

This newsletter is wholly owned and operated by FTA Resources, LLC.

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