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Structuring Mergers and Sales

• f Closely Held Businesses

Navigating Complexities Regarding Valuation, Due Diligence, Stock vs. Asset Sale, and More Today’s faculty features:

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THURSDAY, FEBRUARY 26, 2015

Presenting a live 90-minute webinar with interactive Q&A Benjamin Lindblad, Partner, Dorsey & Whitney, Minneapolis John Marsalek, Partner, Dorsey & Whitney, Minneapolis

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Ben Lindblad

lindblad.ben@dorsey.com

John Marsalek

marsalek.john@dorsey.com

February 26, 2015

STRUCTURING MERGERS AND SALES OF CLOSELY HELD BUSINESSES

Structuring Mergers and Sales of Closely Held Businesses

• Introduction

– Key legal, business and tax considerations – Due Diligence – Transaction structure – Valuation Challenges

6

Key Considerations

Key Considerations (Cont.)

• Deal Structure

– 3 basic types of transactions

• Asset Purchase
• Stock Purchase
• Merger

Discuss later in more depth

8

Key Considerations (Cont.)

• Diligence/Pre-Sale Preparation

– Discuss later in more depth

9

Key Considerations (Cont.)

• Valuation Challenges

– Discuss later in more depth

10

Key Considerations (Cont.)

• Indemnification

– Joint and several liability – Subject matter – Survival – Escrows

11

Key Considerations (Cont.)

• Indemnification (Cont.)

– Limits on Indemnification

• Cap
• Baskets

– Deductible – Dollar One or tipping basket

– Other Limits on Indemnification

– Antisandbag – Disclaimer of Damages

12

Key Considerations (Cont.)

• Closing Conditions

– Conditions that must be true to close the deal – Representations and warranties – Common Closing Conditions

13

Key Considerations (Cont.)

• Third Party – Timing Issues

– Regulatory – Contracts – Stockholder Approval

14

Key Considerations (Cont.)

• Non-competes

– Scope – Geography – Length

15

Key Considerations Conclusion

• Key Considerations
• Focus on the following three

– Due Diligence – Structure – Valuation Challenges

16

Pre-Sale Process Diligence

Pre-Sale Process Diligence

• Start Planning Early

– Sale preparation and sale process will take time – Know seller’s goals – Identify transaction objectives – Objectives may impact transaction structure – Assemble advisors

18

Pre-Sale Process Diligence (Cont.)

• Valuation

– Value of the business – Financial models – Key financial issues

• Audited financials (last 2-3 years)
• Quality of earnings
• Balance Sheet – Working Capital
• Projections

19

Pre-Sale Process Diligence (Cont.)

• Get the Business Ready

– Document procedures and business practices – Organize the business to address potential problems

• General corporate clean-up

– Organize and update corporate records and books – Qualified to do business in each jurisdiction? – In good standing? – Corporate filings/franchise taxes up-to-date? – Tax and financial records – Copies of records

20

Pre-Sale Process Diligence (Cont.)

– Organize the business to address potential problems (Cont.)

• Operations

– Consider how best to convey information to buyer – Consider how to stage the disclosure of the information – Consider the good and the bad of the company’s business and how you will explain it

21

Pre-Sale Process Diligence (Cont.)

– Organize the business to address potential problems (Cont.)

• Customers, Vendor and Supplier contracts

– Complete, written and signed copies of each contract – Check expiration dates and termination provisions – Check change of control or assignment clauses – Consider re-negotiating key contracts

22

Pre-Sale Process Diligence (Cont.)

– Organize the business to address potential problems (Cont.)

• Real Estate Leases
• Real Property
• Personal Property Leases
• Material Contracts
• Assets
• Debt
• Legal Claims
• Intellectual Property

23

Pre-Sale Process Diligence (Cont.)

– Identify Consents and Approvals

• Third party consents
• Required approvals and permits
• Approvals necessary to effect the sale
• Requisite board or stockholder approval

24

Pre-Sale Process Diligence (Cont.)

– Employees

• Protect the company’s confidential information and

intellectual property, e.g., noncompetes

• Loss of key employees
• Cross-train employees
• Extensive sale process will take its toll on your employees
• Consider incentives to keep key people throughout the

sale process

• Company’s Benefit Plans

25

Pre-Sale Process Diligence Conclusion

• Preparing a business for sale will help identify

problem areas, which can be addressed in advance

• Addressing any problems will help the seller

– maximize its value – decrease risk – close quickly

26

Due Diligence Overview

• Overview of Due Diligence

– Factual investigation of the target company – Investigation will confirm desire to complete the acquisition and justify the purchase price – Due diligence used to negotiate the purchase agreement

• Reps and warranties will reflect such risk allocation
• Disclosure Schedule
• Breach – indemnification claim

– Integration

27

Due Diligence Overview (Cont.)

