As in most industries, the mergers and acquisitions industry has its own terminology, which can be confusing to occasional transaction participants. Here we present many of these terms so that you can have a better understanding and comfort level when discussing a potential business sale, merger or acquisition. Many of these terms are accounting, finance or legal in nature.

Accrual Method of Accounting: A method of accounting wherein income and expenses are recognized on the financial statements when the business first acquires the right to receive the income (even though payment may not yet be received) or the obligation to pay the expense (even though payment may not yet be remitted). Most C Corporations are required to use the accrual method of accounting. Investors and lenders will generally want to see accrual statements.

Add-Backs: Adjustments to the normalized income statement that are made in order to give a more accurate picture of a company’s earnings, which generally include (a) non-recurring expenses, such as the cost of moving the plant, and (b) owner perquisites such as non-business travel and entertainment. Add-backs are some of the adjustments made to arrive at normalized cash flow, EBIT, EBITDA and SDE. All add-backs should be verifiable, as they will eventually be subject to scrutiny by buyers and their advisors, and lenders.

Allocation of Purchase Price: In an asset sale, the purchase price must be allocated to tangible and intangible assets and goodwill. The buyer and seller agree on and report the same purchase price allocation to tax authorities (IRS form 8594). Different price allocations will have different tax implications for the buyer and seller, and their interests are not always aligned. You must obtain advice from your tax advisor.

Amortization: The periodic write-off of the cost of an intangible asset over its estimated useful life. The amortization concept is equivalent to depreciation of tangible assets.

Angel Investor: A high-risk investor who invests in promising early-stage companies. Angels often have valuable business experience and can also serve as advisors and/or board members to the company.

Appraisal: See Valuation.

Asset Approach to Valuation: A general way of determining a value indication of a business by using one or more methods based on the value of the assets of that business net of liabilities.

Asset-Based Lenders: Commercial lenders who are willing to take on more risk than commercial banks; lending against fixed assets, accounts receivable and inventory and being subordinate to commercial banks.

Asset Sale: A sale/purchase of certain (usually most or all) business assets that are both tangible and intangible in nature, and often some liabilities, leaving the seller with the corporate entity and possibly some remaining assets and liabilities. This type of sale significantly reduces the possible liability of a business purchaser, usually has tax benefits to the buyer, and may increase the time it takes to close a deal. Asset sales account for a majority of business sale/purchase transactions.

Auction Process:  An auction is a type of business sale process that involves competitive bidding. As M&A advisors, we use auctions to maximize price and terms for seller clients. Auctions are most effective in a strong M&A market.

Balance Sheet: A statement of the financial status of a business on a certain date. Also called the statement of financial condition, it summarizes a company’s assets, liabilities, and owners’ equity.

Basket: In a purchase agreement, the minimum loss a buyer must suffer before the buyer can recover damages under the indemnification provisions. If a Deductible Basket, the seller is
responsible for damages over the basket amount (e.g. if $100 basket and $150 loss, seller pays $50). If a Tipping Basket, seller is responsible for all damages if the basket amount is reached (e.g. if $100 basket and $150 loss, seller pays $150).

Blue-Sky: That portion of a claimed value or requested price that cannot be supported or shown to exist through the application of recognized business valuation methods. (Blue sky is not the same as goodwill)

Book Value: That figure derived by deducting balance sheet liabilities from assets.

Bridge Loan: A temporary loan to cover the financing shortfall of the acquisition until permanent funding is available.

Bulk Sale: A law that regulates the transfer of business assets to prevent sellers from receiving sale proceeds before creditors are paid. If a business owner wants to conduct a bulk sale of business assets — that is, sell an unusually large amount of inventory, merchandise or equipment — the business owner must publish a notice of bulk sale and give written notice to creditors. Then, the owner must set up an account to hold the funds from the sale for a brief period during which creditors may make claims against the money. The prohibition against bulk sales is spelled out in the Uniform Commercial Code — and laws modeled on the UCC have been generally adopted throughout the country. The California bulk sale law is contained in division 6 of the Commercial Code and is significantly different from the UCC version.

C Corporation: A corporation whose profits are taxed separate from its owners under subchapter C of the Internal Revenue Code (versus an S corporation, whose profits are passed through to shareholders and taxed on their personal returns under subchapter S of the Internal Revenue Code).

