Bridging the Finance and Valuation Gap Negotiating and Structuring - - PowerPoint PPT Presentation

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Presenting a live 90-minute webinar with interactive Q&A

Equity Rollovers in M&A: Bridging the Finance and Valuation Gap

Negotiating and Structuring Rollovers; Tax Considerations for Buyers and Sellers

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNESDAY, JUNE 7, 2017

David R. Hardy, Partner, Osler Hoskin & Harcourt, New York George H. Wang, Partner, Barton, New York

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

Financial vs. strategic buyers



Non-control, post-closing equity participation by seller’s management team/founders



Non-control

○

Typically 10 - 40%

• Up to 49%

 Type of security

○

Equity

• Same rights as buyer or junior in rights

○

Debt - subordinated Seller Note 

Anchor Investment vs. Tag-on portfolio acquisition



Objectives – Defer tax gain to rollover participants; step up to buyer

6

Example 1



8-12% of the equity post transaction allocated/reserved for senior management

Example 2



Pursuant to a merger, or other mutually agreeable form of transaction, (x) one or more Investor(s) will acquire all of the equity of Target currently held by Old PE Fund, (y) the Phantom Equity (defined below) of Target will be redeemed by Target so that it is no longer outstanding and (z) substantially all of the equity currently held by the management team and management companies

• wned by the management team (the “Management Companies”) will be “rolled forward” so that

the management team and the Management Companies will remain equity holders in Target post-

• Transaction. (20% pre-closing management participation)

Example 3



Seller Note: If the Company's ratio of indebtedness divided by LTM EBITDA will be less than 4.5 immediately as of the closing, then the Seller, or an affiliate of the Seller, will lend to the Company an amount in cash equal to the amount required to cause such ratio to equal 4.5. The definition of LTM EBITDA will be mutually agreed between the parties. Such loan shall be made pursuant to a promissory note on terms and conditions to be mutually agreed by the parties and will be subordinated to all other debt of the Company, and will be subject to a subordination agreement satisfactory to the lenders.



Seller Co-Investment: Due to the importance of the Seller to Target, Seller has the option to co-invest up to 49% of the closing equity value of the Target in order to share in the future equity appreciation.

7



Incentivizes on-going management



Management participation in future appreciation



Subsequent PE exit, IPO or sale 

Aligns management with acquirer



Bridges financing and valuation gaps

8



Representative deal terms from a recent PE term sheet:



Enterprise valuation = 6.1 x LTM historic EBITDA + 6.1 x post-closing annualized, normalized quarterly EBITDA



Debt financing

○

Senior or mezzanine debt – up to 4.5 x LTM EBITDA

○

Seller note = shortfall of senior/mezz debt to 4.5 x multiple 

Equity roll – co-invest up to 49% of closing equity value

9



Potential conflicts of interest



Fiduciary duty of rolling persons



Decision by conflicted members of board



Alignment with buyer vs. seller

○

Use Rep and Warranty Insurance to mitigate issue? 

Selection of only certain rollover participants



Complication of negotiations



Rights of the rolling management vs. buyer.



Equity vs. non-equity members of management 

Equity of buyer and founders may not be of same class

10



Type of equity



Common vs. participating preferred (PIK dividends) 

Tax considerations



Stock vs. asset deal



Buyer’s basis step up vs. taxable roll-over parties



Ability to convert corporation to pass-through structure

○

Delaware vs New York entity



Acquisition at holdco or subsidiary level



Domestic vs. cross-border considerations



e.g. Luxembourg CPEC structure

11



Maintain percentage of equity

 Maintain percentage of debt equal to equity percentage 

Exceptions:



Options and incentive plans to directors, employees and consultants



Redemption from majority shareholder (not to exceed 10%) for resale to new investors



Minority may not have financial wherewithal to buy

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

Priority of Payment to Rollover participants



Pari passu



Preferred return to PE fund/Fund and management

○

On IPO, Fund typically receives preferred return 

“Promote” style compensation to management?



Liquidation preference to preferred?



