Appendix A: Glossary

Accrual Basis: One of two primary accounting methods which recognizes income and expenses based on when they are “accrued” or when they actually occur. 

Add-Backs: An adjustment made to the income or expenses in a financial statement when calculating the cash flow of a business (i.e., SDE or EBITDA).

Add-On-Acquisition: The purchase or acquisition of a smaller company which is added on to a larger platform company by a corporate buyer to complement the acquirer’s business model.

Allocation of Purchase Price: The allocation of the purchase price of a business, for tax purposes, among various classes of assets which are defined by the Internal Revenue Service, such as inventory, goodwill, land, or buildings.

Asset Deal: One of three ways to structure an acquisition for legal purposes in which the buyer purchases the individual assets of the seller, as opposed to purchasing the seller’s stock or merging with the seller.

Basket: The minimum dollar threshold amount that must be met before a seller becomes liable for the buyer’s losses caused by the seller’s breach of representations and warranties. A basket functions similarly to an insurance deductible in which the seller is not liable for breaches until the threshold amount, or deductible, is exceeded.

Bill of Sale: The document with which ownership of the assets of a business are transferred from seller to buyer – if the sale is structured as an asset sale.

C Corporation: A corporation that has been elected to be taxed as an entity separate from its shareholders in accordance with Subchapter C of the Internal Revenue Code and may therefore be subject to double taxation if the sale is structured as an asset sale.

Capital Expenditures (CapEx): An investment made in the fixed or capital assets of a company that is expected to have a useful life longer than one year or that is not intended for resale. Examples of capital expenditures include software, office equipment, buildings, land, factories, and equipment. Capital assets are usually depreciated as opposed to being expensed. Inventory is not a capital asset.

Capitalization Rate (Cap Rate): The rate of return, expressed as a percentage, that is expected to be generated. The cap rate is calculated by dividing the income of the business by its purchase price. The cap rate is the inverse of the multiple. If the cap rate is 20%, the multiple is 5.0.

Cash Basis: One of two primary accounting methods which reports income when received and expenses when paid out.

Cash Flow: The amount of cash generated in a business after all expenses, inflows, and outflows of cash. This term is also loosely used to refer to EBITDA or other measures of cash flow. You should always ask for a definition if this term is used.

Confidential Information Memorandum (CIM): A document compiled by a business broker, M&A advisor, or investment banker that describes a company as a potential acquisition target and is used to generate interest in a company from prospective buyers. A typical CIM is 20- to 40-pages long and is only released to pre-screened buyers after they have signed a non-disclosure agreement.

Depreciation: An annual tax deduction that allows for the loss of value of a tangible capital asset, such as a business vehicle or real estate improvement, due to a decline in value over a period of years. Assets can either be expensed (written off in one year), depreciated (written off over a number of years), or amortized (for intangible assets).

Double Taxation: The taxation of income twice on the earnings of a C Corporation. Income is first taxed at the corporate (entity) level and then taxed again at the individual level when dividends are paid to shareholders. Double taxation is a concern when the owner of a C Corporation sells their business and structures the sale as an asset sale. The solution to avoid double taxation is to structure the sale as a stock sale or merger.

Due Diligence: The buyer’s thorough verification and investigation of a business after the seller accepts a letter of intent to determine if both parties wish to proceed with the transaction. Most due diligence periods range from 30 to 90 days, and some may be indefinite as long as the parties continue to negotiate in good faith.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): The most popular measurement of the cash flow of a middle-market company which includes earnings before interest, taxes, depreciation, and amortization.

Earnout: An agreement whereby the buyer pays part of the purchase price to the seller based on the future performance of the company or the fulfillment of some other specified event.

Entity: A separate, legal entity authorized to act separately from its owners, such as a C Corporation, S Corporation, or LLC.

Exclusivity: A provision in a term sheet or letter of intent in which the seller agrees not to solicit offers or negotiate with other potential buyers for a specific period of time.

Fair Market Value (FMV): The most common standard of value used in business appraisals. FMV is the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.

Generally Accepted Accounting Principles (GAAP): The common set of principles, standards, and procedures established by the Financial Accounting Standards Board (FASB) that companies use to compile their financial statements.

Goodwill: An intangible asset associated with the acquisition of a company normally carried on the acquiring company’s balance sheet. It is the portion of the purchase price allocated to the value in excess of the tangible assets acquired.

Gross Profit: The total revenue minus the cost of goods sold, or the profit a company makes after deducting the direct costs related to manufacturing and selling products and services from the total revenue.

Holdback (a.k.a. Escrow): An amount of the purchase price that is withheld from the seller, typically by a neutral third party (i.e., escrow agent) in a separate account for a period of time after the closing to satisfy any of the seller’s indemnification obligations. The amount is paid to the seller after a specified amount of time following the closing, typically 6 to 18 months, if the buyer makes no indemnification claims.

