m&a transaction consideration: evaluating cash, stock...

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


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


Company Overviews

8


Speaker Backgrounds

9

Mitchell Martin

Principal

[email protected]

(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

[email protected]

(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.


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


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


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


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


SECTION 3

14


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


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


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


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


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


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


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


SECTION 4


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


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


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


♦ 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

Parent

Holdco

Subsidiary

Rollover Property

Rollover Equity

Rollover

Property

Rollover

Equityholders

Investors

Parent

LLC

Selling

Equityholders

Target Corporate

Subsidiary

Basic Transaction Structure:


30

Corporate

Subsidiary

Rollover

Equityholders Investors

Parent

LLC

Target

When the Dust Settles:

100%

100%


♦ 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


♦ 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


♦ 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


♦ 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


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


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


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

m&a transaction consideration: evaluating cash, stock...

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