Example 1



First, PE fund receives return of equity investment without any return on capital



Second, co-investors receive return of co-investment (based on closing value) without return of capital



Third, distributions pro rata



Example 2



First, PE fund and co-investors receive pro rata distributions until capital and deemed capital is returned



Second, PE fund and co-investors receive distributions equal to 10.1% IRR



Third, co-investors receive a promote of 17.5% and PE fund and co-investors share pro rata in 82.5% balance



Example 3



Pro rata distributions to PE fund and management

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

Tag along with debt or equity – pro rata



Substantially all deals



Bear pro rata price adjustment, indemnity obligations



Exceptions to Tag-Along



Sale to shareholders,



less than 10% Equity or Debt,



per registered offer



Drag along on sale of company or substantially all assets



Any minimum price to require drag



Rights of first refusal / first negotiation



More limited than Tag along/ drag along



Possible lock-up period

○

Three years, except for Permitted Transfers, vs. immediate right to sell



Board/Observer Seats

14



S-1 Demand



Number



By whom



When – anytime, after qualified IPO 

Piggyback



Against whom – anyone, issuer only



Proper notice



Priority 

S-3

15



Voting Rights



Board seat



Supramajority rights

○

Amend charter or capital structure

○

Change business

○

Change auditors or accounting principles

○

Make non cash distributions of profits

○

Merger or sale of business

○

Enter contracts or capital expenditures in excess of $



Veto rights

○

Wind-up or liquidate



Merger or sale of business 

Dividends



Rarely paid currently, accumulated and paid at liquidity event 

Voting with majority on transfers of assets, acquisitions, election of Board

16



Vesting – say three years



Permitted transfers



Right to initiate sale, including engage advisors and require rollover to participate in marketing efforts



Right to force partial sale of a development project



Rights regarding corporate opportunities:



Side by side fund 

Non-compete and customer/employee non-solicit covenants



Term following rollover equity no longer having securities



Buyer having de minimus amount (10%) 

Rights of redemption



Equity transfer restrictions



Access to financial statements and other information and personnel

17



Subordination



Fully subordinate vs. pari passu 

Secured



Second lien



Unsecured note 

Acceleration on sale or change of control



“AHYDO” (accelerated high yield discount obligations) interest provisions



Avoid adverse tax effect

18



Mechanism for Fund to charge fees to target



Term – ten years, thereafter automatic renewal but terminable by PE fund



Advisory fee – 2% EBITDA or annual minimum



Expense requirement including counsel and auditor fees



Transaction fees – 1% of consideration for refinancing’s, equity or debt

• ffering, dividends recaps



Fees violative of financing agreements will accrue and be payable when allowable

19



Mechanism for Fund to charge fees to Letter of Intent



Rollover Agreement



Securityholders’ Agreement



Registration Rights Agreement



Certificate of Incorporation



Rights, Preferences and Designations 

Seller Note



Non-solicit and non-competes

○

3-4 year average non-compete



Advisory Agreement for Fund

20

George H. Wang is a corporate transactions attorney who focuses his practice on mergers, acquisitions, joint ventures, investments and broad- scope business transactions on behalf of clients in North America, Asia and

• Europe. He has represented domestic and multinational clients on numerous

domestic and cross-border merger and acquisition, private equity, venture capital and related transactions. George has led several large cross-border private equity and merger and acquisition transactions, including a transaction which was awarded 2013 Domestic Deal of the Year by LatinFinance. George has represented strategics, private equity funds, their portfolio companies and family offices in acquiring North American, Asian and European targets, completing serial acquisitions, multi-continent M&A transactions, acquisitions of United States public companies and “going private” transactions and joint ventures. George was recently named Cornell Asian Alumni Association Honoree of the Year by his alma mater, Cornell University (B.S.) and The Cornell Law School (JD). For more than a decade, George served as an Educational Counselor to the Admissions Committee of The Massachusetts Institute of Technology (S.M. in Engineering). He is the immediate past Board Chair of the Asian American Federation, the leading pan-Asian Advocacy organization in the New York metropolitan area working to advance the civic voice of Asian Americans.

413906.1

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Seller Equity Rollovers in M&A Tax Considerations

David R. Hardy, Partner Osler, Hoskin & Harcourt LLP New York City dhardy@osler.com

Stafford Webinar June 7, 2017

LEGAL_1: 44339532.1

Tax Considerations Agenda

• 1. Deal Objectives
• 2. Basic Tax Consequences of Middle Market

Acquisition Transactions

• 3. Requirements for Stepped-Up Basis to Buyer
• 4. Requirements for Tax-Free Rollover to Sellers
• 5. Restructuring Opportunities to Harmonize

Buyer and Sellers Objectives

Equity Rollovers Tax Considerations

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Stafford Webinar June 7, 2017

a. Buyer’s Objectives

• Acquire Control
• Maximize After-Tax Returns – Stepped-Up Asset Basis
• Minimize Fiduciary Complexities or Impediments to Resale
• Preserve Historic Licenses Without Tax Contingencies
• Retain Key Management Personnel

b. Seller’s Objectives

• Achieve Liquidity Event
• Maximize After-Tax Proceeds – One Level of Tax
• To Retain a Participation in Post-Transaction Appreciation

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Stafford Webinar June 7, 2017