CapEx: An abbreviation of Capital Expenditure.

Capital Expenditure: An amount spent (often during a particular period, say annually) to acquire or improve long-term assets such as property, plant and equipment.

Cash Basis Accounting: A method of accounting wherein income and expenses are recognized (on the financial statements) when the business receives the income or pays an expense.

Cap:  In a purchase agreement, the maximum amount of damages a buyer can recover from the seller under the indemnification provisions. Agreements can have separate caps for different types of breaches.

Capitalize: To classify a cost as a long-term investment, rather than expensing it to current operations. A capitalized cost does not appear on the income statement, but instead appears as a credit on the long-term assets account and a debit on the cash account of the balance sheet. However, the depreciation expense related to the capitalized cost will appear as an expense on the income statement. Since the long-term assets account is larger due to the effect of capitalization, the depreciation costs are also proportionately larger. Thus, the timing of expense recognition is changed, but eventually all capitalized expenses do get recognized on the income statement.

Capitalization: A conversion of a single period stream of benefits into value.

Capitalization Rate: A divisor (usually expressed as a percentage) used to convert earnings or cash flows into value as part of the capitalization process.

Cash Flow: Cash that is generated over a period of time by a business enterprise. There are many types of cash flow. When the term is used, it should be supplemented by a qualifier (e.g. “discretionary” or “operating”) and a more specific definition. The definition should state, for example, whether the cash flow calculated is that available to debt and equity holders (pre-debt), or just equity holders (after debt service). See Net Cash Flow.

Closely Held Corporation: A corporation whose stock is owned by one or a few shareholders and is operated by this person or close knit group.

Collateral: Property pledged by a borrower to guarantee payment of a debt. Bank loans are usually collateralized or secured by the company’s accounts receivable, inventory and equipment, and frequently by some secondary source of repayment.

Conditions to Closing: Obligations that must be fulfilled in order to legally require the other party to close the transaction. Other than conditions to closing relating to corporate approvals and governmental filings and approvals, compliance with a particular condition to closing may be waived by the party that benefits from the condition.

Confidential Information Memorandum (CIM): A document containing a detailed analysis and narrative description of a company and its future prospects. Often called a “Deal Book” or “Offering Memorandum”.

Confidentiality Agreement: A document signed by potential buyers that requires them to keep the information contained in the CIM, other evaluation materials and all discussions completely confidential. This document is signed BEFORE the CIM is provided.

Contingent Liability: (a) A possible obligation from past events that will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the business; or (b) A present obligation from past events but is not recognized because (i) it is not probable that an outflow of resources will be required to settle the obligation; or (ii) the obligation cannot be measured reliably. Some examples: in corporate reports are pending lawsuits, judgments under appeal, disputed claims, and the like, representing potential financial liability.

Covenant: An agreement between buyer and seller that restricts each party from taking certain actions, particularly during the Letter of Intent period and prior to closing. Affirmative covenants obligate the seller or the buyer to take certain actions prior to the closing.

Depreciation: The allocation of the cost of a tangible asset to expenses over the asset’s estimated useful life.

Discount Rate: A rate of return (cost of capital) used to convert a monetary sum, payable or receivable in the future, into present value.

Discounted Cash Flow (DCF): A valuation model that assigns a value, in today’s dollars, to the discrete cash inflows and outflows that are reasonably expected to occur during future periods. DCF considers risk and the time value of money.

Due Diligence: The investigation of the business (and buyer) in an attempt to verify information given or uncover previously unknown information.

Earn-Out: A contract provision stating that the seller is to be paid some amount of consideration based on the business achieving certain financial metrics (usually sales or profit-related) in the future. Common situations in which earn outs are negotiated are (a) a high percentage of business is with a few customers, and (b) valuation is based on significant sales and earnings growth, e.g. a new product introduction.

EBIT: Acronym for Earnings Before Interest and Taxes. The earnings remaining after cost of goods sold, and all selling, general, and administrative expenses (SG&A), but before interest and taxes. EBIT is normally calculated and presented on a normalized basis, where one carefully identifies and adjusts for non-operating and nonrecurring income and expense. See also, Seller Discretionary Earnings. Add-Backs and EBITDA.

EBITDA: Acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is a very common M&A term, but should always be just a starting point for discussion regarding financial performance. EBIT and cash flow are more realistic metrics than EBITDA because they account for (historical or projected) capital expenditures.

