Helpful M&A Tips for Entrepreneurs

H. Len Musgrove, Jr., Esq.
© Musgrove Law Firm, P.C. 2017

Many of our entrepreneur and privately held clients are considering a sale of their closely held businesses as a means of unlocking value from their hard-earned, sometimes life-long efforts, balancing their portfolios or simply “taking some chips off the table” for their personal estate planning. Many experts consider now to be an excellent time to package and sell businesses, with a robust mergers and acquisitions (“M&A”) market predicted for 2017 and 2018.  However, savvy entrepreneurs understand that the process is not a simple one, rather it takes years of planning and sound management decisions in order to truly unlock the potential of maximum value to a buyer, whether a strategic buyer or an equity group buyer.

For purposes of this discussion, I will assume that the potential seller’s company (the “Target”) is a corporation, although the concepts for the popular limited liability companies or limited partnerships are similar.   Accordingly, we will speak of shareholders rather than members and partners as the equity owners of the Target.   Although our Firm focuses on and handles a significant number of M&A transactions for both Sellers and Buyers, in nearly equal numbers, the focus of this article will reflect the perspective of the Seller side, with particular insights as to the decision process of the Seller and its shareholders.  A final fundamental point is that although the tax consequences of an M&A transaction do not “wag the dog”, they are critically important to the net funds that the shareholders receive as a logical conclusion of the M&A transaction, sometimes known as the “SMM”, or the small matter of money.  Accordingly, it is wise idea to have your CPA and your M&A legal team have open and frequent discussions during the negotiation, due diligence and closing process of the Target’s planned transaction in order to make the proposed M&A transaction as tax efficient as possible to the Target and its shareholders.

TYPES OF M&A DEALS.  There are two primary types of M&A transactions:   asset purchases and stock purchases.  The former structure is widespread in the middle market, as savvy buyers pay particular care to isolate the liabilities to be assumed from the Target, as well as focusing on acquiring specific, but not necessarily all, of the assets of the Target.  By contrast, a stock purchase is actually a buy/sell transaction between the buyer and the shareholders of the Target, who in turn sell their shares of stock of the Target to the buyer.  Since the Target remains intact, the buyer essentially purchases the business and all of the assets of the Target as well as assuming all of its liabilities.  Variations of the stock purchase transaction include mergers, triangular mergers, reverse triangular mergers, stock purchases with IRC Section 338(h)(10) elections and more.

WHAT TO AVOID.  If there is a certainty to the hundreds if not thousands of M&A transactions that I have observed in over thirty plus years of practicing corporate law, it is that the absolute worst structure for the shareholders of the Target is the sale of appreciated assets of a C corporation, due to the terribly inefficient double taxation imposed on the transaction, once at the Target level and again at the shareholder level upon distribution of the after-tax net proceeds.  More than a handful of attempted transactions using this structure were ultimately killed by the Target’s shareholder when they realized that more than two-thirds of the attractive sounding gross proceeds of the asset sale would ultimately end up in the hands of the federal and state governments.  That, my friends, is a poorly executed plan that directly impacts the SMM.  Even worse, such a result could have easily have been avoided by better planning in conjunction with one’s legal and tax advisors.  Don’t wait to plan!

EXCELLENT DEAL FOR SELLER.  By contrast with the inefficient sale of appreciated assets by a C Corp described above, there are multiple types of M&A deals that achieve quality, efficient results for the Target’s shareholders.  As noted above, either a sale of stock (whether by C Corp, S Corp or other entity types) virtually always results in efficient long-term capital gain income tax treatments (currently taxed at 20% for federal income tax, but could be even lower by year end if Congress acts as has been proposed) or a sale of assets with the allocation of the purchase price to goodwill and intangible assets will greatly mimic the sale of stock for the Target’s shareholders so long as the Target is an S Corp or a similar pass-through entity.  While we can be selective on behalf of the Target and its shareholders, an all-cash (or nearly all-cash) transaction tends to be the most advantageous for the seller, in contrast to a transaction with substantial deferred purchase price or the promise (but rarely the certainty) of earn-out, deferred payments.   Finally, the seller should strive to negotiate for reasonable limitations on the indemnifications that the buyer will seek, both in terms of length of time and market caps (which limit the total claw back) and baskets (which prevent any claims below an agreed “deductible” amount) on the ultimate liability that a buyer could pursue against the Target and its shareholders.

