Understanding your buyers

Your universe of potential buyers can have a significant impact on the shape, structure, and speed of a deal. This section explores some of the unique features, and potential challenges, of some of the different types of buyers – private equity, strategic, and US.

Private equity

Jargon busting, documents, and drivers

For many founders, private equity ("PE") jargon can be bewildering. The good news is that none of this is rocket science.

private equity investor’, ‘fund’, ‘sponsor’ and ‘institutional investor’ – while these are all different types of investors, these terms are pretty much interchangeable.
'leveraged buy-out' – short-hand for any transaction where existing management and/or new management together with a PE investor acquire a company using third party debt.
'senior debt' vs 'junior debt' – senior debt is usually advanced by commercial banks and so called because they normally take first-ranking security over the assets of the business. 'Junior debt' or 'mezzanine debt' ranks behind senior debt but ahead of equity. These can include high street lenders or other boutique debt providers who specialise in this type of transaction.

The terms of the documents on a PE deal may also seem somewhat "over-the-top", perhaps even suffocating. It may be tempting to think that the buyer is looking to control the business. It is almost never the case that institutional investors want to take control, they would prefer to leave the management team to run the business day-to-day. However, they approach investments with heavy duty documentation to ensure that a sufficient level of protection for their investment is maintained.

The jargon and documents of the private equity world may be unfamiliar at first but understanding what drives an institutional investor on a leveraged deal is simple. Essentially it is getting the right mix of equity and debt to leverage the equity returns. This will be determined by confidence in the strength of the business plan and the amount of debt and interest it is believed the business can support through its free cash flow.

The function of PE houses is to make acquisitions, help build and grow the business, and sell them. This means that PE buyers can often move faster than their trade counterparts due to their streamlined internal systems and external approach (including their familiarity with doing transactions).

In addition, perhaps unlike trade buyers, from the outset a PE investor will be considering their exit (which will typically occur within five years of their initial investment). This mindset is a defining feature of a PE buyout and will influence the structure of the deal and what protections you should expect.

How will you invest?

A PE buyer will most likely want you re-invest or roll-over in the newco structure (the percentage of your proceeds from the sale that they want you to invest will be a matter for negotiation). What does this involve?

Rollover and reinvestment

PE investors will ask you to "rollover" or reinvest some of your sale proceeds in the company. Managers are often asked to reinvest a certain amount of their proceeds after tax, but this may vary depending on the nature of your sale process and the commercial negotiations. In a rollover, the seller retains a portion of their shares in the company being sold and transfers these into the new ownership structure. This means that the seller continues to hold a minority stake in the company and shares in its future profits. A rollover often serves as a sign of the seller's confidence in the company's future performance. Reinvestment, on the other hand, means that the seller takes the proceeds from selling their shares and invests that amount back into either the same company or another project. This could involve buying back shares in the same company (after having sold all their shares) or investing in another business or project. In summary: With a rollover, the seller retains part of their shares from the outset within the new ownership structure, whereas with reinvestment, the seller first sells their shares and then reinvests the proceeds. A rollover of shares in a German target company into an EU/EEA tax resident company can often be implemented in a tax-neutral way depending on the acquisition and holding structure on the buyside. However, no tax-neutral rollover is available when transferring shares into a non-EU/EEA resident company. As regards the reinvestment, there are no tax benefits because any capital gains can only be reinvested on an after-tax basis.

Sweet equity

Managers of a company are typically allocated "sweet equity" to incentivise future performance which will need to be carefully structured from a tax law perspective in order to avoid dry income taxation. You may be allocated some as a founder if you are staying on in the business. This gives managers a financial stake in the business and incentivises them to grow the company because they will then receive significant returns on an exit for a low investment cost (i.e., it "sweetens" their deal with the company). PE investors will set aside a "pot" or "pool" (a certain number of reserved shares) of sweet equity on completion of a transaction so that any existing and future managers can be allocated shares. Sweet equity shares generally have limited rights and protections. For example, you may not have any voting rights nor any rights to receive distributions, and you will likely be required to sell your sweet equity if you leave the company prior to an exit (and will get different amounts for it depending on how you leave, for example as a "good", "bad" or "intermediate" leaver – for more on these terms see the table below). For tax purposes, sweet equity is typically structured in such way that it qualifies for the preferential capital gains taxation schemes under German tax law (flat tax, partial income method or capital gains exemption).

