Congratulations! Your company or client is considering an M&A—often the pinnacle of a company’s lifecycle. M&A transactions, while exciting, require a substantial lift from the management team, in-house legal team, external legal team, and tax and other external advisors to prepare for, negotiate, and close the deal. This guide will help direct you through your M&A transaction.
Carta has a number of resources in place that can help companies moving through an M&A, and this guide will direct you to those resources. It is important to emphasize that M&A transactions of any size are complex, and likely have significant tax and legal implications for the buyer, target, and stockholders of the target.
An important note before we dive in: Make sure to consult legal and tax professionals every step of the way to ensure you are optimizing for your objectives in the deal. Nothing in this guide should be viewed as supplanting legal and tax guidance during an M&A deal, but instead are resources that can supplement the process to make it easier and more efficient.
What is a merger & acquisition (M&A)?
M&A stands for “mergers and acquisitions” and is used colloquially to describe transactions where one company (the buyer) purchases all or a portion of another company (the target). Leveraged buyouts, consolidations, acqui-hires, or restructurings are all terms that you may have heard that fall under the broader umbrella concept of M&A.
M&A deal structures
There are three common structures for M&A transactions: a stock sale, an asset sale, and a merger. The type of transaction structure informs the level of due diligence, and the definitive documents and types of consents (both from stockholders and third parties) that will be required. (See how founders can navigate the M&A process.)
Stock sale
A stock sale is when the target company’s stockholders sell their stock to the buyer, such that the target becomes a wholly owned subsidiary of the buyer.
Asset sale
An asset sale occurs when the target sells all or substantially all of its balance sheet assets to the buyer, and then typically the company dissolves and pays the proceeds of the sale to the stockholders in the company wind-down process.
In some cases, partial asset sales can also involve the acqui-hire of specific teams (through new offers of employment with the buyer) and associated intellectual property. Any parts of the target company that were not sold off would continue to exist and operate without the acquired teams and associated IP.
Merger
A merger occurs when two companies merge together to form one company. There are many different strategic motivations for mergers, and mergers can be financially and legally structured in different ways and even in combination with other deal types.
Some common financial and legal structures for M&A include:
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A reverse triangular merger, where the buyer forms a new subsidiary that merges with the target company, resulting in the target surviving the merger and becoming a wholly owned subsidiary of the buyer. This is the most common structure for corporate M&A.
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A recapitalization, where the current owner sells a majority or controlling stake to a private equity firm and changes its structure of debt and equity.
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A leveraged buyout or leveraged recapitalization, a type of recapitalization where a private equity firm acquires a company with the help of debt funding, with the assets of the acquired company serving as collateral for the debt.
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A divisional carve-out or spin-out, where a company wants to divest a business line or set of assets, contributes the business line or set of assets into a new entity, and then sells the entity via a stock sale or merger.
M&A strategies
In terms of strategic thinking behind a deal, some of the most common rationales for acquisitions include:
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Horizontal acquisitions, where companies in the same industry, performing similar distribution or production processes, consolidate in order to achieve economies of scale and synergies (similar to roll-ups, described below).
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Vertical acquisitions, where companies in the same industry, with expertise at different stages of the distribution or production processes, consolidate in order to reduce costs across the supply chain and increase overall efficiency in bringing the product or service to market.
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Concentric acquisitions, where companies with different products, but similar customer bases, consolidate to gain an advantage in distribution, including increased cross-selling capabilities.
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Conglomerate acquisitions, where companies in different industries and/or in different geographies consolidate in order to extend corporate territories or product offerings to the customer.
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Roll-ups, a strategy traditionally used by private equity firms but increasingly used by others including venture capital, buy-and-build entrepreneurs, and search funds, where a firm acquires a platform company and consolidates multiple businesses in the same industry into the platform company to achieve economies of scale and find cross-selling opportunities.
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Bolt-ons or tuck-ins, where a private equity firm acquires one or more smaller companies and merges them with a larger, more established portfolio company. The acquired company or companies typically complement the offerings, products, or geography of the current portfolio company.
Private equity M&A
Private equity firms (or private equity sponsors) are a type of professional investor that often specializes in buying and selling companies through M&A, typically taking at least majority control. PE firms use their expertise in governance, finance, strategy, and execution to improve the performance of the companies they acquire, with the aim of later exiting their investment through a sale or IPO and generating (hopefully) a competitive return on capital for their investors. Because of this investment strategy, management teams at PE portfolio companies can expect a hands-on, growth-oriented approach from the buyer throughout the lifecycle of the investment, including in the preparation and execution of the M&A deal.
While the deal structure and overall transaction timeline of private equity M&A will be consistent with the information in this article on other M&A deal types, a company being acquired by a private equity firm should be familiar with some additional considerations:
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Private equity firms typically have different motivations and incentives than corporate acquirers. A PE firm is less likely to be a permanent home, because the firm will eventually need to exit its investment and realize a gain from the investment. Management of a target company should understand how the PE firm’s plans to accelerate growth and/or achieve operational efficiencies may impact the company’s long-term future.
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Because a PE firm typically acquires control of a portfolio company, it is generally the case that the entire capital structure of the portfolio company is restructured in the acquisition, including using borrowed money to finance the acquisition in a leveraged buyout (see above). The cost of debt in a leveraged buyout should be relatively low, because target companies for PE firms tend to have a history of operations, forecastable cash flows, and assets that can act as security for loans. In addition, debt can be favorable to the target company as a tax shield, as interest payments on debt can be deducted against corporate income. However, the target must maintain the necessary cash flows to make timely payments on the debt. Failure to make payments on the debt could lead to default, which can further lead to higher interest rates, insolvency, or ceding control of the company to the debt lenders.
