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
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THURSDAY, DECEMBER 4, 2014
Presenting a live 90-minute webinar with interactive Q&A
Christopher M. Flanagan, Partner, Edwards Wildman Palmer, Boston
Mitchell Martin, Principal, McLean Group, McLean, Va.
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December 4, 2014
Transaction Currency
M&A Transaction Considerations: Evaluating Cash, Stock, Seller Notes and Earnouts
Table of Contents
SECTION 4
SECTION 2
SECTION 1
Trends in Choice of Transaction Consideration
The Tax Treatment of Earnouts
ESOPs as an Alternative Structure
Tax Structuring Issues in Two-Tiered Acquisitions with Hybrid Consideration SECTION 5
SECTION 3
Presenter Introduction
6
Presenter Introduction
SECTION 1
7
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
Presenter Introduction
Company Overviews
8
Presenter Introduction
Speaker Backgrounds
9
Mitchell Martin
Principal
(703) 752-9009
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 Flanagan
Partner
(617) 239-0485
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 2014. He
has also been listed in the Tax Law section of the Best Lawyers in
America publication for the past two years.
Trends in Choice of Transaction Consideration
SECTION 2
10
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
• 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
Source: Duff & Phelps PPA Survey
Trends in Choice of Transaction Consideration
Shift Towards Contingent Payments
11
Upfront Payments (% of Total Valuation)
33%
34%
20%
13% 76% - 100%
49 - 79%
26% - 50%
6% - 25%
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
Trends in Choice of Transaction Consideration
Alternative Consideration – Buyer Debt & Equity
12
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 non-
public stock is used
• Target must assume a level of performance risk
once the deal is closed, despite losing control of
the assets
Buyer Debt Buyer 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
Trends in Choice of Transaction Consideration
Alternative Consideration – Escrows and Earnouts
13
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
The Tax Treatment of Earnouts
SECTION 3
14
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
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
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
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
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
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
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
ESOPs as an Alternative Structure
SECTION 4
ESOPs as an Alternative Structure
What is it?
23
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
ESOP Shareholders Lender Loan
Repayment
Cash
Stock
Cash
contribution
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
Potential Benefits
24
ESOPs as an Alternative Structure
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 3rd 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
Considerations
25
ESOPs as an Alternative Structure
Tax Structuring Issues in Two-Tiered Acquisitions with Hybrid Consideration
SECTION 5
26
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 tax-
deferred 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
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
TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION
29
Parent
Holdco
Subsidiary
Rollover Property
Rollover Equity
Rollover
Property
Rollover
Equityholders
Investors
Parent
LLC
Selling
Equityholders
Target Corporate
Subsidiary
Basic Transaction Structure:
TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION
30
Corporate
Subsidiary
Rollover
Equityholders Investors
Parent
LLC
Target
When the Dust Settles:
100%
100%
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
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
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
TAX STRUCTURING ISSUES IN TWO-TIERED ACQUISITIONS WITH HYBRID CONSIDERATION
♦ Potential Solutions:
♦ Provide for adjustments to rollover equity to account for post-
closing 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
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
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
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
[email protected] (703) 752-9009
Christopher Flanagan Partner
[email protected] (617) 239-0485
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