Thirty-five Years of Lessons on Mergers and Acquisitions
Whether you are buying or selling a company, plan ahead.
For over thirty-five years, we have been helping clients buy and sell businesses, and we have learned that planning ahead can be the key driver to achieving a deal that makes everybody happy.
Time kills deals. For this reason, we have developed a process that allows the buyer and seller to collectively address various important issues and get to finish line. Issues to be considered when buying or selling a company include the following:
- Stock versus Assets
- Partners and investors
- Funding the acquisition
- Integration – post transaction
We will unwrap each issue separately, starting with tax planning.
We start with tax planning not because that is the logical place to start, it is because that is where everybody starts. But as a tax lawyer and a CPA I don’t believe this is the correct starting point. Nonetheless, we will start here.
There are many factors for tax planning. For this reason, it is wise to address terms and structure of the deal first. Tax planning begins by balancing the competing interests of mitigating exit tax to the seller with optimizing tax planning for the buyer. These are competing forces usually but they do not always have to be. There are elections it can be made that can benefit both the buyer and the seller. Additionally, there are post-transaction planning options to the seller that may mitigate or eliminate exit tax altogether.
The buyer generally is looking to get a step up in basis. The seller is generally looking to reduce tax on exit. Tax planning also includes addressing the tax treatment of legal, accounting and due diligence costs.
The IRS requires taxpayers to capitalize amounts paid to facilitate a business acquisition or reorganization transaction. An amount is a facilitative cost if the amount is paid in the process of investigating or otherwise pursuing the transaction. Typical facilitative costs would include the following:
- appraisals and valuations,
- negotiating the terms or structure of the acquisition,
- tax advice on the acquisition,
- application fees, bidding costs, or similar expenses,
- preparing the bid, offer, or purchase agreement,
- obtaining regulatory approval of the acquisition, and
- finders’ fees or brokers’ commissions, including contingency fees
However, an exception to the general rule for capitalization is made if the activities are performed before what is known as the “bright-line” date. The bright-line date is defined as the earlier of (1) the date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed; or (2) the date on which the material terms of the transaction (as tentatively agreed to by representatives of the acquirer and the target) are authorized or approved by the taxpayer’s board of directors.
It is important to note that in an asset acquisition (as opposed to a stock transaction) these costs are allocated to the assets purchased, and can be depreciated or amortized over the life of the assets acquired.
An amount paid to integrate the business operations of the taxpayer with the business operations of another is not considered a facilitative cost, regardless of when the integration activities occur. Examples of deductible integration costs include costs to:
- relocate personnel and equipment,
- provide severance benefits to terminated employees,
- integrate records and information systems,
- prepare new financial statements for the combined entity, and
- reduce redundancies in the combined business operations.
An amount that is contingent on the successful closing of a transaction (“success-based fee”) is presumed to facilitate the transaction (and therefore must be capitalized). The IRS has provided a safe harbor election, however, that allows taxpayers making the election to deduct 70% of the success-based fee and capitalize the remaining 30%.
Debt Finance Costs
Under the regulations, costs incurred to facilitate borrowing are treated as amounts that do not facilitate any other transaction. Thus, these costs can be amortized over the life of the loan.
Covenants Not to Compete
Covenants not to compete that are entered into in connection with the acquisition of a trade or business must be amortized over 15 years, even though the life of the contract may be significantly shorter.
Now that tax has been considered, we can get to the important “first thing”: negotiating the terms. This is the most important step in the process. This is the point of go and no go. For the deal to work, the buyer and seller need to have a convergence of goals.
This is when it must be clear what is being sold and what is being acquired. Will the transaction be a sale of assets or stock ownership? This distinction is very important. When the buyer acquires stock, the buyer is acquiring a lot of intangibles like know-how, trade secrets and a workforce in place. Leases and contracts do not need to be transferred to a new entity. Real estate does not need to be redeeded. Registered vehicles do not need to be reregistated. Trademarks do not need to be refiled. But with the acquisition of stock shares, the buyer also gets known and unknown liabilities, or what are known as “contingent liabilities.” For this reason, stock ownership requires careful thought and far more due diligence than the purchase of assets.