• What Do You Review?

– Financial Diligence to confirm value of the business

• Audited financials (last 2-3 years)
• Quality of earnings
• Balance Sheet – Working Capital
• Projections

28

Due Diligence Overview (Cont.)

– Financial Diligence to confirm value of the business (Cont.)

• Tax Diligence
• Corporate Structure
• Tax Returns and Workpapers
• Audit Reports
• State and Local Taxes
• Tax Elections
• Compensation and Employment Taxes

29

Due Diligence Overview (Cont.)

• What Do You Review? (Cont.)

– Legal Diligence

• Steps required to effectuate transaction
• Contractual obligations
• Regulatory compliance – Environmental, FCPA, etc.

30

Due Diligence Overview (Cont.)

• Diligence Team

– Internal and External Experts – Accountants – Attorneys – Business team members – Corporate Development

31

Due Diligence Overview (Cont.)

• How Does the Process Begin?

– Financial Statements – Comprehensive Request List – In-person meetings – Meetings with customers, suppliers, regulators

32

Due Diligence Overview (Cont.)

• Dealing with Diligence Results

– Low risk, low cost issue

• Ignore for purposes of transaction
• Address post-closing

– High risk, low(er) cost issue

• Holdbacks or escrows
• Additional reps + indemnification

33

Due Diligence Overview (Cont.)

• Dealing with Diligence Results (Cont.)

– Low risk, high cost issue

• Purchase price adjustment

– High risk, high cost issue

• Walk away

34

Due Diligence Overview (Cont.)

• Best Practices

– Understand the key reason(s) for the transaction – Team Leader – Right team with right level of experience – Insist on full access – Ask lots of questions and be persistent – Bring material issues to the forefront immediately – Allow for time

35

Due Diligence Overview Conclusion

• Diligence helps the Buyer confirm that it is

getting what it thought it was

• Helps decrease risk
• Helps integration

36

Transaction Structure

Transaction Structure

• Three Common M&A Transaction Structures

– Asset purchase – Asset Purchase Agreement – Stock purchase – Stock Purchase Agreement – Merger – Agreement and Plan of Merger

38

Transaction Structure (Cont.)

• Structuring Considerations

– Factors in Determining Transaction Structure

• Tax considerations
• Assumption of liabilities
• Scope of acquisition (entire company or line of business)
• Assignment and third-party issues (licenses, permits,

contracts, etc.)

39

Transaction Structure (Cont.)

• Structuring Considerations (Cont.)

– Factors in Determining Transaction Structure (Cont.)

• Nature of target (public company vs. private company)
• Nature of acquisition (negotiated vs. hostile)
• Shareholder consent
• Accounting treatment

40

Terminology

41

• “P” means “parent”, the acquiring entity
• “S” means a wholly-owned subsidiary of P
• “T” means “target”, the acquired entity
• Unless otherwise clear from context, each entity

is a corporation

Asset Purchase

42

T

T Shareholders

P

P purchases substantially all of T’s assets from T, and may assume some or all of T’s liabilities, in consideration for cash, notes, or some other mix

• f taxable consideration.

Asset Purchase (Cont.)

43

• T recognizes gain or loss
• T’s tax attributes do not carry over to P
• P takes a purchase price basis in T’s assets
• T retains its tax attributes
• If T is liquidated, T’s shareholders recognize

gain or loss

Asset Purchase (Cont.)

• Legal Considerations

– Transfer of Liability – Third Party Consents – Stockholders’ Approval

44

Stock Purchase

45

T

T Shareholders

P

T Stock Cash

P purchases all of T’s stock from T’s shareholders in exchange for cash, notes, or some other mix of taxable consideration. T becomes a wholly-owned subsidiary of P.

Stock Purchase (Cont.)

• Tax Consequences

– T’s shareholders recognize gain or loss – T recognizes no gain or loss – T’s basis in its assets remains unchanged – T retains its tax attributes – P takes a purchase price basis in the T stock

46

Stock Purchase (Cont.)

• Legal Considerations

– Transfer of Liability – Third Party Consents – Stockholders’ Approval

47

Stock Purchase Treated as Asset Purchase

48

T

T Shareholders

P

T Stock Cash

T is an S corporation. P purchases all of T’s stock from T’s shareholders in exchange for cash, notes, or some other mix of taxable consideration. P and T’s shareholders jointly make a 338(h)(10) election.

Stock Purchase Treated as Asset Purchase (Cont.)