Indemnification: A provision in the purchase agreement that allows a buyer to seek recourse against the seller for losses suffered due to breaches of representations and warranties.

Intellectual Property (IP): The legally protectable intangible assets of a business, which can include patents, copyrights, trade names, domain names, trade secrets, and trademarks or service marks. Intellectual property can be registered (e.g., trademarks, patents) or unregistered (e.g., trade secrets). 

Internal Rate of Return (IRR): The annual rate of growth an investment produces. The interest rate, applied to a stream of cash flows, causes the sum of the outflows and inflows to equal zero. IRR is one of the most comprehensive measures of calculating returns and accounts for both the impact of leverage and time. It is the most common measure of return used by private equity firms to measure the performance of their funds (i.e., acquisitions). IRR is heavily dependent on the amount of time an investment is held. IRR is most commonly used by private equity and venture capital groups when calculating returns. Other more advanced versions of IRR also exist, such as the modified internal rate of return, or MIRR.

Letter of Intent (LOI): A preliminary agreement that outlines the essential terms of an acquisition and signifies the parties’ commitment to start due diligence and begin working toward a purchase agreement. The letter of intent is replaced by a purchase agreement prior to or at the closing.

Main Street: The segment of the business landscape made up of small “mom-and-pop” businesses such as restaurants, coffee shops, landscaping companies, auto and truck service centers, convenience stores, most franchises, and small businesses that offer services. Main Street businesses are predominantly valued using a multiple of SDE and sold by business brokers.

Merger: One of the three primary methods of structuring a transaction for legal purposes. The combination of two or more companies into one with a single entity by filing a Certificate of Merger with the secretary of state. Transactions can be structured for legal purposes as an asset sale, stock sale, or merger.

Middle Market: The segment of the business landscape consisting of mid-sized businesses, such as manufacturing firms, distribution companies, wholesalers, and large service-based companies. The middle market is further divided into the lower, middle, and upper-middle markets and is primarily served by M&A advisors and investment bankers.

Non-Compete Agreement: A contract that limits the seller or key employees from competing with the business after the closing. Most non-competition agreements range from two to five years. A non-compete agreement is legal in all states in the sale of a business, whereas non-compete agreements in an employment context are illegal in some states.

Non-Disclosure Agreement (NDA): A legal contract between the buyer and seller that outlines confidential material, knowledge, or information that both parties want to share with each other for specific purposes, but with restricted access to or by third parties. The NDA is typically signed early in the transaction after the teaser profile is provided, but before the buyer is given access to the confidential information memorandum (CIM) or financial statements.

Non-Solicitation Agreement: An agreement signed by employees and management whereby they agree not to solicit customers or other employees of the company regarding job opportunities upon the termination of their employment agreement. Non-solicitation agreements are commonly used as an alternative to non-compete agreements because they are viewed as more enforceable.

Normalize (a.k.a. Adjust, Recast): The process of adjusting, normalizing, or recasting a business’s financial statements to determine the true earnings (i.e., EBITDA) of a company.

Normalized (Adjusted, Recasted) Financial Statements: Financial statements that have been adjusted to calculate a company’s SDE or EBITDA.

Net Income: The amount of money earned after deducting all expenses, including overhead, employee salaries and benefits, manufacturing costs, inventory costs, distribution costs, and marketing and advertising costs from a company’s gross revenue.

Platform Company: A large company that is the foundation to acquire and add smaller companies to, such as through an add-on or bolt-on acquisition, or by a financial or strategic buyer to complement the acquirer’s business model.

Private Equity Firm: A company that raises money from institutional investors (i.e., limited partners) and then invests these funds into private companies. A private equity firm normally has multiple funds, with each fund having a lifespan of 10 to 12 years. Private equity funds are often structured as a general partnership, or other similar entity, in which the private equity firm is the general partner, and the investors are limited partners.

Promissory Note: A document signed by a purchaser of a business that includes a written promise to pay the balance of the purchase price over an extended period of time.

Representations and Warranties: Statements and guarantees by a buyer or seller of a business relating to the assets, liabilities, and contacts of the business that are being acquired, or the business that is making the acquisition. Breaches of representations and warranties are addressed in the indemnification section of the purchase agreement. A percentage (usually 10%) of the purchase price is normally held back (known as a holdback) in an escrow account for 6 to 18 months following the closing to fund any indemnification claims. This amount is later released to the seller if no claims are made during this time period.

Re-Trading: The practice of renegotiating the price and terms of a company after the initial price and terms have been agreed to. This occurs when the buyer performs due diligence during negotiations and potential risks are uncovered during the process. While not as common as in the past, such actions by buyers definitely do occur and they not only aggravate sellers, but can also jeopardize the closing of a deal. There are times when buyers are justified in seeking an adjustment, as in the case of a discovery that certain deal fundamentals are not supportable under the scrutiny of the buyer’s due diligence.