If the buyer acquires assets, however, the buyer is generally getting specific known things, and the risk of acquiring unknown liabilities, or what are called “contingent liabilities,” is significantly less. Some assets can carry liabilities with them, such as deferred maintenance and environmental liability. But with an asset purchase titles need to be revised; contracts may need to be amended; leases may have to be renegotiated.
Also, the key to negotiating terms is the valuation of the company. This is generally a great point of contention and a battleground but it does not need to be. There are a lot of ways to approach this. First, the parties have to come to some understanding early as to what “earnings capitalization factor” to use (also known as a “earnings cap factor”). The earnings cap factor is a simple multiplier used to approximate the potential discounted cash value of the company, based on the company’s ability to generate cashflow. The greater the earnings cap factor, the greater the value. For purposes of the formula, in lieu of “cashflow”, annual Earnings Before Interest, Depreciation and Amortization (“EBITDA”) is generally used. EBITDA is a rough approximation of cash flow from operations. So, for example, if a company has EBITDA of $1m and a proper Earnings Cap Factor for this company is 5, it would have a value of $5m. We believe it is important to establish the formula early so that there is a way to resolve the evaluation question. If the formula is accepted, the rest is simple math.
In establishing value, the next critical factor after the earnings capitalization factor is to calculate EBITDA. Although this would seem like a fairly straightforward problem it is actually not, especially if the target company being acquired is a closely held company. In this regard, EBITDA must be “normalized, “ meaning it should be adjusted to reflect results as they would be after the acquisition. So, for example excessive compensation to owner or failure to pay owner would be adjustments. Excessive travel or other types of abnormal expenses would have to be adjusted to come up with “normalized EBITDA”.
After we have negotiated what is being sold and purchased and have a rough idea of what value it will have, we must negotiate how payments will be arranged. Usually the seller wants to be paid immediately and the buyer wants as much time as possible. Additionally, payments can be structured in a way to address certain key issues driving valuation. For example, it could be uncertainties as too future events such as the retention of key accounts working employees. These types of uncertainties can be built into what are called “earn-outs”. This means that if the future contingencies do not happen then the buyer will get the additional payments in the future. When I represent the seller, I do not like earn-outs because after one sells company, the seller no longer has any control over business decisions and accounting. Because earn-outs are generally driven off financial results, having no control over the accounting can mean operations can be burdened with buyer overhead that drives down the earn-out potential. If a seller takes an earn-out, we believe that the seller needs to be actively involved in decisions after the sale (either a consulting contract or an ongoing role in management) and have the right to financial statements after the sale.
Funding the transaction
Getting funding for the transaction is oftentimes vital. There are investors and lenders who will participate in transactions. Sometimes only transitional, bridge funding is necessary. Often times the seller is the funder.
We recommend placing acquisition debt into the structure. That sometimes means forming an acquisition vehicle to borrow money and raise investor capital to fund the deal. Under the TCJA, however, new rules limit the ability to deduct interest expense under certain circumstances. Too much debt may give rise to nondeductible interest expense.
Many acquisitions fail. They fail because the buyer has not thoroughly considered how the company will be integrated into the buyer’s business.
We strongly believe that early on in the negotiating process the buyer needs to be considering how the acquired company, its assets, its processes, its information systems and its workforce, and its culture, will be integrated into their business. Some people refer to this list as “synergies”, but there is more to it than that. Too often we have found too little thought goes into this because the buyer is focused on one or two aspects of the targets business without fully appreciating what they are acquiring. Sometimes the buyer is focused on only certain key accounts that the target has or key assets and patents. In those cases, the transaction should have been narrowed down to a key asset purchase or license and not an acquisition of a company. Considering integration helps focus on what the buyer really wants from the deal, so buyers should consider it early.