• 1. Deal Objectives

• 1. Deal Objectives (con’t.)
• c. Structuring Tax Free Rollovers –

With Basis Step-Up

• For Partnerships and Flow

Through Entities

• For S Corporations
• For C Corporations

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Stafford Webinar June 7, 2017

• 2. Basic Tax Consequences

a. Share Sale of Taxable C Corporation

• Seller’s Sell Shares – Realize a Capital Gain on Shares Taxed 20%

Rate – One Level of Tax

• Buyer Buys Shares – Obtains a Cost Basis in Shares. Share

Investment is not Depreciable; Share Basis Will Only Produce a Tax Benefit When Resold. b. Sale of C Corporation’s Assets

• Selling Corporation Pay Tax on Asset Gains at 35%; then Distributes

Cash to Shareholder Who Pay Tax on Their Share Gains at 20% – Two Levels of Tax (But Consider Shareholder Goodwill and Non- Competes)

• Buyer Get Stepped Up Asset Basis, Including Goodwill and Going

Concern Value Amortizable Over 15 Years; Avoids Historic and Contingent Liabilities.

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Stafford Webinar June 7, 2017

• 2. Basic Tax Consequences (con’t.)

c. Sale of Partnerships, Branches, or Disregarded Entities

• All Transparent or Flow-Through Entities.
• Buyer May Buy Ownership Interest or Assets; Purchase Price

Treated as Paid for Assets. Stepped-Up Asset Basis Increases Depreciation and Amortization Allowing Tax Sheltered Cash Flow to Pay Down Acquisition Debt.

• Sellers Sell Assets or Ownership Interests in the Entity. Sellers

Realize a Capital Gain on Assets – One Level of Tax at 20% Rate (Except Depreciation Recapture Taxed at Ordinary Rates). d. S Corporation – Treated as Modified Flow Through.

• Sale of Assets Gives Buyer Stepped Up Asset Basis – Selling

Shareholders One to Level of Tax (Asset Gains May Flow Through at Ordinary Rates for Receivables and Depreciable Assets).

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Stafford Webinar June 7, 2017

• 2. Basic Tax Consequences (con’t.)
• Consider §1374 Entity Level Tax for S Corporations That

Have Converted From C Corporations During the Prior 5 Years.

• Sale of Shares Gives Buyer a High Share Basis, No Asset

Step-Up; Sellers have one Level of Tax.

• e. Section 338 Election (Similar Results May Exist Under 336(e))
• 338(g) Allows Sale of Shares to Be Treated as an Asset Sale

by the Target Company (Tax Obligation Retained in the Entity).

• 338(h)(10) Allows Shares Sale to be Treated as an Asset Sale

But Asset Gains are Taxed to Selling Consolidated Group or Selling S Corp Shareholders (Tax Thrown Back to Sellers).

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Stafford Webinar June 7, 2017

• 3. Requirements for Step-Up

a. Buyer’s Asset Step-Up Requires

• Asset Purchase
• A Constructive Asset Purchase – Purchase of Transparent

Entity (Partnership, Branch or Disregard Entity)

• Deemed Asset Purchase Under Section 338

b. Asset Purchase is Prohibitively Expensive if:

• Seller is a C Corp. with Substantial Asset Gains (Self Created

Goodwill Has a Zero Basis)

• Seller is a C Corp. without a Large NOL

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Stafford Webinar June 7, 2017

• 3. Requirements for Step-Up

(con’t.)

• c. Section 338 Requirements
• Buyer Acquires 80% of Vote and Value of Shares
• Share Acquisition Obtained by Purchase (Not Non-Taxable

Share Contribution or Tax-Free Reorganization)

• Share Acquisition Must Occur Within a 12-Month Acquisition

Period

• Buyer Election 338(g) (Basic 338) or Mutual Election by

Buyer and Seller Under 338(h)(10) with Agreed Upon Purchase Price Allocation (i.e., Tax Thrown Back to Sellers)

• Difficult for Tax Free Rollover Because All Target’s Assets

Have Been Sold All Selling Shareholders Will Recognize Proportionate Share of Taxable Gain

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Stafford Webinar June 7, 2017

• 4. Requirement for Tax Free

Rollover

• a. Generally All Sellers Will Be Taxable on Cash

Received for Target Equity

• b. Compensatory Shares Will Generate Ordinary

Income to Employees. Post Closing Vesting Requirements are Inconsistent with Rollover Treatment

• c. Sellers Either: (i) Don’t Sell (Some or all Sellers

Retain Some or all Equity), or (ii) Exchange Old Equity for New Equity in a Tax Free Incorporation Transaction

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Stafford Webinar June 7, 2017

• 4. Requirement for Tax Free

Rollover (con’t.)