Escrow Holder: A neutral third-party that prepares routine financial, compliance and legal documents related to the transfer of a business and holds funds until the parties fulfill specified conditions.

Executive Summary: A 1-page profile of a business that is used to solicit buyer interest. It usually has all identifying information removed. This is also called a “teaser”.

FIFO: Acronym for the First In, First Out inventory valuation method. The first inventory units purchased are considered to be the first sold. Therefore the cost of the inventory would be based on the most recent units purchased. The end result of this method (in an inflationary cost environment) is that the ending inventory value is higher, and therefore cost of goods sold is lower, which in turn makes gross profit and net profit greater. The opposite would be true if purchase costs were declining over time. See LIFO.

Fair Market Value: The amount that a hypothetical willing buyer would pay a willing seller acting at arm’s length in an open and unrestricted market, when neither is under any compulsion to buy or sell, and when both have reasonable knowledge of the relevant facts.

Financial Buyer: A buyer that values a business based on the expected future economic performance of that business if operated on a standalone basis (without additional synergistic benefits). Financial buyers are typically willing to pay fair market value. Individual owner/operators, management employees and most private equity buyers are examples of financial buyers.

Floor Price: The lowest preconceived price a seller will or should accept.

Form 4506: A form often required by an acquisition financing lender to obtain copies of federal tax returns (of the seller and buyer) from the IRS for verification purposes.

Free Cash Flow: Free cash flow is usually calculated as net operating income plus depreciation and amortization (non-cash charges), less capital expenditures, plus/minus changes in net working capital. Free cash flow, in essence, is the amount of cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is what allows a company to pay dividends, reduce debt and pursue opportunities that enhance shareholder value, such as develop new products or make acquisitions.

GAAP: Acronym for Generally Accepted Accounting Principles. GAAP includes the standards, conventions, and rules accountants follow in recording financial transactions and preparing financial statements. GAAP comes from the Financial Accounting Standards Board (FASB), a non-profit organization created by the accounting profession to develop and maintain standards. GAAP is slowly being phased out in favor of the International Financial Reporting Standards (IFRS).

Going Concern Value: The value of a business enterprise that is expected to continue operating in the future. The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, a customer base and suppliers, and the necessary products, systems and procedures in place.

Goodwill: Generally means the difference between the purchase price and the value of the assets of an acquired business.

Holdback: In a purchase agreement, this provision provides for a portion of the consideration to be deposited in escrow (or withheld by the buyer) to be applied toward future indemnification claims by the buyer. After a specified period, the balance is released to the seller.

Income Approach: A way of determining a value indication of a business using one or more methods that convert anticipated economic benefits into a present single amount.

Installment Method: A method of accounting under which gains are recognized as payments are received.

Indemnification:  In a purchase agreement, indemnification provides protection to the buyer if the seller makes representations and warranties that turn out to be inaccurate, or the seller fails to perform a covenant, and the breach results in additional costs or damages to the buyer post-transaction. The buyer also indemnifies the seller for its actions.

Indication of Interest:  Similar to a Term Sheet. An indication of Interest (IOI) is a non-binding letter used to express interest in acquiring the business. The IOI will typically include a value range, due diligence plans, a high-level proposal for deal structure, and expectations for seller transition.

Intangible Assets:  Non-physical assets (such as franchises, trademarks, patents, copyrights, goodwill, mineral rights, securities and contracts), as distinguished from physical assets, that grant rights, privileges, and have economic benefits for the owner.

Investment Banker:  A business intermediary for Middle-Market companies who sometimes provides additional services such as bridge loans or underwritings. For Main Street and lower Middle Market transactions this person is usually known as a business intermediary, M&A advisor, or business broker.

Lease Assignment:  When selling a business that occupies leased premises, a buyer typically “assumes” the lease. Commercial leases are personal property and belong to the business or its owner, who is the tenant. A tenant (seller) may assign his “right, title and interest” in that lease to an “assignee” (buyer). The act of assignment does not relieve the original tenant, or “assignor” from his obligations under the lease unless the landlord specifically releases him. It is unusual for a landlord to release an assignor, but the tradeoff is that it makes it easier for a landlord to consent to an assignment. Typical lease language states that the lease is assignable with landlord’s consent, sometimes “not to be unreasonably withheld”. Some leases can not be assigned. Some require the tenant to pay the landlord a fee to consider an assignment of the lease.

