M&A deals are often categorized by size: smaller deals (generally identified as deals with transaction values between $5 million and $50 million) may have first-time sellers and fewer equity holders, which can impact the negotiating and due diligence processes, deal terms, and post-closing activities.
After 2021, M&A deal valuations have been lower, and the volume of lower middle market M&A deals has been increasing. Multi-year research from SRS Acquiom around lower middle market (“LMM”) M&A deal terms shows how these deals are different from larger deals. See the most recent SRS Acquiom Lower-Middle Market Deals Report
This article provides insights into identified trends and what to watch for when negotiating your next LMM deal. Please note this article does not address Life Sciences M&A, which has its special considerations.
What Is Unique About Lower Middle Market M&A Deals?
LMM Transaction Volume is Significant
Lower middle market M&A deals are a large part of the current M&A transaction volume. Economic challenges since 2021 have resulted in smaller deals with heavily negotiated terms, but the volume of LMM deals is robust.
Smaller Does Not Mean Less Complicated
While a lower up-front transaction value might indicate that the target has fewer financial assets, or they are in an earlier stage of their growth cycle with less employees and geographic reach, less does not always mean simpler. Smaller deals can get just as complicated as larger deals.
Despite most deal parties’ desire to condense due diligence and the transaction timeline, business and legal complexities make this difficult. Intuition may lead a deal party to believe that smaller deals would result in less complicated negotiations and post-closing activities. However, the data suggests that this is not the case. Deal parties should expect a lengthy process and to spend time negotiating tricky deal points and post-closing activities. To help get the most advantageous deal, LMM sellers should use current market and claims data to identify areas where they may have leverage with the buyer and to prioritize which deal points they should focus on.
- LMM Buyer Uncertainty Leads to Higher Earnouts and Bigger Escrows
M&A market data from 2022–2023 showed a buyer-favorable market - particularly around seller indemnities and other financial risk protections. Although the buyer-favorable market appears to be softening somewhat in 2024, LMM buyers are continuing to take advantage of this market condition, particularly when the target is a start-up, or has less experience in the M&A market, or has limited financial resources.- Increased Use of Earnouts. Despite the smaller deal size, more than a third of LLM buyers insist on earnouts as part of the transaction purchase consideration. The smaller the deal, the larger the earnout percentage. 2024 data shows that smaller LMM deals (< $25M) often have an earnout that is twice as large (as a percentage of the closing payment) as a deal double the size. The median earnout performance period of 24 months is the same as for larger deals, although distributions may occur over several years.
- More and Bigger Escrows. Even though LMM valuations are smaller than larger deals, LMM buyers want multiple options to recover post-closing claims and losses. This market trend is leading to customized escrow structures. Including Purchase Price Adjustment (“PPA”) escrows (discussed below), virtually all LMM deals have at least one escrow (or holdback) and more than half of the smaller deals have two or more escrows. Although Reps and Warranties Insurance (“RWI”) is expensive, and may be out of reach for smaller deals, a third of the smaller deals have both RWI and a general indemnification escrow or a special indemnification escrow. For LMM deals with a traditional indemnification structure, the median size of the general indemnification escrow is 12.5% of the transaction value, which is notably higher than the median of 10% across all deals. Add this larger escrow amount to separate, special escrows, such as PPA, tax or litigation escrows, and LMM sellers are putting a larger percentage of their transaction value at risk compared to the overall deal market.
Purchase Price Adjustments Are the Norm for LMM Deals
92% of LMM deals include a PPA, generally addressed in the consideration section of the M&A agreement. Due to this high usage frequency, it is becoming more common to also include a relatively small, separate escrow for payment of the PPA. Nearly half of LMM deals include a separate PPA escrow with a median size of 1.23% of the transaction value which is 40% higher than across all M&A deals.
LMM Seller’s General Reps & Warranties Survive Longer
LMM deals are less likely to include RWI. RWI is obtained in less than one-third of LMM deals compared to 40% of all deals. If there is no RWI, an LMM seller’s general reps and warranties survive beyond the median overall deal survival period of 15 months 96% of the time compared to 88% of all deals. Even with RWI, LMM seller reps & warranties survive 61% of the time for larger LMM deals and 80% of the time for smaller LMM deals compared to 50% of overall deals. These more stringent requirements may be the result of LMM sellers having less negotiating leverage against buyers, being unable to negotiate away from harsher indemnification terms, or because due diligence revealed significant seller risks.