Protecting your investment

As an investor after the sale, you will want to consider how best to protect yourself and your investment. Set out below are a list of the key equity terms and how you might want to position yourself against a PE investor. These are designed to be indicative of a typical situation and not to provide legal advice. You should always obtain legal advice and personal tax advice to understand exactly how the proposed structure will impact you.

Key terms	Institutional investor position	Manager/Founder position
Board composition	PE investors will insist on a contractual right to appoint a certain number of their representatives (perhaps a majority of the board) as directors. Their directors (or their alternates) will usually have to be in attendance at all board meetings for them to be valid.	As the founder or the management group together, you may want the right to appoint a director. Also beware of any directors' fees charged by the institutions – they should always be reasonable and capped at an annual amount.
Consent matters	PE investors will usually specify some shareholder and operational matters that need their approval before the company can undertake them, such as varying the rights attaching to their shares, issuing new shares and unbudgeted spending.	You should consider any consent matters carefully - they should not impact or restrict the day-to-day running of the business. Managers should also request certain consent rights, such as any amendments to the equity documents that could disproportionately affect their terms or the economic rights attached to their shares. Founders may want consent rights similar to those given to the investor (this will usually depend on the size of their investment stake).
Additional consent matters	Institutional investors will require additional consent rights in certain default situations, such as a material failure to perform against budget. These rights are intended to allow the PE investor to control management and/or shareholder matters (if they do not already have control) and if necessary to initiate rescue financing or to remove or appoint directors.	You should ensure that the trigger situations to implement such additional consent rights are sufficiently material (e.g., financial default events) and if a rescue financing is made, you are able to subscribe for additional shares to maintain your pro rata shareholding (a "catch up right").
Permitted transfers	Institutional investors will likely want a veto over certain share transfers to prevent them taking place without their consent.	You should ensure the equity documents allow certain transfers to be "permitted transfers" that do not require investor consent. Such transfers may include transfers to a family member or trust for tax planning purposes or transfers to a warehousing entity to be held for new members of the management team.
Drag along right	If an institutional investor wants to sell all of their shares to a third party, it will want the ability to require minority shareholders to also sell their shares (known as a "drag" right) so that the new third party buyer can acquire 100% of the business.	You should aim to agree a threshold to exercise the drag (e.g., 50% or more of the ordinary share capital) and/or the drag rights could be suspended for a period of time or until certain returns are achieved to give the managers the opportunity to follow through on the business plan. Consider if there are circumstances where you would like to force a sale.
Tag along right	PE investors will usually want this right only to apply if the sale would result in a new investor taking control of the company.	You should ensure that if a material level of shareholders receive an acceptable offer from a third party, they are obliged to provide that the third party makes an offer to purchase at least the same proportion of the other shareholders' shares on the same terms (a "tag" right).
Leaver provisions	If you leave the business before an exit, a PE investor will typically want you to sell some or all of your sweet equity back to the company. This allows it to reallocate your sweet equity to any new managers to encourage them to grow the business. The amount of money you will get for your sweet equity will depend on the circumstances in which you leave. Typically, there are "good", "intermediate" and "bad" leavers. It is possible that a PE investor may also look to reduce the interest/coupon on your loan notes/preference shares.	The investment documents should clearly define what constitutes a "good", "intermediate" or "bad" leaver as this will determine what price you will receive for your shares. Good leavers typically leave employment due to death, disability or illness, intermediate leavers have often been terminated with notice, whereas bad leavers have voluntarily resigned, been dismissed for cause or breached their restrictive covenants. Good leavers usually receive "market value" for their shares, bad leavers the lower of the price they paid and market value and intermediate leavers receive market value for an increasing percentage of their shares the longer it is until they become a leaver (this is called "vesting").
Restrictive covenants	A PE investor will seek to limit your ability to damage the business of the company if you leave and will require managers to agree to certain restrictions ("restrictive covenants") including agreements not to compete with the business and not to solicit customers or staff.	Restrictive covenants in the investment documents may cut across any restrictive covenants you already have in your employment agreement. You should always make sure the restrictions are reasonable and do not prevent you from earning a living after you leave the business. Non-compete provisions in the service agreement are only allowed with at least 50% of compensation whereby such restrictions in the equity documentation do not trigger a compensation requirement.
Representation and warranties	The founders and existing shareholders will be asked to give representations and warranties, such as to the accuracy of your financials and management to confirm certain factual information contained in the various vendor due diligence reports and/or those reports commissioned by the institutional investor. If you fail to disclose anything which makes a warranty untrue, you will be in breach of warranty and may be liable to pay the institution’s damages.	You should expect to be able to cap your liability under the representations and warranties by negotiating a financial limit on your liability and ensuring the warranties expire after a certain period of time. Proper preparation and disclosure mitigate against the risks of any claim arising.
Information rights	You and the management team will be asked to provide various information to the PE investor, including accounts, capital tables, an annual business plan and budget (that the investor will likely want to approve) and a management pack (often measuring performance against KPIs).	You should ensure that the information obligations are achievable for you and your team and will not unduly distract management from running the business. You should also want to consider what information you would want as a shareholder if you were no longer a director or employee of the business.