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Some private equity transactions lead to changes in management. If the company’s existing management is staying in place, acquisition of a company by a PE firm is often a chance for existing managers to get liquidity for their holdings in the target company, while also retaining optionality to recognize the potential upside of a future exit.
Deal preparation
So you are going through an M&A and you’ve determined your deal structure—now what? Carta can help with due diligence preparation, “delivering” stock certificates or other cap table information, and offboarding from Carta (if the company is sold and no longer needs to manage a cap table). Read more below, and then reach out to your company’s customer success manager or a member of the Carta support team.
Here are some other key areas where Carta can help you prepare before the process begins:
Modeling deal outcomes
Carta’s scenario modeling allows you to visualize the expected payouts by shareholder or share class based on exit value, expected non-convertible debt, and preferential payment terms to any preferred stock. While this doesn’t replace an allocation spreadsheet or “ waterfall” (prepared in accordance with the terms of the definitive agreement governing the terms of the transaction), you’ll be able to get an understanding of anticipated returns based on deal size. This information is key as you enter into term sheet negotiations, so that you understand your breakeven valuation.
In most cases, Carta’s scenario modeling and cap table management software can serve as the starting point in constructing the allocation spreadsheet so your business team, investment bank, or law firm doesn’t have to model from scratch.
For more information, see:
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Scenario modeling for companies on Carta’s corporations platform
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Scenario modeling for VC investors contemplating an exit for a portfolio company
Due diligence
Due diligence is a comprehensive review of the activities of a business, including financial, commercial, and capitalization matters. Due diligence in an M&A deal is typically the most time-consuming part of the process, given the information asymmetries that could result in a buyer assuming unknown liabilities in the deal. Also, the buyer could be taking on new stockholders or investors if buyer stock is to be used as consideration in the deal, so the buyer (and potentially the target) will want to diligence those new stockholders to understand who they are and the existing rights that they have in the target company.
M&A due diligence will be much more robust than the diligence experienced to date for a typical venture-backed company—think a diligence request list with at least 10 pages of categories, versus a two to three page diligence request list in a typical venture financing.
The goal for the buyer is to leave no stone unturned and to bridge the information asymmetry through a combination of diligence and robust representations and warranties in the transaction document. Sellers need to be organized and prepared for what may seem like endless document and information requests which can be challenging when trying to operate the business and work on other parts of the transaction (e.g., negotiating the transaction documents, working on employee transition plans, etc.).
See an example of a M&A due diligence request list, provided by one of Carta’s partner law firms, and a leader in the M&A space, Goodwin.
Capitalization diligence
Capitalization diligence is a big part of the larger due diligence effort, so auditing your cap table before the M&A diligence process kicks off will save a lot of time and questions down the road. The buyer will typically review the target company’s capitalization table to “tie out,” or confirm the accuracy of, the ownership history of all past and present security holders.
Some common capitalization diligence issues that arise in M&A transactions include:
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Lack of documentation, or unexecuted documentation, for equity issuances—particularly to founders, early employees and early investors
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Lack of proper or accurate approvals for equity incentive plan increases
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Failure to update capitalization table for stockholder name changes or employee departures
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Options with a strike price not based on a valid 409A valuation report
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Failure to comply with Rule 701 disclosure requirements
Carta’s cap table reports can expedite the “tie out” process, serving as the target company’s main repository of documents, valuation reports, equity award documents and stock ledgers. You may also need to prepare and assemble capitalization-related materials for a disclosure schedule, including equity paperwork, ledgers or full capitalization table reports that are attached as annexes to the disclosure schedule. All of these can be downloaded from the Carta cap table.
→ Learn how to download capitalization diligence materials from your Carta account
Financial diligence
The buyer and the target will be asked to share recent financial statements, with the target’s financials particularly scrutinized. Carta automates your expense accounting, including ASC 718 stock compensation expense reports that can be delivered to the buyer as part of diligence.
→ Learn more about financial reporting on Carta
M&A tax implications
Both the buyer and target should engage tax professionals to advise regarding tax structuring and tax implications of the transaction. However, there are also tax implications for most security holders of the target company if they receive a payout upon closing, resulting in potentially significant tax liabilities for rank-and-file employees, who may not be prepared for the out-of-pocket tax costs that result from that type of tax event.
The target company’s stockholders may have equity that is eligible for the qualified small business stock (QSBS) tax benefit, allowing them to exclude up to 100% of federal capital gains tax. Carta can help the target company and its stockholders determine what securities are eligible for the QSBS tax benefit.
→ Learn more about Carta's QSBS attestation letters.
To ensure your employees have sound tax advice and understand the financial implications of the exit, Carta offers personalized tax advice for employees. Our equity advisory services include company-wide educational sessions and unlimited, confidential one-on-one sessions with a tax advisor.
→ Learn more about equity advisory services.
When should I tell Carta about my M&A?
Generally, the earlier we get involved, the better, so we can coordinate with external legal counsel on deliverables and offboarding (if appropriate). Notifying the target company’s customer success manager or Carta’s support team once the letter of intent is signed, and a proposed closing date has been set, can make for a smoother process as you move toward closing. This is particularly important in a stock sale or merger, when there are likely closing deliverables related to equity.
