M&A Transaction Consideration: Evaluating Cash, Stock, Seller Notes and Earnouts

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A M&A Transaction Consideration: Evaluating Cash, Stock, Seller Notes and Earnouts Weighing the Financing and Tax Benefits and Risks of Cash and Non-Cash Purchase Consideration THURSDAY, DECEMBER 4, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Christopher M. Flanagan, Partner, Edwards Wildman Palmer, Boston Mitchell Martin, Principal, McLean Group, McLean, Va. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

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5 Transaction Currency M&A Transaction Considerations: Evaluating Cash, Stock, Seller Notes and Earnouts December 4, 2014

6 Table of Contents SECTION 1 Presenter Introduction SECTION 2 Trends in Choice of Transaction Consideration SECTION 3 The Tax Treatment of Earnouts SECTION 4 ESOPs as an Alternative Structure SECTION 5 Tax Structuring Issues in Two-Tiered Acquisitions with Hybrid Consideration 6

7 SECTION 1 Presenter Introduction 7

8 Presenter Introduction Company Overviews Edwards Wildman Palmer, LLP is a full-service, international law firm with approximately 500 lawyers in 16 offices in the US, Europe and Asia The attorneys at Edwards Wildman focus on corporate and financial transactions, complex litigation, intellectual property, and insurance and reinsurance Specialty areas of strength include venture capital and private equity Edwards Wildman has over 125 years of experience, working with Fortune 500 companies, FTSE 250 clients and start-up companies The McLean Group is an independent, industry-focused investment bank with deep expertise in mergers and acquisitions, corporate finance, capital raises, and business valuations Founded in 1997 Headquartered in McLean, Virginia with additional offices in Chicago, Austin and Silicon Valley Approximately 70 dedicated investment banking and valuation professionals Dedicated industry groups bring extensive domain and transactional expertise to every client engagement Largest valuation practice in the Mid-Atlantic Region, outside the Big 4 accounting firms 8

9 Presenter Introduction Speaker Backgrounds Mitchell Martin Principal (703) Christopher Flanagan Partner (617) Mitchell Martin is co-head of both the firm s M&A Practice as well as its Aerospace, Defense and Government Services industry group. Selected recent transactions include the sale of 3Phoenix to Ultra Electronics, Twisted Pair to Motorola, Corbin Technology to Fulcrum, the divestiture of RedBlack Communications from Ultralife, the leveraged recap of VETS, Inc, SMSi s sale to Boeing, Signature Government Solutions sale to Sotera, the acquisition of Point One by FedCap, and many others. Mr. Martin is regularly quoted as an industry expert in the Washington Post, Washington Business Journal, Defense News, Washington Technology and other industry publications. Prior to joining the McLean Group, Mr. Martin held financial advisory positions with leading investment banks focused on M&A for aerospace and defense companies. Previously, he was an Army Captain and commanded an Infantry Company in the Middle East. Mr. Martin is Airborne and Ranger qualified, and currently holds a Top Secret Security Clearance. Mr. Martin is an Honors Graduate of the United States Military Academy at West Point. He received his M.B.A. from the Sloan School of Management at the Massachusetts Institute of Technology and his M.P.A. from the John F. Kennedy School of Government at Harvard University. He is licensed with FINRA as a Registered General Securities Principal and FINOP (Series 7, 24, 28, 63, 79). Christopher M. Flanagan is a partner in the Tax Department of Edwards Wildman s Boston office. Mr. Flanagan's general corporate and partnership tax practice focuses on tax planning and analysis in the transactional area. He has particular experience in representing public and private companies in taxable and tax-free acquisitions and divestitures of corporate subsidiaries and divisions, and in reorganizations and restructurings. Mr. Flanagan also represents companies in the structuring and formation of major corporate joint ventures, limited liability companies, and large venture capital/private equity funds, as well as advising companies on the tax issues attendant to both public and private debt and equity offerings. Chris also has extensive experience in the taxation of insurance companies and insurance products, and works extensively with the Insurance and Reinsurance Department on both transactions involving the acquisition and divestiture of insurance companies and the structuring of insurance related investments. Chris also has experience in the creation and taxation of captive insurance arrangements, and has authored articles on the topic. Chris is also a former chair of the Tax Section of the Boston Bar Association. In addition to his law degree, he has an LL.M in Taxation. Chris has been recognized as a Leader in the field of Tax Law by Chambers USA in each of the years 2007 through He has also been listed in the Tax Law section of the Best Lawyers in America publication for the past two years. 9