Lehman Formula:  An industry standard commission rate, which is a sliding scale percent on successive million dollar purchase price brackets.

Letter of Intent:  A written offer to purchase a business, usually non-binding, which if accepted by the seller leads to due diligence and the drafting of a definitive Purchase and Sale Agreement.

Leveraged Buyout:  A transaction in which a company’s capital stock or its assets are purchased with borrowed money, causing the company’s new capital structure to be primarily debt. Management Buyouts are generally leveraged buyouts.

Lien: A charge or hold on assets usually by a creditor until the indebtedness is satisfied.

LIFO: Acronym for the Last In, First Out inventory valuation method. The last inventory units purchased are considered to be the first sold. Therefore the cost of the inventory would be based on the earliest purchased cost. The end result of this inventory method (in an inflationary cost environment) is that the ending inventory value is lower, and therefore cost of goods sold is higher, which in turn makes gross profit and net profit lower. The opposite would be true if purchase costs were declining over time. See FIFO.

Main Street Businesses: Generally defines firms with revenues below $5 million. See Middle Market. Our firm generally sells Main Street and lower Middle Market companies, with revenues from $1 million to about $30 million.

Market Approach: A way of determining a value indication of a business using one or more methods that compare relevant characteristics of the subject firm to similar businesses that have sold.

Market Cap: Abbreviation of “market capitalization” that applies to a public company’s worth in the stock market by multiplying the total number of shares outstanding by the current stock price.

Mezzanine Capital: Subordinated to senior debt, it is like a second mortgage, with higher interest rates and often with common stock purchase warrants.

Net Cash Flow: A form of cash flow. When the term is used, it should be supplemented by a qualifier (for example, “Equity” or “Invested Capital”) and a definition of exactly what it means in the given context.

Net Cash Flow to Equity: Those cash flows available to pay out to equity holders (in the form of dividends) after funding operations of the business enterprise, making necessary capital investments, and reflecting increases or decreases in debt financing.

Net Cash Flow to Invested Capital: Those cash flows available to pay out to equity holders (in the form of dividends) and debt investors (in the form of principal and interest) after funding operations of the business enterprise and making necessary capital investments.

Net Worth: See book value. Net worth in M&A is often based on the value of assets and liabilities at their true (market) value, not necessarily as expressed on the balance sheet, and may include the value of intangibles and goodwill not shown on the balance sheet.

Niche: Uniqueness in the marketplace in which the company has a product or service, which has a competitive advantage because there are few competitors.

Non-Operating Assets: Assets not necessary to ongoing operations of the business enterprise.

Normalization: Business valuation usually requires adjusting or “normalizing” financial statements to remove the influence of decisions made by the owners to minimize taxes; and to recast or restate them in such a way as to depict the economic performance and condition of the company from the perspective of an investor who would consider purchasing the company. Normalizing usually involves marking assets and liabilities to market and adjusting financial statements for non-operating assets/liabilities; discretionary, related-party, non-market, nonrecurring and non-operating income and expenses; and accounting irregularities, to depict true business economics and facilitate buyer analysis. Business intermediaries and appraisers normalize income statements using standard methodologies.

Normalized Earnings: Company earnings after the normalization process described above. Normalized earnings are commonly stated at the SDE, EBITDA and EBIT levels.

Off Balance Sheet Liabilities: Unrecorded obligations, such as repurchase agreements, pending lawsuits, and unfunded pensions.

PEG: Acronym for Private Equity Group.

Perquisites (Perks): Owner benefits incidental to a regular salary or dividends, such as personal use of a company automobile, country club membership, and personal entertainment.

Preferred Lender: A lending institution that has met the Small Business Administration’s necessary experience and quality requirements is given “preferred” status, and is allowed to make lending decisions on behalf of the SBA. Working with a Preferred lender can save 30 days in closing a deal.

Price Multiple: The inverse of a capitalization rate.

Recasting: See normalization.

Representations and Warranties: Statements made in a contract by either party that refer to past or present facts or matters that are important to the contract. The contract may then go on to provide that if a party is wrong about a representation or warranty, that the other party has certain remedies available to him or her. Each party must stand behind its representations or pay the price for breaching them.