EXCELLENT DEAL FOR BUYER.  Although most of this discussion has focused upon the seller side, our Firm represents a significant amount of buyers in M&A transactions as well.  Naturally, the approach of our team if we are acting as buyer counsel is quite different than if we are negotiating for a dream deal for the seller.  Buyers are ever mindful of the amount and degree of risk they are willing to assume, so the deal structure tends to lean toward a targeted asset purchase with carefully defined liabilities to be assumed, if any.   If the deal needs to be a stock purchase, then we would typically advise a triangular merger or at least the use of a subsidiary purchaser to further isolate any risks that might dance out of the closet of the Target.  To the contrast of the ideal seller deal, I am not a fan of all-cash up front deals for my buyers.  By contrast, I prefer deferred consideration through either earn-outs, higher value (and sometimes lengthier) employment contracts and similar tools that either make a significant portion of the overall purchase price deductible to the buyer or make the Target pay a portion of its own purchase price in the case of earn-outs.  These techniques greatly reduce the net cost, as well as the risk, to my buyer clients.  Finally, I seek higher caps, lower baskets and holdbacks or escrowed funds to provide more protection and stronger claw back rights for my buyer clients.

FINAL CAVEAT.  I recently had the privilege to speak about the legal perspective of M&A transaction with two brilliant industry experts who discussed both the buyer and seller sides, respectively, of successful M&A transactions.  While planning for the panel discussion, it immediately became clear that each of the three of us, despite our differences in backgrounds and approaches, were believers in planning, carefully investigating your worthy opponents in an M&A transaction and using a seller’s or buyer’s best team to get to the finish line of a successful M&A transaction.  While quality legal counsel is a fundamental to a successful M&A deal, it is my view that the best M&A transactions have more to do with quality trade partners across the table from you, as well as lots of due diligence and research, than solely a brilliantly-written definitive purchase agreement.  There is no substitute for planning before a seller is ready to sell and thorough due diligence and vetting before a buyer is willing to part with cash.

Please reach out to any of our accomplished lawyers and team members at Musgrove Law Firm, P.C. if we can be a resource to you with respect to a possible M&A transaction.  As a quick tool, please feel free to click on the link below for our M&A Tips Outline which can be saved and printed at your convenience.   Happy negotiating!

MA Presentation Outline 02 23 2017

Series LLC’s: Are they right for you?

C. Bruce Willis, II, Esq.
© Musgrove Law Firm, P.C. 2014

Texas has been at the forefront of the formation of new classes of business entities behind Delaware and Nevada since the inception of corporations law, whether it be corporations, limited liability companies, limited liability partnerships or limited partnerships.  Texas adopted the concept of series limited liability companies through the Texas Business Organizations Code after the successes and ease of use of the entity in other states.  Many business owners either (1) do not know what a series limited liability company is or (2) know the concept of a series limited liability company but did not know they are available in Texas or how to fully use the new entity to their benefit.

What is a Texas series limited liability company (“SLLC“)?

An SLLC is a limited liability company (the “Mothership“) with the ability to create a series of separate limited liability companies (each, a “Series Pod“) formed underneath the Mothership.  Each Series Pod has its own members, managers and/or membership interests, liability and bank accounts, separate and apart from any other Series Pod formed under the Mothership and from the Mothership itself.  Think of it like the concept of a parent company with subsidiaries, where the subsidiaries are their wholly owned companies.  The Mothership has one EIN, which is used for all of the Series Pods. Each Series Pod is generally owned 100% by the Mothership, but this does not need to be the case, as the Mothership can own 50% of the Series Pod, while a separate investor can own the other 50%.  For books and records purposes, each Series Pod is a separate legal entity with its own books and records, and if 100% owned by the Mothership, the Series Pod is considered a disregarded entity for federal income tax purposes and has its own allocation and distribution of profits and losses with the property it holds.  Each Series Pod will have its own separate name, as you may have guessed.

Formation of the Series Pod is easier and more streamlined than a typical parent-subsidiary relationship and the cost is greatly reduced.  Typically, each Series Pod is formed by the resolution of the Mothership’s governing authority of member(s) or manager(s), as the case may be, with an assumed name certificate of the Mothership.  Other than this formation through assumed name certificate, the EIN of the Mothership will be used for each Series Pod and the only other documents needed will be the company agreement for the Series Pod to designate the member(s) and manager(s).

How will the SLLC be beneficial to my business?