10 SECTION 2 Trends in Choice of Transaction Consideration 10

11 Trends in Choice of Transaction Consideration Shift Towards Contingent Payments Over the last several years we have witnessed a shift in transaction consideration from cash at close to more contingent payments A recent study found that two thirds of all deals contain a contingent compensation component representing 25% or more of the total valuation While 100% cash at close is generally preferred by sellers, there are disadvantages and reasons for exploring alternative consideration Cash Advantages Simple and easily defined Upfront Payments (% of Total Valuation) Secure and not subject to valuation problems Best for quick and final closing of transactions Cash Disadvantages Buyer assumes all performance risk after deal closing Less favorable tax treatment than other forms of consideration Requires buyer liquidity and increases the need for financing 20% 13% 34% 33% 76% - 100% 49-79% 26% - 50% 6% - 25% Source: Duff & Phelps PPA Survey 11

12 Trends in Choice of Transaction Consideration Alternative Consideration Buyer Debt & Equity By accepting portions of the transaction payment in buyer debt or equity, the seller can gain tax advantages and participate in additional upside Both parties are invested in the longer-term success of the combined entity Buyer Debt The two debt instruments most common in M&A transactions are notes and bonds.. Debt Advantages Reduces Buyers liquidity requirements Straightforward Valuation Target assumes limited performance risk after deal closing Debt Disadvantages Sometimes complex, especially when securities used as consideration carry special rights or restrictions. Target owners must wait to realize proceeds from the transaction. Frequently drives complex tax issues Risk of structural subordination Buyer Equity Buyer shares, although in some cases less liquid, can provide the seller with significant upside and a stake in the combined entity Equity Advantages Reduces Buyer liquidity requirements Distributes performance risk to both parties Tax treatment is usually more favorable than for cash consideration Equity Disadvantages Sometimes complex, especially when securities used as consideration carry special rights or restrictions. Valuation is uncertain, especially when nonpublic stock is used Target must assume a level of performance risk once the deal is closed, despite losing control of the assets 12

13 Trends in Choice of Transaction Consideration Alternative Consideration Escrows and Earnouts Earnouts and larger escrows are an increasingly common M&A currency as buyers look to share risk burdens with sellers Buyers are structuring premium valuations contingent upon promised performance; placing an onus on accurate and reasonable projections Typically contingent payments are based upon metrics that are mutually agreeable such as: Topline revenue Gross profit Specified new business capture And in some cases EBITDA will be used as a metric By anticipating buyer s desire to share risk, sellers are able to strategically leverage escrows and earnouts to achieve premium valuations 13

14 SECTION 3 The Tax Treatment of Earnouts 14

15 The Tax Treatment of Earnouts What are Earnouts? Purchase of ongoing business (stock or asset purchase) Post-closing increase to purchase price based upon performance of business Mechanic for buyers and sellers with different expectations as to target company value to come to a common ground Set base purchase price at level that buyer is comfortable it is not overpaying Additional purchase price if target business achieves set milestones; gives the seller extra consideration if the business performs as seller anticipates Both sides may view this equally as a beneficial arrangement 15

16 The Tax Treatment of Earnouts Installment Sale Treatment At most base level, earnouts can constitute simply a form of installment sale for tax purposes Subject to contingent proceeds provisions of installment sale rules If subject to a cap, apply installment sale rules assuming cap will be met at earliest time; loss for remaining basis? If not subject to a cap, but subject to an outside time limit, seller to recover basis ratably over set period (stand alone losses for final period) If no cap and no outside time limit, question as to whether there is a true sale for tax purposes (if there is, recover basis over 15 years) (similar loss issue for outer periods) 16

17 The Tax Treatment of Earnouts Installment Sale Treatment (cont d) Can seek a ruling for alternative recovery method Open transaction method will apply only in rare and unusual circumstances Subject to other rules applicable to installment sales generally Interest charge rule (over $5,000,000 of outstanding installment obligations) Treatment of contingencies somewhat uncertain Acceleration upon disposition (including certain pledges) Imputed interest (possibly OID if involves debt instrument) Seller can elect out of installment sale treatment 17

18 The Tax Treatment of Earnouts Installment Sale Treatment (cont d) In an asset deal, may want to consider allocating installment sale consideration to qualifying assets Maximize benefit of installment sale treatment Note tax-deferred reorganizations with contingent proceeds such as an earnout may involve special issues 18

