Cash, Stock, Seller Notes and Earnouts Weighing the Financing and - - PowerPoint PPT Presentation

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

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

The audio portion of the conference may be accessed via the telephone or by using your computer's

• speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

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.

Tips for Optimal Quality

Sound Quality If you are listening via your computer speakers, please note that the quality

• f your sound will vary depending on the speed and quality of your internet

connection. If the sound quality is not satisfactory, you may listen via the phone: dial 1-888-450-9970 and enter your PIN when prompted. Otherwise, please send us a chat or e-mail sound@straffordpub.com immediately so we can address the problem. If you dialed in and have any difficulties during the call, press *0 for assistance. Viewing Quality To maximize your screen, press the F11 key on your keyboard. To exit full screen, press the F11 key again.

FOR LIVE EVENT ONLY

Continuing Education Credits

For CLE purposes, please let us know how many people are listening at your location by completing each of the following steps:

• In the chat box, type (1) your company name and (2) the number of

attendees at your location

• Click the SEND button beside the box

If you have purchased Strafford CLE processing services, you must confirm your participation by completing and submitting an Official Record of Attendance (CLE Form). You may obtain your CLE form by going to the program page and selecting the appropriate form in the PROGRAM MATERIALS box at the top right corner. If you'd like to purchase CLE credit processing, it is available for a fee. For additional information about CLE credit processing, go to our website or call us at 1-800-926-7926 ext. 35.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please complete the following steps:

• Click on the ^ symbol next to “Conference Materials” in the middle of the left-

hand column on your screen.

• Click on the tab labeled “Handouts” that appears, and there you will see a

PDF of the slides for today's program.

• Double click on the PDF and a separate page will open.
• Print the slides by clicking on the printer icon.

FOR LIVE EVENT ONLY

December 4, 2014

Transaction Currency

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

Table of Contents

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 mmartin@mcleanllc.com (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 cflanagan@edwardswildman.com (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
• nce 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

• f 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

• verpaying

♦ 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

• bligations)

♦ 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

• ffer 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

• perations 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

• wnership 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

• f 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 mmartin@mcleanllc.com (703) 752-9009 Christopher Flanagan Partner cflanagan@edwardswildman.com (617) 239-0485