---
title: M&A Mechanics
summary: Learn the language of M&A so you walk into a transaction informed and protect your net.
est_minutes: 20
sort: 6
---

Headline price is one of many numbers in an M&A transaction. The structure around that headline, earnouts, escrow, working capital adjustments, indemnification, and tax treatment, can each shift the realized outcome by 15 to 30 percent.

By the end of this module you'll have the vocabulary, the term reference, the process map, and the advisor plan. You walk into a deal informed.

**Asset Sale vs Stock Sale**

The first structural decision in any deal: is the buyer purchasing the assets or the stock (equity) of the business?

In an asset sale, the buyer purchases specific assets such as customer contracts, IP, equipment, and sometimes employees. The seller's entity retains liabilities not assumed. The buyer gets a tax basis step-up on purchased assets, which is a depreciation advantage. The seller may have ordinary income tax treatment on portions, which is worse than capital gains. This is often preferred by buyers and often produces a worse tax outcome for sellers.

In a stock sale, the buyer purchases the equity of the seller's entity. All liabilities transfer to the buyer, both good and bad. The buyer doesn't get the depreciation step-up. The seller gets capital gains treatment on the full amount, which is typically lower tax. This is often preferred by sellers.

For operator businesses, this is a major lever. The same headline price under an asset versus stock structure can produce 8 to 15 percent different net-to-seller because of tax treatment.

Negotiate the structure consciously. Don't accept the buyer's default.

**Pricing Mechanics**

The "$5M deal" is rarely $5M to the seller.

The pricing waterfall works like this:

1. **Headline price** ($5M)
2. **Less: Working capital adjustment** (typically -$50K to -$500K)
3. **Less: Debt assumed by buyer** (varies)
4. **Less: Escrow / holdback** (typically 10 to 15 percent held for 12 to 24 months)
5. **Less: Earnout structure** (could be 20 to 40 percent of value contingent on performance)
6. **Less: Transaction fees** (banker, lawyer, accountant, typically 3 to 7 percent of deal)
7. **Less: Taxes** (capital gains plus state taxes, sometimes ordinary income)
8. **= Net to seller**

A $5M headline can become $2.8M to $3.5M net to seller. The difference between $5M and $3M is your retirement.

Each line in the waterfall is negotiable. Most operators only negotiate the headline.

**Earnout Structure**

An earnout is a portion of the purchase price contingent on the business hitting specific metrics post-close.

Earnouts get used when buyer and seller disagree on future performance (the earnout bridges the gap), when customer concentration creates risk the buyer wants the seller exposed to, and when founder-dependency creates transition risk.

Fair earnout structures keep the earnout under 30 percent of total deal value, hold the earnout period to 12 to 24 months maximum, tie metrics to revenue or gross margin (controllable by the seller), let the seller retain operational control during the earnout, and use a clear measurement methodology.

Watch out for unfair earnout structures: an earnout greater than 40 percent of total deal value, an earnout period longer than 36 months, metrics tied to net income (the buyer controls expense allocation and can make the number disappear), buyer ability to override operational decisions during the earnout, and "reasonable best efforts" language without specific commitments.

The earnout language matters more than the earnout amount. Operators who get burned on earnouts usually lost the earnout because the contract gave the buyer control over the metric.

**Escrow and Holdback**

10 to 15 percent of the purchase price typically goes into escrow at closing.

The purpose is to protect the buyer against post-close claims such as reps and warranties breaches, working capital adjustments, and indemnification issues.

Typical terms include 10 to 15 percent of deal value, a 12 to 24 month escrow period, release in stages (some at 6 months, some at 12 months, the balance at 24 months) or all at the end, and specific buckets (for example, 5 percent for general indemnification and 5 percent for specific items).

What you negotiate here is the total escrow percentage, the escrow period length, the release schedule, and specific exclusions. An operator usually wants taxes, fraud, and breach of fundamental reps to be uncapped, with other items capped.

**Working Capital Adjustment**

This is the most-overlooked negotiation in operator-business M&A.

The concept: the buyer is buying the business assuming a "normal" level of working capital (AR, AP, inventory). If actual closing working capital is lower, the buyer pays less. If higher, more.

Here is the math operators forget. Target working capital is set at closing, based on a 12-month trailing average. Actual working capital is measured at closing. The difference adjusts the purchase price.

Example: target working capital is $200K, actual at closing is $50K. The purchase price is reduced by $150K.

This adjustment can shift a deal $50K to $500K. Most operators don't model it. They focus on revenue performance and miss the cash levels.

The defense: clean up working capital before closing. Collect outstanding AR. Manage AP. Hold inventory at normal levels.

**Reps and Warranties Plus Indemnification**

You're representing facts about the business to the buyer. If those facts are wrong, you owe.

Standard reps include that financial statements are accurate, that there are no undisclosed liabilities, that all material contracts are listed, that IP is owned and not infringing on others', that there is no pending litigation, that tax filings are complete and accurate, and that employee matters are clean with no undisclosed claims.

The indemnification structure typically includes a cap on total indemnification liability (typically 10 to 25 percent of deal value), a basket or deductible before claims trigger (typically $25K to $100K), and a survival period that determines how long reps live post-close (typically 12 to 24 months for most reps, longer for fundamental reps like tax and ownership).

Reps insurance is increasingly common. Buyer and seller can purchase R&W insurance that covers indemnification claims. The operator pays a smaller premium upfront versus holding a large amount back in escrow.

**Process and Advisors**

A real sale process takes 6 to 12 months from start to close.

Months 1 to 2 are prep. Engage advisors (a banker if the deal is over $5M, an M&A lawyer always, a tax advisor always), build or finalize the data room, and run a pre-marketing valuation analysis.

Months 3 to 4 are outreach. The banker or M&A advisor approaches qualified buyers, NDAs are signed, the confidential information memorandum (CIM) is sent, and first-round indications of interest are collected.

Months 5 to 6 are due diligence. The top 2 to 4 buyers do diligence, data room access is granted, management presentations happen, and an LOI (Letter of Intent) is selected.

Months 7 to 9 take you from LOI to definitive agreement. Exclusivity is granted to the selected buyer, detailed legal and financial due diligence proceeds, the purchase agreement is negotiated, and all terms are finalized.

Months 10 to 12 are the close. Signing happens, regulatory approvals are obtained if needed, closing conditions are met, the wire transfer goes through, and post-close integration begins.

Advisor costs run as follows. An M&A advisor or banker typically charges 3 to 5 percent of deal value as a success fee plus a retainer. An M&A lawyer runs $50K to $300K depending on complexity. A tax advisor runs $20K to $75K. An accountant for a Quality of Earnings (QofE) analysis runs $25K to $100K.

Total advisor cost is 5 to 8 percent of deal value. It is worth every dollar if the deal is over $2M.

**What To Do Right Now**

1. **Build the M&A Knowledge Base.** Document the 7 components in your own words. Section A.
2. **Build the Deal Term Reference.** Common ranges plus operator-friendly positions. Section B.
3. **Map the 6 to 12 month process.** Section C.
4. **Identify your advisor team in advance.** Even if you're 2 years from exit. Section D.
5. **If you're within 24 months of intended sale**, start engaging advisors in months -6 to -12 from intended close.

Take the quiz.

I'll see you in Module 4.7, Operator Next-Chapter Planning, the final module, which covers life after exit (or after the operator role shifts dramatically).