19 The Tax Treatment of Earnouts Purchase Price vs. Compensation for Services Earnouts can blur the lines between purchase price and payments for services Can be a way to effectively tie seller to remain with company post closing Even if not required to remain employed, realistic expectation may be that targets will only be hit if seller remains active Likely not enough to cause compensation treatment, but may be a concern if have only a single seller/employee Compensation issue arises most often when seller is required to remain employed during earnout period in order to receive payment See Lane Processing Trust, CA-8, 25 F.3d 662 (1994) 19

20 The Tax Treatment of Earnouts Purchase Price vs. Compensation for Services (cont d) If seller is required to remain employed in order to receive earnout (even if targets are met), should raise concern that may be compensation Higher tax rate to seller; payroll taxes; withholding/reporting Current deduction for buyer/target If there are other non-employee sellers who will receive the earnout regardless, may be evidence that is not compensatory Is the payment of the earnout proportional to target ownership, or some other standard? Is the employee adequately compensated for his/her services? Can a target valuation support treatment as purchase price? 20

21 The Tax Treatment of Earnouts Purchase Price vs. Compensation for Services (cont d) No clear answers here, but is an issue that must be addressed Buyers will generally want to be conservative to avoid potential penalties for failure to report/withhold Make sure agreement provides buyer with the right to withhold Benefit of immediate deduction to buyer may support increase to overall consideration to make seller whole Generally best to have sellers and buyers agree to treatment, to avoid inconsistencies 21

22 SECTION 4 ESOPs as an Alternative Structure

23 ESOPs as an Alternative Structure What is it? Due to the current economic climate (to include elevated tax rates starting January 1, 2013), we are observing a renewed interest in ESOPS By allowing management and employees to become shareholders, the owners are able to gain an alternative liquidity event Due to their unique and/or complex structure, ESOP risks and benefits need to be evaluated differently than traditional transactions An Employee Stock Ownership Plan (ESOP) is an employee benefit plan, similar to a profit-sharing plan An ESOP allows management and employees to receive the benefits of ownership and provides a liquidity event for existing owners In a typical scenario, a trust is established into which tax-deductible contributions of new shares or cash to buy existing shares are made the interest and principal paid on debt are not taxed (up to certain limits) Company Cash contribution Lender Loan Repayment ESOP Cash Stock Shareholders 23

24 ESOPs as an Alternative Structure Potential Benefits Tax Benefits For the seller this structure offers the opportunity to defer capital gains taxes (potentially indefinitely). For the target company, the ESOP structure can materially reduce (or eliminate) the company s tax obligations going forward. Flexibility with Respect to Deal Structure and Timing ESOPs are a customizable solution with respect to timing and structure. Well intentioned sellers and fiduciaries have many tools at their disposal to maximize the likelihood the company is successful going forward. Company Will Likely Retain its Culture Unlike a merger or acquisition which would likely result in at least some changes to operations and management, the ESOP structure will likely result in operations continuing with little interruption and could be attractive to existing owners seeking to leave a lasting legacy Management Highly Incentivized The existing management team would likely participate in the ESOP along with other qualified employees and Stock Appreciation Rights (SAR) programs are very common ot offer further incentives; Management could get the benefit of material ownership without having to personally guarantee any debt Employees Act Like Owners Not only will compensation and benefits likely remain unchanged through the transaction, but employees will now receive the benefits of ownership and ideally act like owners and be stewards for the company Additional Benefits for Government Contractors In our experience, a change in ownership can be worrisome to government customers; however, the ESOP ensures there will not be negative changes in how their contracts are executed and that the employees they have grown dependent on have been treated well in the transition. Additionally, the Company benefits as per the FAR it will be able to pass many of the ESOP expenses through its rates, potentially retain its small business status per its NAICS size standard and contracts will not need to be novated in this transaction 24

25 ESOPs as an Alternative Structure Considerations Valuation Depending on the industry, ESOP valuations can be lower than third party market valuations. This is before potential control and marketability discounts for partial ESOP transactions More Stakeholders In addition to the existing ownership and management team, generally speaking a third party ESOP trustee will now look after the interests of the ESOP Trust during the transaction and operations going forward. This can add complexity especially in a subsequent 3 rd party sale. Company Debt / Seller Notes the amount of debt incurred to fund the ESOP transaction needs to be considered; we often see seller notes in these transactions that are subordinate to the bank. In carrying these notes the seller needs to understand her on-going risk profile when compared to other deal structures (or not doing a deal). Repurchase Obligation The repurchase obligations to employees need to be managed and accrued 25