• d. Consistency with Buyer’s Asset Step-Up Objectives
• Target Partnerships are Most Consistent with

Competing Objectives – Sellers One Level of Tax with Rollover Opportunity and Buyers Step-Up

• Sellers Retaining Equity in Excess of 20% can

Prevent §338(h)(10) Election

• For Target S Corporations and C Corporations –

Certain Structures Exist

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Stafford Webinar June 7, 2017

• 5. Harmonizing Buyer and Seller

Objectives

a. Flow Through Targets

• Partnerships, LLC Treated as Partnership, and

Disregarded Entities are not Taxed as Entities. Taxable Income Follows Through to Owners

• Flow Through Entities Most Easily Accommodate

Harmonization of Buyer’s Stepped-Up Basis with Seller Rollover Opportunity

• Seller Rollover Can Be Proportionate or

Disproportionate

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Stafford Webinar June 7, 2017

• 5. Harmonizing Buyer and Seller

Objectives

• b. Flow Throughs

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Stafford Webinar June 7, 2017

Shareholders Private Equity Partnership Target Management 70%

• Example
• Buyer obtains a

Basis Step-Up in Partnership Assets for its Purchase Price (§§754 and 743)

• Sellers Retained

Rollover Shares can be Proportionate or Disproportionate

• Introducing New

Holdco Can Complicate

• Analysis. (See

§§708 and Rev.

• Rul. 99-6)

Cash

• 5. Harmonizing Buyer and Seller

Objectives (con’t.)

c. C Corporation Target – Rollover and Step-Up Together are Difficult

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Stafford Webinar June 7, 2017

Shareholders

Target

Private Equity

Holdco New Target

• Rollover Without Step-

Up – Shareholders Sell Some Shares to P.E. in Taxable Transaction; Shareholders Retain (or Contribute to Holdco) Rollover Equity

• No Tax Basis Step-Up to

Buyer or Holdco!! (Might Consider Interest Expense on Acquisition Debt at Holdco Offset or Shareholder Level Goodwill)

• Rollover can be

Proportionate or Disproportionate

• 5. Harmonizing Buyer and Seller

Objectives (con’t.)

• d. C Corporation Target – Basis Step-Up But With Two Levels of Tax

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Stafford Webinar June 7, 2017

Private Equity Shareholders

Target

Target Assets

• Part Sale / Part Retained
• Ownership. Say P.E.

Fund Contributes Cash for 70% of Targets Assets

• P.E. Fund Buyer Gets

Asset Step-Up for Its Benefit Only (§743)

• Selling Shareholders

Have Two Levels of Tax

• n Cash Portion of the

Transaction

• 5. Harmonizing Buyer and Seller

Objectives (con’t.)

• e. S Corporation Target
• Section 338(h)(10) Election Available to Treat Stock Sale

as an Asset Purchase (Buyer Gets Step-Up)

• Buyer Must Acquire 80%; All Assets Deemed Sold
• S Corp.’s Taxable Gain Allocated to Selling

Shareholder’s – Pro-Rata. (Target Sellers Seeking Rollover will be Taxable)

• Buyer Acquires Historic Entity with any Tax

Contingencies

• f. F Reorganization Structure – Preserves Historic Licenses,

but Buyer Avoids Historic Tax Contingencies

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Stafford Webinar June 7, 2017

• 5. Harmonizing Buyer and Seller

Objectives (con’t.)

38

Stafford Webinar June 7, 2017 Private Equity

Shareholders

Target Target LLC

• F Reorganization Steps:
• Seller’s Drop Target S
• Corp. into New

Holdco and Elect Q Sub Status – Tax Free

• §368(a)(1)(F)
• Sellers – Merge Target into

LLC

• Buyers Purchase all or

Most of LLC. Not a 338, but a Partnership Purchase (Can Acquire Less than 80%)

• Buyer gets Stepped Basis;

Sellers gets One Level of tax and Proportionate Rollover Opportunity. Holdco C New S Cash Target LLC Units

Bio

David’s practice focuses on corporate and international tax including the tax issues affecting corporations in the energy industry. He has been involved in cross-border merger transactions, including public company stock acquisitions, joint ventures, project financings, cross-border security issuances, inbound and outbound securities, real estate and private equity

• partnerships. David is the past President of the International Tax Institute in

New York, past chair of the Taxation Committee of the International Bar Association and a long time member of the Executive Committee of the NYS Bar Tax Section. In addition, he is a frequent speaker at tax conferences and frequently writes on various topics. He has been the principal author of a number of NYS Bar Tax Section reports on subjects including the anti-double dip finance provisions, the anti-hybrid provisions

• f the U.S.-Canada treaty, the non-recognition rules regarding the outbound

transfers of intangible property, and the consistency principle in tax treaty interpretation.

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