Strategic buyers

Also commonly referred to as "trade buyers" in an international context, this is a type of acquiror operating in the same or an adjacent space as your company, which is often making the acquisition for strategic rather than purely financial reasons. Strategic goals can vary, but typically include a desire to integrate assets and operations with a view to realising cost or other synergies, gain new customers, talent or intellectual property, expand product lines and offerings, and/or accelerate growth in new markets.

Sometimes, because they are buying for their own strategic reasons, such buyers are prepared to make higher offers for businesses than PE houses who are looking for a purely financial return from the existing business. This is particularly the case now with many strategic buyers able and willing to fund acquisitions exclusively from existing cash resources rather than having to rely on debt finance, which has become materially more expensive in the sustained higher interest rate environment.

Being part of a larger group may also offer new and enhanced opportunities to scale your business, with ready access to new markets, sectors, and/or sales and distribution channels, all of which will be particularly relevant if there's an earn-out or you're taking equity in the buyer group.

Against that backdrop, we consider some of the key features of an acquisition by a strategic buyer.

Deal structure

Strategic buyers tend to want to acquire 100% control when they undertake an acquisition and then integrate the business into their wider group. This may mean that ongoing management is given less autonomy than in a private equity deal, find themselves operating in a different business culture, or are no longer required for the ongoing business. Management teams that do stay on are likely to need to make a transition from being "decision makers" to "decision takers", but the flipside of this structure and approach is that you tend to get more of an opportunity for a "clean break" than on a PE deal.

If you're going to stay on in management at the business, as with a PE investor, you should give careful thought to the cultural fit and your ongoing employment rights. It's understandable for your main focus to be on getting the deal over the line but asking the right questions about what "integration" means for you and your team and what support and investment the business will be given following completion of the sale is important. Doing this before you hand over the keys to your business and relinquish negotiating power is key.

In terms of process and documentation, compared to private equity buyers strategic buyers sometimes have less flexibility on terms, sometimes having an internal "playbook" they need to follow, and can be slower and more cautious, particularly if it's a first time or transformational deal for them. They also commonly want to receive a great deal of information about the strategic and technical elements of the business (beware the business and legal hazards in doing that!), but there may be less of a focus on short-term financials than a PE investor would have and the diligence process may otherwise be simpler given the buyer's greater existing knowledge of the market.

You may also find yourself dealing with a "hybrid" of PE and strategic buyers if a company already owned by a PE house (known as a "portfolio company") is making the acquisition (a "bolt-on" or “add-on” acquisition). The terms you receive as a seller may, in that case, be a combination of those provided by PE buyers on a typical buy-out (e.g. rollover or reinvestment on a higher level) and those of strategic buyers or more slanted to one type of buyer or the other, depending on the process of the negotiations.