49

• If P purchases the stock of T, under certain

conditions an election may be made under Section 338(h)(10) or Section 336(e) to treat the transaction as a taxable sale of assets by T to a “new” T, followed by a liquidation of old T.

• T must be a member of an affiliated group

(whether or not filing a consolidated return) or an S corporation.

• The tax consequences are described under

“Asset Purchase”, above.

Merger Structures

• 3 Types of Mergers

– Direct Merger – Forward Triangular Merger – Reverse Triangular Merger

50

Direct Merger

51

T

T Shareholders

P

Cash

T merges directly into P, with P

• surviving. P succeeds to all of

T’s assets and liabilities. T’s shareholders receive cash, notes, or some other mix of taxable consideration.

Direct Merger (Cont.)

52

• Treated as a taxable sale of assets by T to P,

followed by a liquidation of T.

• The tax consequences are described under

“Asset Purchase”, above.

Forward Triangular Merger

53

T merges into S, with S surviving. S succeeds to all

• f T’s assets and liabilities. T’s shareholders receive

cash, notes, or some other mix of taxable consideration.

T

T Shareholders

P

Cash

S

Merge

Forward Triangular Merger (Cont.)

54

• Treated as a taxable sale of assets by T to S,

followed by a liquidation of T.

• The tax consequences are described under

“Asset Purchase”, above.

Reverse Triangular Merger

55

S merges into T, with T surviving. T becomes a wholly owned subsidiary of P. T’s shareholders receive cash, notes, or some other mix of taxable consideration.

T

T Shareholders

P

Cash

S

Merge

Reverse Triangular Merger (Cont.)

56

• Treated as a taxable sale of T stock by T’s

shareholders to P.

• The tax consequences are described under

“Stock Purchase”, above.

Mergers

• Legal Considerations

– Transfer of Liability – Third Party Consents – Stockholder Approval

57

Acquisition Summary for Corporations

• Treated as Asset

Purchase

– Asset Purchase – 338(h)(10) Election – Direct Merger – Forward Triangular Merger

• Treated as Equity

Purchase

– Stock Purchase – Reverse Triangular Merger

58

Purchase of a Partnership

59

T

T Members

P

T Interests Cash

T is an LLC with multiple members, and has not made a check-the-box election. P purchases all of T’s equity from T’s members in exchange for cash, notes,

• r some other mix of taxable

consideration. T becomes a wholly-owned subsidiary

• f P.

Purchase of a Partnership (Cont.)

60

• T is a partnership for federal income tax

purposes.

• T’s members are treated as selling their equity

in T.

• For P, however, the transaction is treated as if

(1) T made a liquidating distribution of its assets to T’s members, and (2) immediately after the liquidating distribution, P purchased the assets of T from T’s members. Rev. Rul. 99-6, 1999-1 C.B. 432.

Purchase of a Disregarded Entity

61

T

T Member

P

T Interests Cash

T is an LLC with a single member, and has not made a check-the-box election. P purchases all of T’s equity from T’s member in exchange for cash, notes, or some other mix of taxable consideration. T becomes a wholly-owned subsidiary of P.

Purchase of a Disregarded Entity (Cont.)

62

• T is disregarded for federal income tax

purposes, and prior to the transaction T’s assets are treated as held directly by T’s member.

• Treated as a taxable sale of assets by T’s

member to P.

Pre-Tailoring Transactions

Pre-Tailoring Transactions – Conversion

• A pre-acquisition conversion to an LLC can be

used to

– Cure tax faults in T – Remove unwanted assets – Prepare the entity for P’s holding structure

• Does not address liabilities for pre-closing taxes

64

Pre-Tailoring Transactions – Conversion (Cont.)

Example

• P has agreed to buy all of the stock of T, an S

corporation; parties have agreed to make a Section 338(h)(10) election to treat the transaction as an asset sale.

• However, T has faults in its S election that could

jeopardize the Section 338(h)(10) election.

• In order to ensure that the transaction is treated

as an asset sale, S agrees to convert T to an LLC before closing.

65

Step 1: Formation of HoldCo

66

HoldCo

T Shareholders

T

Holdco Stock T Stock

T shareholders contribute all of their T S corporation shares to HoldCo in exchange for HoldCo shares. HoldCo makes an election to be treated as an S corporation. T makes an election to be treated as a qualified subchapter S subsidiary.

Step 2: Conversion of T to LLC

67

HoldCo

T Shareholders

T

T is immediately converted to a limited liability company (with no check-the-box election). Step 1 and 2 together are treated as an “F” reorganization. No gain is recognized by T, HoldCo, or the T shareholders.