Return on Investment (ROI): The return on an investment divided by the investment amount. Calculating ROI is quick and easy, enabling you to readily compare the potential returns on different investments. While calculating the ROI can be useful, the ROI has several shortcomings, such as not accounting for time or leverage. While ROI isn’t commonly used to value a business, it’s helpful to understand what impact ROI may have on the value of your business and how many different factors can impact returns. ROI is the inverse of a multiple. Common multiples for most small businesses are 2 to 4 times SDE. This equates to a 25% to 50% ROI. Common multiples for mid-sized businesses are 3 to 7 times EBITDA. This equates to a 16.6% to 33% ROI. The riskier your business, the higher the rate of return your buyer will require to compensate for the risk, and the lower the multiple you will receive. If your business is larger and less risky, an investor might decide they need only a 20% return, or a 5.0 multiple, to justify the risk. If your business is smaller, a 40% return, or a 2.5 multiple, may be required to justify the higher level of risk.

Return on Value Drivers: A proprietary model developed by Morgan & Westfield in which implementable strategic actions are prioritized based on which drivers will have the greatest impact on the value of a business in the shortest period of time and which also pose the lowest risks to implement. 

Roll-Up: The purchase or consolidation of smaller companies in an industry by a larger company in the same industry. The strategy is to create economies of scale and “roll-up” all the small companies into one big company to sell in the future with the hope of expanding the multiple (i.e., multiple expansion).

S Corporation: Short for “Subchapter S Corporation,” a state-incorporated business that elects to receive special tax treatment. An S Corporation is restricted to 100 shareholders, shareholders must be U.S. citizens/residents, and only one class of stock is permitted to be issued, although it can have both voting and non-voting shares. Most small and mid-sized companies are structured as an LLC or S Corporation, whereas most larger companies are structured as a C Corporation.

Search Fund (Independent Sponsor): An investment vehicle formed by individuals who deploy privately raised capital to search for and acquire privately held companies. Whereas an independent sponsor generally does not take on the day-to-day operations of a company, a search fund seeks to acquire a single business and then operate it. Independent sponsors come in all ranges and sizes, some have incredible relationships with family offices and private equity and the ability to quickly close deals, while others do not. A search fund has investors who have already committed search capital and thus have skin in the game.

Seller Financing: A loan which is payable (i.e., promissory note) from the buyer of a business to the seller or owner of a business, and is commonly used to acquire businesses as an alternative to third-party (i.e., bank) financing.

Stay (Retention) Bonus: A bonus given to employees, usually by the seller, to ensure they stay on board after the business is sold. A typical bonus ranges from 5% to 20% of the annual base salary and is released in multiple stages (i.e., ⅓ at closing, ⅓ at 6 months, and ⅓ at 12 months after the closing).

Stock Sale: One of the three primary methods of structuring a transaction for legal purposes whereby the buyer purchases the stock, or entity (a stock sale), of the seller, as opposed to purchasing the assets of the seller (an asset sale). Transactions can legally be structured as an asset sale, stock sale, or merger.

Strategic Buyer: A buyer or company that may provide similar or complementary products or services to the target and is often a competitor, supplier, or customer of the target, or one that brings other synergies to a potential acquisition.

Successor’s Liability: Liability that passes from the seller of a business to the buyer of a business by operation of law without an express contractual agreement for the buyer to assume the liabilities of the seller. Successor’s liability is most common in the areas of tax and environmental liabilities and can be imposed by governmental institutions. Successor’s liability is mitigated through extensive due diligence, representations and warranties, and escrowing a portion of the purchase price to fund indemnification claims.

Sweat Equity: An increase in value that is created as a direct result of hard work by the owners. Sweat equity is recognition of a partner’s contribution to a business in the form of effort while financial equity is the contribution in the form of capital.

Teaser Profile: A short summary of a business that doesn’t normally reveal the company’s identity. This is provided to prospective buyers before the buyer signs a non-disclosure agreement.

Term Sheet: A document that outlines the key terms of the purchase or sale of a business.

Trailing Twelve Months (TTM): A term used to describe the most recent 12 consecutive months of a company’s financial performance data, as opposed to a fiscal year.

Uniform Commercial Code (UCC): A standardized set of laws and regulations for transacting business with the aim to make business activities consistent across all states, and that has been adopted to some extent in all 50 states. 

Working Capital: The amount by which current assets exceed current liabilities in a business. Working capital is calculated as the value of accounts receivable, inventory, and prepaid expenses, less the value of accounts payable, short-term debt, and accrued expenses. Working capital is normally included in the purchase price of mid-sized businesses.