Every industry has its own jargon. If you aren’t familiar with the acronyms or terms, it can feel like trying to understand a foreign language. In this article we’ve created an incomplete, informal glossary of commonly used terms in our world of ESOPs and business acquisitions (M&A). Hopefully this list is helpful as you consider the potential sale of your company. Many of these are likely to come up as you make your way through the process.
Common ESOP Terms
An ESOP is a tax-qualified, defined contribution plan. The company sponsoring the ESOP makes retirement contributions to the plan on behalf of the participants, which is normally converted to shares of company stock in their accounts.
ESOP distributions are how former participants receive the value of their ESOP account, usually in the form of cash. According to IRS requirements, benefits must be distributable in the stock of the employer corporation; however, participants do not have the right to demand stock from an ESOP that holds stock of an S corporation or a C corporation with restrictive bylaws. In that case, the company is required to extend a put option to repurchase the shares from the distributee.
Diversification is the ability of an active ESOP participant who meets certain age requirements to exchange employer securities held in their ESOP account for cash or other investments.
An employee joins the ESOP once certain minimum conditions are fulfilled, like a minimum tenure with the company.
Employee Stock Ownership Plan (ESOP)
ESOP stands for Employee Stock Ownership Plan and it refers to ownership of a business by its employees through a tax qualified defined contribution retirement plan.
A participant in an ESOP is simply an employee who is eligible for the ESOP.
Each year, an ESOP company is assigned an updated market value stock price by the trustee who relies on an independent appraisal of the company’s value conducted by a certified business valuation advisor. The stock price multiplied by the total shares in a participant’s account determines their ESOP account value.
An ESOP trustee is an individual or institution with fiduciary authority and discretion over the plan. This includes voting the shares on behalf of the participants and establishing the annual stock price.
The process by which the employee gains full rights to the shares contributed to their ESOP account. At Empowered Ventures, employees attain full vesting after four years of service.
ESOP participants have at least some voting rights. In private companies, ESOP participants must be able to direct the trustee on the voting of allocated shares for sale of all, or substantially all, of the company’s assets, merger, liquidation, recapitalization, reclassification, dissolution or consolidation. Participants generally do not have voting rights over the conduct of normal business, including acquisitions of other companies.
Common M&A Terms
Adjustments to net income that are made to give a more accurate picture of a company’s future earnings potential. These generally include non-recurring expenses, such as the cost of moving, and 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.
A sale or purchase of certain (usually most or all) business assets that are both tangible and intangible in nature—as well as some liabilities, leaving the seller with the corporate entity and possibly some remaining assets and liabilities. Asset sales account for most business sale/purchase transactions.
A contract provision stating that the seller is to be paid some amount based on the business achieving certain financial metrics (usually sales or profit-related) in the future. Earn outs are often negotiated because a high percentage of sales are with a few customers, or because valuation is based on significant sales and earnings growth.
Acronym for Earnings Before Interest and Taxes. Calculated by adding interest expense and corporate taxes to net income.
Acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. Calculated by adding interest expense, corporate taxes, depreciation and amortization to net income.
The EBITDA multiple is a financial ratio that compares a company’s enterprise value to its annual EBITDA (which can be either a historical figure or a forecast/estimate). This multiple is used to determine the value of a company and compare it to the value of other similar businesses.
A legal arrangement in which a third party temporarily holds large sums of money or property until a particular condition has been met.
A hold back is a portion of the purchase price that is not paid at the closing date. This amount is sometimes held in a third-party escrow account (usually the seller’s) to secure a future obligation, or until a certain condition is achieved.
Indication of Interest (IOI)
A non-binding letter or document provided by a potential buyer that expresses interest in acquiring a particular company and usually includes an estimated market value for the company.
Usually the exemption for the buyer from incurred penalties or liabilities after the closing from incomplete representations and warranties of the seller.
Letter of Intent (LOI)
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.
Market value is the price an asset would fetch in the marketplace, or the value that the investment community gives to a particular equity or business.
Normalized Earnings (or Adjusted EBITDA)
Company earnings after the normalization process based primarily on the add-backs.
Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity.
The non-contingent price the buyer pays to acquire a company. Some portion is usually paid at closing; some may be held back or placed in escrow; and some may be in the form of a seller note.
Debt the selling business owner agrees to take on as part of the transaction.
SDE (or Seller Discretionary Earnings)
SDE is similar to normalized earnings and represents the full financial benefit available to a full-time business owner-operator. It is usually calculated the same as adjusted EBITDA.
A strategic (or synergistic) buyer is one that is seeking the added economic benefits attributable to synergies between the target business and the acquiring business. Usually this buyer is from the same industry as the target business, such as a competitor.
The excess value of all current assets over all current liabilities on the balance sheet. It represents the liquid assets needed to operate the business in the short-term.
While this list is certainly not comprehensive, it covers a good portion of our daily lexicon. Selling your business might be the most important financial transaction you ever make—we hope this glossary of terms helps you feel more prepared as you consider your options.
Want to learn more about the process of selling your company? Drop us a note or give us a call. We’d love to help.