ROI / ROE: Acronyms for Return on Investment and Return on Equity. Must be greater than the cost of capital in order to create shareholder value.

Rollover:  The amount of equity retained by the selling shareholder(s), measured as a percentage of total equity of the new company and the dollar value of equity retained.

S Corporation: Common business slang to distinguish a corporation whose profits are passed through to shareholders (without a corporate level tax imposed) and taxed on their personal returns under subchapter S of the Internal Revenue Code. An S corporation has restrictions with respect to stock ownership, such as it must be owned by thirty-five or fewer individuals.

SBA (Small Business Administration): A federal agency, created in 1953, that grants or guarantees long-term loans to small businesses.

SBA Loan: Loans made to buyers of small businesses by banks or other qualified financial institutions and guaranteed by the Small Business Administration of the U.S. Government. These loans usually have terms of 7 to 10 years, variable interest rates, and monthly payments starting 1 month after closing. SBA Lenders require sufficient earnings from the business to cover a buyer’s normal living expenses, principal and interest payment on the loan and future capital expenditures, plus a comfortable (for the lender) margin of safety. The strength and accuracy of the business tax returns will be the primary basis for the lending decision. The buyer will need to have sufficient down payment, strong credit and relevant management experience.

SDE: Acronym for Seller’s Discretionary Earnings.

Scalability: A scalable company can maintain or improve profit margins while sales volume increases. A firm (or plant) is said to achieve “scale” when it reaches the smallest output that it can produce such that its long run average costs are minimized. A business model that scales well will be able to increase efficiency and gross margin performance and/or operating profit as sales volume increases.

Seller Discretionary Earnings (SDE): EBITDA + a replacement general manager’s compensation. Often called just Discretionary Earnings. This is the most common level of earnings presented for owner-operated Main Street businesses, by business intermediaries, appraisers and sellers. Comparable sale data often includes SDE and Price/SDE multiples.

Seller Financing: The seller extends his or her own notes to the buyer in lieu of all cash at closing or other debt financing, such as bank loans. Seller financing is typically unsecured and subordinated to all other debt.

Senior Debt: The most secure bank debt and the first in line with primary collateral. Often senior debt is a short-term revolving loan that is paid down completely within a year.

Stepped-up Basis: In most asset transactions, the basis of the assets of the target corporation is stepped up in value to the purchaser’s cost. For the buyer this shelters future income from taxes.

Statement of Cash Flows: A financial statement showing a firm’s cash receipts and cash payments over a specified period.

Stock Sale: A form of acquisition whereby all or a portion of the stock in a corporation is sold to the purchaser. There are advantages and disadvantages to the parties in a stock sale compared to an asset sale, which vary with the nature of the business and the specific circumstances of the parties.

Strategic Buyer:  A strategic (or synergistic) buyer is one that is willing to pay a premium over the fair market value of a business based on the added economic benefits attributable to synergies between the target business and the acquiring business.

Subordinated Debt: Refers to non-bank debt, which is less secure than bank (senior) debt. To attract lenders, borrowers often give subordinated lenders rights to convert their debt to equity.

Survival Period:  The length of time after the closing during which the representations and warranties must be true and the seller is responsible for indemnifying the buyer (i.e. claims by the buyer must be made on or before that date).

Synergy: Interaction among two or more acquired parts of a corporation that creates a combined economic contribution greater than the sum of the individual parts.

Term Sheet: A preliminary, non-binding and nonexclusive agreement setting forth very basic terms under which an investment will be made. The term sheet usually precedes the Letter of Intent.

Tight Money: When banks hold back on making loans, it restricts acquisitions.

UCC Filing: A security interest in most types of business personal property (promissory note, corporate stock certificate, equipment lease, etc.) is “perfected” by filing a UCC-1 financing statement with the Secretary of State office.

Valuation: The act or process of determining the value of a business, business ownership interest, security or intangible asset. A valuation report is often referred to as a valuation or appraisal.

Working Capital: The excess value of all current assets over all current liabilities on the balance sheet; represents the liquid funds available to operate and grow a business in the short-term.

Obviously, this list is not comprehensive and contains only a small part of the M&A lexicon. Selling your business may be the most important financial transaction of your life, so learn as much as you can — you’ll only get one chance to do it right. If you would like to learn more about the process of selling or acquiring a company, we invite you to attend one of our M&A workshops or call to request a confidential consultation.