Creative deal structures and deal terms move to lower middle market

When selling your business, price is not the only important factor you’ll negotiate with a buyer. The deal structure includes a wide range of considerations from transaction type, ownership and payment structures, working capital, assurances, timelines, and more.

What we’re seeing in the market right now is a rise in creative deal structures. These are non-typical solutions that help dealmakers bridge some sort of gap between the buyer and seller. If properly negotiated, these structures can make a lot of sense for both sides, but it’s critical for a seller to have an experienced M&A advisor and transaction attorney on their side to ensure they understand these more complex provisions.

An earnout is, perhaps, the classic example of a creative deal structure. Under these agreements, the seller receives additional payments provided the business hits certain targets down the road. Earnouts can be a great way to bridge valuation gaps, such as when the business is expecting a big performance boost in the near future – and the seller wants to be paid for those as-yet-unrealized gains.

Some creative deal structures are more common in the middle market M&A (transactions with values over $50 million). But as private equity buyers continue to shift into the lower middle market (business values of $2 million to $50 million), they’re bringing deal structures like these with them:

Reps and warranties insurance. When selling your business, typically you’re going to “represent and warrant” certain things about the business (e.g., you’ve provided accurate info, no known legal or customer issues pending). If something turns out to be not wholly accurate, the buyer can come back to you for a certain percentage of the purchase price.

In smaller deals, the seller will simply agree to a guarantee. But as transactions get larger, buyers may ask sellers to put that money in escrow. That money is then tied up for a certain period of time, not earning any returns.

As an alternative to escrow, the deal can include reps and warranties insurance. In this case, the insurance company does their own due diligence and agrees to take on that risk. The advantage for sellers is that they don’t have to hold that money in escrow anymore and shed the risk of covering a reps and warranty claim during the warranty period.

Premiums for reps and warranties insurance often start at around $250,000. Because of the cost and additional diligence required by the insurer, it was only common in larger transactions over $50 million. Now we’re seeing that move down into deals as small as $10 million in enterprise value.

In some cases, buyers are using reps and warranties insurance as a tool to win the deal. If competition is strong (and these days it often is), buyers may offer to pay for reps and warranties insurance. As sellers evaluate multiple offers, they might consider the opportunity to bypass escrow as a factor that tips them in a buyer’s favor.

338(h)(10). In these transactions, the deal is treated as a stock sale from a legal standpoint but as an asset sale from a tax standpoint. From a legal standpoint, this structure can eliminate the need to comply with time consuming and sometimes challenging customer contract “change in control provisions.” For the buyer, that means they can get a step-up in basis and re-depreciate the assets they just acquired.

F reorganization. An F-reorg is a tax efficient method to allow the seller to rollover equity into the new business (i.e. retain a small portion of the business ownership) without paying taxes on the rollover amount.

Without using an F-reorg, for example, the seller might sell 100% of the company and get taxed on that full amount before reinvesting some of their proceeds in the buyer’s new entity.

Deal makers predict an increase in these and other creative deal structures in the year ahead. The pandemic is one factor behind that. Businesses saw their operations disrupted, and that has created some business opportunities and some risks. Alternative deal structures are one way for buyers to mitigate valuation gaps, reduce seller’s taxes, and create win-win agreements between buyers and sellers.

Deal competition and private equity activity are also driving creative structures. According to a Mergermarket survey, private equity respondents indicated they were more likely to consider creative deal structures than corporate dealmakers (75% to 37%).

That may be because private equity firms simply have more experience with these structures. Or it could be that they have a stronger imperative to win deals, and creative structures provide more flexibility to do that. Regardless of the reason, by utilizing an experienced M&A advisor sellers have an opportunity to embrace these more complex deal terms leading to increased enhanced upside.


For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.