Step 3: Purchase of T

68

HoldCo

T Shareholders

T P

T Interests Cash

T is acquired by P. The acquisition is treated as an asset purchase; P receives a stepped-up basis in T’s assets, without making a 338(h)(10) election.

Pre-Tailoring Transactions – Rollover

69

• P may want T’s management to continue, or

“rollover,” their equity stake in T post- acquisition.

• A rollover may be done on a pre-tax or post-

tax basis depending on the tax rate environment.

• Parties should enter into a contribution

agreement to reflect the rollover.

Step 1: Formation of HoldCo

70

P contributes cash to HoldCo for HoldCo stock. T management contributes rollover portion of T shares to HoldCo for HoldCo stock. Under Section 351, T management should not recognize gain on the contribution.

HoldCo

T Management

T Stock

P

Cash

Step 2: HoldCo Purchases Non-Mgmt T Stock

71

HoldCo

T Management

P T

T Non-Mgmt Shareholders

Cash T Stock

HoldCo purchases remainder of T stock.

Valuation

Valuation Issues

• Cash versus Equity

– Cash – Equity

73

Valuation Issues (Cont.)

• Seller Financing

– Buyer issues a note for some of the purchase price – Reduces the amount of debt the buyer needs from outside sources – Seller takes risk of non-payment

74

Valuation Issues (Cont.)

• Escrow Arrangements

– Buyer and Seller agree on value, but not on one

• r more identified risks

– Buyer deposits a portion of the purchase price in an escrow

75

Valuation Issues (Cont.)

• Taxation of Escrows

– Timing of Taxation on Escrow Principal – Timing of Taxation on Escrow Income – Imputed Interest

76

Valuation Issues (Cont.)

• Earnouts and Milestone Payments

– Earnouts are tied to future performance of the business – Milestones are payments for the achievement of certain events, e.g., FDA approval

77

Valuation Issues (Cont.)

• Taxation of Earnouts

– Additional Purchase Price or Compensation? – Installment Treatment – Imputed Interest

78

Valuation Issues (Cont.)

• Asset Allocation Issues

– Allocation important to P and T – Section 1060 – Section 197

79

Valuation Issues (Cont.)

• Taxation of Covenants Not to Compete

– If the purchase of T includes covenants not to compete, a portion of the consideration for the sale of the business must generally be allocated to the agreement. – T’s shareholders will seek to limit the amount allocated to the covenant not to compete because those payments constitute ordinary income rather than capital gain. – For P, the covenant not to compete is generally a Section 197 intangible that is capitalized and amortized over a 15-year term.

80

Valuation Issues (Cont.)

• Transaction Deductions

– The allocation of tax benefits for transaction deductions is often heavily negotiated. – Transaction deductions may arise from

• Option/restricted stock cancellation payments
• Transaction bonuses
• Interest deductions
• Legal and banking fees and expenses

– Is the amount deductible?

• Section 280G
• INDOPCO Regulations

81

Valuation Issues (Cont.)

• Transaction Deductions (Cont.)

– Will T have a final tax return?

• Entering or leaving a consolidated group
• Terminating S corporation status
• Terminating a partnership

– Our watch/your watch

• Deductions for closing payments allocated to T
• Deductions for payments made after the closing,

including escrow or other contingent payments, allocated to P

• Next day rule (1.1502-76)

82

Valuation Issues (Cont.)

• Transaction Deductions (Cont.)

– Tax benefit payment for post-closing deductions? – Employment taxes?

83

Valuation Issues (Cont.)

• Limitation on Net-Operating Losses

– Section 382 limits the deductibility of T’s net

• perating loss carryforwards (“NOLs”) following

an “ownership change.” – An “ownership change” occurs where there is an increase in stock ownership of more than 50 percentage points within any three-year period by any “five-percent shareholders.” – Limitation = the fair market value of T’s stock immediately before the change in ownership multiplied by the “long-term tax-exempt rate.”

84

Valuation Issues (Cont.)

• Golden Parachute Payments

– Payments to disqualified individuals that equal or exceed three times the individual’s average annual compensation are generally

• Not deductible by the corporation
• Subject to 20% excise tax payable by the individual

85

Valuation Issues (Cont.)

• Golden Parachute Payments (Cont.)

– Includable payments

• Option acceleration
• Transaction bonuses
• Severance
• P retention payments
• Other compensatory amounts (e.g., continuation medical

coverage)

86

Valuation Issues (Cont.)

• Golden Parachute Payments (Cont.)

– Exceptions

• Shareholder approval

– Waiver – Disclosure statement – Approval by more than 75% of voting power (excluding person affected)

• Small business corporations

– P issue!

• Loss of deductions
• Disgruntled employees
• Reporting obligations

87