During an M&A transaction, many issues populate that need immediate attention. In this article, I’m going to highlight the top 5 burning issues and the challenges thereof, that both the parties face while negotiating a transaction.
1. Structure of the deal
There are 3 ways to structure a transaction: (i) stock sale, (ii) asset sale and (iii) merger. The acquirer and the target have competing interests with each of 3 alternatives. Hence, it’s important to recognize and address material issues while negotiating a deal structure. Highlighted below are 4 areas that needs to be considered when structuring the deal
i. Liability: Unless contractually negotiated otherwise, in a stock sale, upon the consummation of transaction, the target’s liabilities are transferred to the acquirer by operation of law. Similarly, in a merger, the surviving entity assumes all liabilities of the merged entity. But, in an asset sale, the acquirer picks and chooses and assumes only the designated liabilities; the non-designated ones remain with the target
ii. Contracts: Target’s existing contracts might sometimes prohibit assignment. In that case, a pre-closing consent to assignment must be obtained. However, for a stock purchase or merger, no such requirement exists unless the contracts state otherwise; the prohibitions get activated upon a change of control or by operation of law
iii. Stockholder Approval: In an asset sale, the Board of Directors of the target can grant an approval at the corporate level without obtaining the approvals from the individual stockholders. But in a stock sale, all selling stockholders need to accord their approvals for the transaction. When unanimity, in a stock sale, is questionable, a merger can be an effective alternative – the acquirer and the target can negotiate to arrive at a mutually acceptable stockholder approval threshold that is sufficient to consummate the deal
iv. Tax: While asset sales and stock purchases have immediate tax consequences for both the acquirer and the target, certain mergers can be structured in such a way that at least a portion of the sale proceeds can earn tax deferred treatment.
a. From an acquirer’s perspective, an asset sale is most desirable because a “step up”, which is usually the fair market value, enables the acquirer to significantly depreciate the assets and improve profitability post closure. The target gains a corporate tax liability for the asset sale and its shareholders a tax on subsequent dividends.
b. In a stock purchase, the selling shareholders benefit from the long-term capital gains, provided they own the stock for at least a year. The acquirer, however, would only obtain a cost for the stock purchased, and not for the assets. The assets costs remain unchanged and cause an unfavorable result if the fair market value is higher.
c. Election 338 h(10) proves beneficial to both the parties. It allows the buyer to record a stock purchase as an asset acquisition and obtain the desired step-up in the assets.
2. Cash or Stock
Cash: From the target’s perspective, cash is the best method of payment because it’s the most liquid and least risky financial instrument for the sellers. It represents the true market value of the transaction and removes all contingency payments (except possible earn-out), thereby effectively pre-empting all rival bids (assuming there is an equity portion in the rival bid). Generally, the acquirer pays the cash from its working capital, excess cash on its Balance Sheet or untapped credit lines
Stock: This mode of payment involves an exchange ratio, whereby the target shareholders receive acquirer’s stock at a determined ratio relative to the target’s value. Issuing equity may reduce the acquirer’s future cost of debt financing and hence, improve debt rating, but there are transaction costs, brokerage fees, risks (stockholders’ potential rejection of the deal), registration costs (if the acquirer is public), etc. Of course, it goes without saying that issuance of equity generally provides more flexible deal structures.
Whether it’s stock or cash, the ultimate payment method may be derived based on what value the acquirer places on itself. Generally, the acquiring company will offer equity, if its stock is over-valued and cash when it’s under-valued.
3. Working Capital Adjustments
In any M&A transaction, the buyer always acquires a target with adequate working capital such that it can meet the business needs (like enabling business operations and generating profits) after deal closure, including liabilities to customers and trade creditors. An effective working capital adjustment insures the buyer against the target initiating (i) accelerated collection of debt, or (ii) delayed purchase of inventory/selling inventory for cash or payment of creditors.
For measuring the working capital, the definitive agreement will include a mechanism that compares the actual working capital at the closing against a target level – the target level will be viewed as the normal level for business operations based on the target’s historical operations over a defined period of time. Unusual activities, “one-times”, add-backs, and cyclical items will also be considered as part of the working capital calculation. For any disputes that may arise between the parties related to the calculation, dispute procedures are set forth clearly in the definitive agreement.
4. Contingency to the payment
Acquirer’s Letter of Intent should clearly indicate any contingency to the payment of the purchase price including any escrow and earn-out. Escrows are included to provide alternatives for the acquirer if there are breaches of the representations and warranties made by the target. Escrows are a standard in M&A transactions, and typically include an amount of 10 – 20% of the overall price with an escrow period of 12 – 24 months from the date of closing.
Earn-outs are most often used to bridge the valuation gap between the target and the acquirer. Earn-out provisions are typically tied to the future performance of the business (like future revenue), with the target and/or its stockholders only receiving the additional consideration to the extent certain milestones are achieved. The concern with earn-outs is that post-closing the target loses control over the company and decisions made by the acquirer after closure can dramatically impact the ability to achieve the agreed milestones.
5. Representations and Warranties
Often the acquirer would want the definitive agreement to include detailed representations and warranties by the target with respect to authority, capitalization, intellectual property, tax, financial statements, compliance with law, employment, material contracts, etc. Hence, it’s crucial for the target to review these representations carefully. Disclosure schedules should be as detailed as possible. One of the most debated issues is the “10b-5” representation, which requires the target to make a general statement that no representation or warranty contains untrue statement or omits any material fact that is necessary to make any of them not misleading.
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