Structuring The Right M&A Deal
“Let them decide the headline selling price as long as I can decide the structure!”
I often hear from a Chief Executive Officer or the main shareholder of a business being sold that I have agreed the headline price with the buyer and now I will leave the details to my team. This is music to the ears of an experienced buyer who often say, “Let them decide the headline selling price as long as I can decide the structure!” and I will be good. This is because an experienced buyer or seller will have in his/her arsenal a wide range of options to adjust the net sales price, especially when buyers, typically private equity, ask the sellers to roll over a proportion of the equity in their business.
Key questions sellers must ask themselves is how much net cash after tax they want, by when, and whom should receive the monies. This is especially the case if you are considering inheritance tax planning. Also, certain sellers of the same business may have many different objectives, depending on their stage in their career and personal life, as to whether they wish to remain with the business post close and/or their risk appetite for wishing to share in any potential future upside in the business after close. Accordingly, all offers need to be carefully analyzed, in terms of net consideration and probability of completing and receiving the consideration, before accepting any offer.
So what are the questions that both a buyer and seller should consider when entering into a M&A transaction.
Earn-outs, Loan Notes and Retained Equity
Not all consideration is in cash and not all buyers have financing in place. An element of consideration may be deferred to a point in time post-completion and only be due and payable based on a performance target(s) being achieved. Alternatively, the sellers may assist the buyer with bridging a funding gap by leaving money in the business in the form of loan notes or equity. These loan notes may earn interest and will be repaid at some future point in time during the investment period. However, a third party debt provider, may insist on a higher priority for collateral purposes which imposes a higher risk of default for the sellers. Alternatively, the sellers may either wish or be asked to retain an equity stake in the business (or in the larger group acquiring the business) and share in the upside or down side on a subsequent sale. Buyers like this option as it shows commitment and belief by the sellers to the continued success of the company (i.e., both parties’ interests are aligned).
While the earn-outs and retained equity may incentivize the seller post-acquisition, there are considerable risks to the seller, often linked to the reason for the exit (“Good Leaver” versus “Bad Leaver”). In addition, earn-outs can be difficult to enforce as it can be complicated to identify the earnings related to the original target business with a new consolidated structure and with new accounting policies and cost base. In addition, the seller has to negotiate the priority of earn-outs as typically financial lenders like to have higher priority over repayment than sellers.
Acquisition of Assets or Shares
Due to a number of tax reliefs available, a purchase of shares or assets can dramatically affect the net acquisition cost for the buyer and the net proceeds the sellers receive. No one structure is good for each deal and the optimal structure depends on many factors which need to be evaluated on a deal by deal basis. Buyers generally favor asset acquisitions as this generally enables unknown liabilities to be left behind with the sellers and enables a step up in the tax basis of the acquired business; this enhances a buyer’s returns as it can amortize the stepped-up assets and deduct the purchase price against future profits of the business. However, this structure typically does not work for transactions where:
The sellers are rolling over equity;
There are not sufficient taxable losses to shelter the taxable gain for the sellers arising from selling the assets;
The nature of the assets do not allow sufficient future taxable write-offs; and
It would be very difficult to assign multiple contracts and licenses to a new company (e.g., government contractors).
An asset deal normally requires the sellers to pay tax on 100% of the consideration which can be double taxed if the company is a closely held C corporation.
A stock transaction generally allows the gain to be taxed as a taxable capital gain, as offset by the base cost of the sellers’ investment in the business. However, the assets are not stepped up for tax purposes unless:
The parties agree to a 338(h)(10) election (in the case of acquisitions of S corporation or corporate subsidiaries) which allows a stock transaction for legal purposes being treated as an asset purchase for tax purposes. For this election to be effective, the buyer must buy at least 80% of the shareholdings. In addition, this method does not permit tax-free rollovers of the sellers’ equity.
For acquisitions of freestanding C corporations, a 338(g) election is made unilaterally by the buyer after purchasing stock from the sellers. The buyer generally bears the incremental tax burden from the gain on the deemed sale of the target’s assets. Even though the 338(g) election results in treatment of a stock acquisition as an asset sale, the buyer assumes a stepped-up tax basis in both the acquired net assets and the target’s stock. This is because taxes are paid by both the buyer and the target’s shareholders on the deemed asset sale and the stock sale, respectively. Section 338(g) elections are rare because the current tax cost of the deemed asset sale usually exceeds the present value of tax savings from the tax basis step-up.