Many times, we have found that the target company has information systems or a way of doing business that is superior to the acquirer’s systems, but the acquirer is often blinded to this because they are focused on other things. If the buyer can recognize this early in the negotiating process inconsiderate at the time, we believe they will end up having a faster implementation after the acquisition and there’s much lower risk of failure.
Process to follow
Now that the issues of been addressed, what process should be followed? Many times, we are presented with a pile of legal documents from either the buyer or the seller asking for our review and comments. When we ask how the documents were prepared we generally discover that they were prepared in the process that was inverted. By that I mean, they started with the lawyers instead of starting with the business deal. Usually at that point we recommend putting all the paperwork beside and starting over. This is not to slow things down; it’s actually to speed things up, as we will explain.
As I said earlier, time kills deals. A process that starts with hundreds of pages of legal documents it will die there. We strongly recommended a process that keeps the lawyers away as long as possible.
The first place to start is to identify who will be on the team (“The Team”). The Team needs to be as small as possible and made up of operations level personnel and at least one finance person. The Team will be charged with first identifying if the transaction should be pursued at all and if so how will it help the large organization achieve its goals. Is this regard, we do not believe that the ultimate decision maker should be part of The Team initially, if ever. It is important in the negotiations to be able to differ to higher authority. This gives the negotiating party time to consider proposals and not get forced into a hasty decision.
The Team from the buyer and the seller group will sit together and begin the process. They will enter into a Letter of Intent, or Memorandum of Understanding. Recall that this event triggers the capitalization of ongoing expenses (Taxes, above). This is generally a letter that spells out the following:
- Although it is not a contract the parties are entering into a process to arrive at the contract;
- The seller will generally also agree to not market the company for the target while negotiations are underway;
- The parties also will agree to not disclose any information gathered during the negotiation process.
The Teams will develop a timetable. The timetable should identify following key dates (1) when should negotiations be concluded; (2) when should documents be completed, and; (3) what is the target date for the deal to close. Time kills deals, and setting a timetable keeps the deal on schedule.
The term sheet is everything. The more articulate the term sheet, the more precise to legal documents will be and the more efficiently the whole process will go. I do not mean lengthy and wordy when I say “articulate”. I mean just the opposite: bullet points and specific milestones and outcomes. I find it is very helpful if the buyer and seller can be candid about their goals, because what is important to one person may not be is important to another, offering the parties an opportunity to reach their respective goals without compromising the outcome for the other party. This type of discussion also can lead the parties to conclude there is no deal to be had and save everybody a lot of unnecessary time and expense.
After the initial teams have established the basic terms, it is time to bring in the accountants and tax people to structure the deal to achieve the terms while reducing exit costs to the seller and allowing tax optimization to the buyer. Accountants also will want to the address the accounting for the acquisition, the valuation of goodwill and other intangibles and any impact on existing bank covenants.
Through this process of refinement, the term sheet will become more articulate. Upon completion, bring in the lawyers to draft the contracts and begin the due diligence process.
Due diligence is when the buyer has a chance to get out of a bad deal. It’s important to know what you are about to acquire and make sure that It does not have problems you are not aware of. If the transaction is the acquisition of stock ownership or a membership interest in an LLC, the buyer must do extensive review of known and unknown liabilities.
Sometimes during the review of the target’s accounts certain contingent liabilities can be identified, for example income tax or payroll tax related liabilities. Depending on the severity of the issue, it could be a signal to run from the deal or it could be a problem that can be resolved through and adjustment to the purchase price, escrowing some of the purchase price until the issue is fully resolved, and earn-out or transaction insurance.
The buyer and seller should also review their respective debt covenants with banks and existing investors to see if the transaction requires their consent. We find too often this is overlooked. All
Companies can grow organically and they can grow strategically through acquisitions and mergers. The most successful ones do it both ways.
We have learned over the years there are some deals you need
to walk away from and there are other deals that make a lot of sense. Following
the process outlined above will help both the buyer and the seller arrive at
the right outcome.
 By “stock ownership” I mean share capital as well as limited liability company membership interests.