26 SECTION 5 Tax Structuring Issues in Two-Tiered Acquisitions with Hybrid Consideration 26

27 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Common structure in PE transactions involves a parent holding company (often an LLC) with a wholly-owned corporate subsidiary Plan to acquire target (assets or equity) for cash plus parent LLC equity interests Can be part of initial acquisition or later bolt-on acquisition Intent is for LLC equity interests to be received on a taxdeferred basis ( rollover ) Requires structure to provide for direct issuance by parent LLC Drop down rollover property to subsidiary to consolidate ownership of target business 27

28 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION May be tax or business reasons for using parent LLC equity in the rollover portion of the transaction Tax-deferred rollover might not be available (or might be more limited) using subsidiary equity (e.g., in a bolt-on acquisition) Facilitate Section 338(h)(10) election (after-tax roll) Business objective of having rollover sellers treated in the same manner as other parent LLC investors 28

29 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Basic Transaction Structure: Investors Rollover Equityholders Rollover Property Rollover Equity Selling Equityholders Parent Holdco Parent LLC Subsidiary Rollover Property Target Corporate Subsidiary 29

30 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION When the Dust Settles: Rollover Equityholders Investors Parent LLC 100% Corporate Subsidiary 100% Target 30

31 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Questions arise regarding logistics of split implementation of potential purchase price adjustments (e.g., net working capital adjusters, earnouts, escrows, and indemnities) To what extent should parent LLC account for its share of these items itself? As opposed to having it all run through the subsidiary Concern is that IRS could attempt to assert differing tax treatment for the parties if they do not follow their own split form Could adversely impact tax deferral on rollover Could result in income to acquiring parties 31

32 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Potential Recharacterization Opportunities: Treat subsidiary payment of parent LLC obligations (for example, funding escrow or paying earnout) as deemed payment from subsidiary to parent LLC Potentially taxable as a dividend or other income Treat acquisition as purchase in the entirety by the subsidiary, using parent LLC equity as a form of consideration Potential loss of tax deferral on rollover Potential income to subsidiary on use of parent equity to satisfy obligation 32

33 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Potential Solutions: Parent LLC separately funds purchase obligation beyond issuance of rollover interests (appropriate portion of escrow, NWC adjustments, earnouts, etc.) Need to break post-closing items into pieces attributable to different types of acquired property (rollover and cash portions) Parent LLC will need a source of cash for this Cash payments by parent not tax deferred 33

34 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Potential Solutions: Provide for adjustments to rollover equity to account for postclosing items Post-closing payments would be satisfied in same ratio of rollover equity to cash as initial closing piece Break acquired rollover property into two pieces: piece attributable to up-front closing payment and piece attributable to post-closing items Roll over first piece to parent LLC; sell second piece to subsidiary Likely involves complicated calculations and projections 34

35 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Sample Clauses Separate Parent LLC and Purchaser-Subsidiary Post-Closing Purchase Price Adjustments Escrow Funding Immediately prior to the Effective Time, the Rollover Sellers shall contribute to Parent LLC the number and type of Rollover Securities set forth opposite each such Rollover Seller s name on Schedule A, in each case pursuant to individual Contribution Agreements dated the date hereof by and between each Rollover Seller and Parent Holdco (the Contribution ). In consideration of the contribution, Parent LLC shall issue to each Rollover Seller such number of Parent LLC Units as set forth in the applicable Contribution Agreement with such Rollover Seller and remit certain cash to the Escrow Account, as described below. Immediately after the consummation of the Merger, (a) Parent LLC shall 35

36 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Sample Clauses (continued) contribute the rollover Securities, together with cash equal to the portion of the Escrow Amount allocable to the Rollover Securities (the Cash Escrow Contribution ), as an equity contribution to Purchaser, and (b) Purchaser shall include the Cash Escrow Contribution in the deposit of the Escrow Amount. 36

37 TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION Sample Clauses (continued) Assignment of Indemnity Payments/Obligations by Parent LLC to Purchaser-Subsidiary: Parent LLC hereby irrevocably assigns to Purchaser, and Purchaser hereby accepts and assumes from Parent LLC, (i) any rights to receive after the Effective Time any portion of the Excess Merger Consideration or any indemnification payment as a Buyer Indemnified Party, including any funds released from the Escrow Account [, and (ii) any obligation to pay after the Effective Time any portion of any adjustment to the Merger Consideration [i.e., Additional Purchase Price] or any indemnification payment]. 37

38 Mitchell Martin Principal (703) Christopher Flanagan Partner (617)