Alternatively, the company could be merged into a newly formed company of the buyer’s on a tax-deferred basis if the transaction qualifies as a reorganization for tax purposes. However, this structure does not generally allow a step up in the tax basis of the assets being acquired and the sellers must own at least 40% of the consideration in the new company; thus reducing the amount of cash consideration received by the sellers at close.
Cross-border transactions lead to multiple additional complications because of the differences in tax legislation from country to country.
Working Capital and Net Debt/Cash Free
Most transactions will have working capital targets set which generally requires the sellers to leave enough working capital in the business at close so that the business can continue to operate normally without any debt to finance general operations. However, the working capital target, and subsequent true up, can be used to adjust the net consideration by either setting a low or high working capital target. There are many ways to set working capital targets (e.g., average working capital for a trailing period (e.g., 3, 6 or 12 months) based on purely historical results and/or a combination of historical and forecast results, based on a period end, a forecast at close or just agree on a specific $ amount) and many definitions of accounting policies (e.g., accounting policies based on GAAP, company policies (i.e., as used in monthly, quarterly or audited financial statements), or company policies as long as consistent with GAAP) and what is exclude or included within working capital (e.g., with regards to bonuses, tax, spare parts, inventory) which can easily be used to adjust the calculation of working capital at close.
Continued Involvement of Management and Non-Competition Clauses
Buyers often want the management team to remain with the business, at least for an initial six month hand-over period and sometimes for two years or more; the period often depends on the reasons for buying the business. Sellers need to ask themselves some tough and personal questions; namely do they want to work for someone else and no longer be the boss, for how long do they want to remain, is it better to remain in the business to help protect any potential earn-outs, and what should be my remuneration be after close?
Before rushing to any public announcements, management need to think carefully about their answers as a management team wishing to leave early may cause the buyers to think that the management team does not believe in the future of the business and/or there is additional risk in transitioning the business over to the new owners. These buyer concerns may impact the size and/or structure of the consideration. Also buyers are likely to ask for non-competition covenants from the shareholders and the senior management team; consideration needs to be given to these restrictions, including the term of the restriction, so that the buyer is protected and the management team can continue to work in their field of expertise after a certain reasonable period if they choose to leave the company. An item which is often overlooked until too late is that there are certain key (non-shareholder) employees on which the future success of the company is dependent. For these key employees, a buyer may need employment contracts in place in order to both insure their success of the company post close as well as to secure support from lenders and/or equity partners.
Warrantied, Indemnities and ESCROW Accounts
Even after completing a significant amount of due diligence, buyers quite rightly ask for warranties and indemnities to protect against misrepresentations and monies to be paid into ESCROW accounts to reduce the risk of non-payment of claims made under the sale and purchase agreement, especially in cases of multiple and small (in terms of shareholdings) sellers. What is reasonable varies from deal to deal and on the risk appetite of various parties but must be fully considered as these terms, especially with regards to ESCROW accounts, impact the timing of when monies can safely be consider as non-returnable proceeds.
Conclude It is vitally important to take a step back before negotiating and make sure you know what is important for you. During negotiations, it is essential that you do not become involved in the pennies, but rather to focus on the bigger picture, if you want to conclude a deal quickly at the right price; too often deals collapse because one party losses interest because of the passage of time. I remember the deal when, a soon to be very rich (multi-million dollar) seller asked for his old water cooler and printer in his office be given to him as part of the deal, which had gone on for over ten months at great expense in terms of professional advisors and management’s time and the increasing risk that the transaction would become public knowledge before the deal was closed. I said “Yes and I would have the equipment delivered to his home refilled with a new water tank and toner if we could conclude the deal today”. He did and the seller forgot about challenging his non-competition period, a key concern for the buyers.
Sellers and buyers must be familiar, or be advised by good, proactive professionals, on multiple potential structures and the implications for the alternative structures before they sign the letter of intent; the reason being is it can be very difficult and/or expensive to modify a structure at a later stage of negotiations. The principals, buyers or the sellers, must make sure that all members of their own deal team, be it employees or third party advisors, communicate freely between each other so that all issues and solutions are fully understood by everyone and appropriately and promptly actioned by the correct party rather than being forgotten. In too many cases, lack of communication and poor project management leads to missed opportunities to maximize the terms for either party.
Advanced preparation and expertise in M&A transactions are now as important as ever, especially if you are facing an experienced M&A transaction person on the other side of the negotiating table. If you want to conclude the right deal for you in what is sometimes a life time opportunity, come prepared with the proper tools and experience at your side.