Consideration structure

Unlike private equity buyers, strategic buyers do not tend to ask management to "rollover" or reinvest a portion of their sale proceeds into the company. They often instead offer more money up front, use "earn-out" consideration structures, and might, less commonly, offer shares in the ultimate, perhaps listed, controlling company of their group.

Earn-outs

An earn-out usually provides that the sellers will be paid further consideration if the business achieves certain targets in the years after the sale (commonly the one- to three-year period after the sale). The targets may be financially driven, such as revenue, EBITDA or ARR, targets, or strategically driven, such as product development milestones, or a mixture of the two.

Earn-outs are used both to bridge valuation gaps between buyers and sellers and to incentivise the selling management team to stay on in the business, help with integration, and drive future performance. Unlike the equity issued to management on a PE deal, the upside of an earn-out is commonly capped, but it may be easier to achieve the target than performing above the third party and shareholder debt hurdles set in a private equity structure (but, of course, this will depend on where the targets are set).

Having less control over the business could also mean that achieving the target is not entirely in the hands of management (e.g., does the business require investment from its owners, could business be diverted away from it, or could employee numbers be cut?). This means you should pay close attention to the contractual restrictions on the buyer and its obligations to assist you in achieving the earn-out targets. Remember that the people you're dealing with at the buyer and/or their priorities may change over the course of an earn-out period, so you could be caught out if you haven't built the appropriate guardrails into your documents.

It's worth you considering the culture of the buyer in helping previous sellers achieve their own targets, and you should also consider what happens if you leave the business before the earn-out is paid out. In some circumstances, if you are a "good leaver", for example, if you are unwell, retire or die, you or your estate may be permitted to keep a greater share of the proceeds than if you are a "bad leaver", for example if you are dismissed or resign.

It is also particularly important to structure earn-outs correctly for tax reasons, see Part 3 for further details.

Share consideration

Selling your shares in return for shares in the buyer adds a new dimension to a deal, particularly where it's a pure share for share deal or where the share component of a mixed cash/share deal is significant. In those circumstances, sellers will need to grapple with many of the same issues as a buyer. These include:

Valuation of consideration shares

If consideration shares are being offered, you'll need to agree a value for them. This can be a thorny issue when it comes to unlisted companies, particularly if a buyer is seeking to rely on a previous valuation. It will also be important to understand what class of share you're being offered and where it sits in the return waterfall, noting that the consideration shares are being acquired for value and should be treated accordingly.

Reverse due diligence

Most sellers aren't expecting to have to carry out due diligence when they launch a sale process, but where a significant portion of the overall consideration is in the form of shares, it would be worth carrying out some level of reverse/confirmatory due diligence on the buyer to ensure there are no material flags that impact your willingness to do the deal. If the buyer has completed a funding round recently or has itself been acquired (e.g., by a PE house), it might be possible to get access to the investors' due diligence reports on a non-reliance basis to short-circuit some or all of that exercise and bridge the gap between the date of those reports and your deal with appropriate warranty cover.

Contractual protections

As a future shareholder in the buyer, you should expect some level of contractual protection in relation to your "investment", both in terms of representation and warranties cover in the SPA (i.e., beyond the typical fundamental buy-side title/capacity warranties) and appropriate minority shareholder protections in the shareholders' agreement and/or articles of association. The extent of those protections will depend on relative bargaining positions and the size of your stake in the buyer – the stronger your hand and the larger your stake, the more you can expect here.

US buyers in Germany

It is increasingly common to find German growth companies the subject of interest from US acquirors, particularly given the relative strength of the US dollar and the perceived discount at which German targets trade relative to their US peers.

US buyers, especially those less familiar with the German market, tend to have a different approach to deal terms and may look to implement these even where the target is based in Germany and German law is chosen as the law governing the transaction documents, so it's important to understand these differences in approach to help bridge the expectation gap on transatlantic deals.

We set out below some of the key differences between German and US buyers in their approach to the legal terms.