Fewer Termination Fees on LMM Deals
Termination fees, which may be payable if the deal doesn’t close as planned and are more often required for deals where the purchase price is being financed by the buyer, were included in only 2% of LMM deals compared to 13% of all deals. In the few cases where termination fees were included, they were not payable solely by the LMM seller. They were either payable by the buyer or by both the buyer and the seller, which is comparable to all deals. The lack of termination fees in LMM deals is probably because smaller deals are less risky and rarely require financing and LMM sellers do not have the negotiation leverage to require buyers to pay a break-up fee if the deal falls through.
Mitigating Post-Closing Risk for LMM Deals
LMM deals are trending toward sellers providing robust indemnities and placing a large percentage of the deal consideration at risk through earnouts, PPAs, and escrows. As such, LMM sellers should consider what rights to negotiate to monitor the business's post-closing operations and obtain information that supports the calculation of earnout target achievement. Buyers rarely provide post-closing information or operational diligence guarantees to the seller unless specifically included in the M&A agreement, so deal parties should carefully consider negotiating robust information rights to stay abreast of post-closing business operations.
Buyer Operational Covenants
Since many LMM deals have earnouts, LMM sellers are interested in requiring the buyer to operate the post-closing business in a certain manner and provide comfort that projected business goals can be achieved. LMM sellers should consider negotiating one or more of the following buyer covenants in the M&A agreement.
- No Actions Detrimental to the Earnout. This is a covenant that the buyer shall take no action the primary purpose of which is to prevent a post-closing milestone achievement. This covenant is included in LMM deals less frequently than in larger deals. For smaller LMM deals (<$25 million) it is included in 75% of deals compared to 85% across all non-Life Sciences deals.
- Commercially Reasonable Efforts (“CRE”). Approximately one-third of LMM buyers agree to a specified CRE standard that the buyer will operate the post-closing business in good faith in accordance with industry norms or as further specified in the M&A agreement. This frequency is similar to all deals, although private equity buyers are less likely to agree.
- Past Practices. LMM buyers are becoming less inclined to agree to operate the post-closing business in accordance with past practices, although financial buyers who plan to keep the seller’s existing management team in place are willing to consider this covenant.
- Maximize Earnout. This is a covenant that the buyer will operate the post-closing business to maximize the earnout payout. It is very rare for LMM deals to include this covenant.
Information Rights
LMM sellers may not be part of the post-closing management team, so receiving timely, detailed information around business performance and earnout achievement is critical. More than 90% of LMM deals require post-closing reporting, which is similar to all deals.
The M&A agreement should describe the agreed accounting standards, required operational and financial information supporting compliance with the operational covenants, PPA mechanisms, and earnout target achievement, when the information will be provided, the level of detail required, seller’s rights to request additional information, and the process for the information to be audited or corrected, if necessary.
Robust information rights can help avoid disputes between the deal parties if post-closing performance doesn’t go as planned. However, the seller’s leverage to achieve comprehensive information rights is more limited than in larger deals.
Both the SRS Acquiom Lower-Middle Market Deals Report and the 2024 SRS Acquiom M&A Deal Terms Study show that deal size can be a major factor in a seller’s M&A negotiating leverage and the terms of the M&A agreement. Despite the smaller deal valuations, LMM deals are generally buyer-favorable and often result in complex indemnification provisions and post-closing mechanics such as escrow management, earnout achievement tracking, and dispute resolution processes. Understanding the data and differences in LMM deals can assist deal parties with advance planning and negotiation strategy for their LMM deals.
Kip Wallen
Senior Director, Thought Leadership tel:720-452-5364
Kip Wallen is a senior director leading the SRS Acquiom thought leadership practice. He leverages his extensive expertise and SRS Acquiom proprietary data to produce resourceful content regularly utilized by market practitioners. Kip has broad experience in M&A and provides guidance on market standards and trends.
Previously, Kip was a Director with the SRS Acquiom Transactional Group, where he collaborated with clients and counsel to negotiate M&A documents including purchase, escrow, payments, and other transactional agreements. Before joining SRS Acquiom, Kip was an attorney with a Denver-based boutique business law firm where he assisted clients with M&A transactions as well as general corporate governance and securities matters.
Kip is an avid supporter of the Colorado Symphony, serving as Treasurer and Trustee. He is an active participant on the American Bar Association’s M&A Committee. In 2016, Kip completed Leadership 20 with the Denver chapter of the Association for Corporate Growth.
Kip received his J.D. from the Sturm College of Law at the University of Denver and an M.S. in Economics, B.S. in Economics and B.A. in International Relations from Lehigh University. He is a member of the Colorado bar.