Typically, a limited liability company will suffice for business needs of most clients, but there may be certain instances where the SLLC would work, such as income properties, various businesses held by a parent company for liability protection or any other property ownership, which may need separate liability protection separate and apart from each property.  An example is aircraft. Suppose that a business owns a fleet of ten aircraft used for either air ambulances, general transportation for charter or transportation of freight. Each aircraft is owned by one company but with the enormous liability, costs, maintenance and insurance premiums, then each aircraft needs its own entity.  Typically, this has been done with each aircraft being placed in its own S-corporation or limited liability company, but an SLLC would be perfect in this situation with each aircraft in its own Series Pod, as each aircraft would have separate liability from each other aircraft Series Pod and the profits and losses and the taxes would flow through to the Mothership for accounting purposes.  Thus, the SLLC would be easy for the business owner for both a legal and tax perspective.  Another example is a husband and wife that own several different businesses.  The husband and wife could form the Mothership as a holding company with each business in its own Series Pod.  Again, the SLLC would be perfect as each business has its own separate liability from the other entities and annual tax and legal filings would be as if it was one entity filing for the husband and wife with one K-1, depending on whether husband and wife are filing separate and jointly.

If you would like more information, please feel free to contact me or one of our Firm’s other attorneys.

Five Fundamental Mistakes Business Owners Make

H. Len Musgrove, Jr., Esq.
© Musgrove Law Firm, P.C. 2014

Every business owner and budding entrepreneur faces countless challenging decisions each and every day.  Will I make another payroll?   Should I upgrade my infrastructure?  How can I improve sales?  Can I afford to hire that talented potential employee?  Can I afford not to?  At Musgrove Law Firm, P.C., we have the opportunity to work with talented business owners each day, and we have the privilege of assisting them with their legal and strategic business challenges.

After practicing law for nearly three decades, I have formed some opinions about things that intelligent businessmen and businesswomen often overlook in their quests to make their beloved businesses more successful.  I consider each of these potential omissions to be fundamental in nature, meaning that an entrepreneur’s failure to address these issues can be quite detrimental, and in some cases even fatal, to their businesses.  In a nutshell, business owners often feel they are “too busy running the business” to address these key issues.  In no particular order, here are Five Fundamental Mistakes to Avoid:

  • Failing to Have a Clear Exit Strategy;
  • Failing to Properly Insure Your Business;
  • Failing to Address the 4 Terrible D’s;
  • Failing to Address Retirement of a Business Owner; and
  • Failing to Plan for Your Sudden Demise.

Adopting a Clear Exit Strategy for your business should in most cases be addressed on day one or even before in the planning stages of the budding business.  Do you intend for this business to be a multi-generational family business to last for decades?  Are you a “serial entrepreneur” that has a pre-determined shelf life for your business before you plan to package and sell it?  Have you and your business partner or partners come to a clear understanding of the rules of the road if one of you leaves the business for any reason? (see more on this issue under the 4 Terrible D’s below)   Are you the “services partner” who plans to buy out his or her investor partners down the road?  In any of these situations, making a determination of your goals for the business will greatly assist you in making decisions about the business before you actually have to make them.

All businesses need adequate Insurance.   No one ever believes that a catastrophic event will cripple your business or that a trusted employee will steal and commit fraud to your detriment.   Yet these are two simple examples of the “what if’s” of business ownership, and each of them happens to good businesses and smart business owners each day.   You should question your insurance team member as to the amount of business interruption, fraud protection and general comprehensive liability insurance you can afford and integrate into your business plan.  Although the latter can replace damaged or destroyed plan, property and equipment, what about a true business interruption such that you cannot operate for a short (or long) term?   Your employees still need to be paid, and even the owner likes to continue receiving some income.  In the case of a trusted controller of CFO going sour, it is awfully comforting to know that your policies include a healthy amount of fraud and defalcation coverage.

If you have one or more partners, then you simply cannot afford NOT to address the 4 Terrible D’s:   Death, Disability, Divorce and, often overlooked, Disagreement.  It always is simpler and cleaner to address these issues from Day 1, when the enthusiasm and confidence in the new venture are at their absolute peaks, than it is when one of these events occurs or threatens to do so.  Death issues can be addressed with a clear buy-sell agreement between or among partners, typically backed by “key man” (in which the company owns policies on the owners’ lives) or “cross purchase” (in which the partners insure each other) insurance.   Similarly, short term or permanent Disability can be addressed by insurance, especially if the owner is providing valuable services to the company rather than acting as an investor only.  Divorce can be devastating to a business, particularly in a community property state such as Texas when the property laws provide that assets gained during marriage have a community interest for both spouses, regardless of how the business is owned.   A clear buy-sell agreement addressing the what if’s of Divorce of a partner is absolutely fundamental to avoiding having your business hijacked by a skilled family lawyer representing an angry spouse.   Finally, possibly the most fundamental Terrible D of all, Disagreement, must be addressed.   What if one partner wishes to retire and the other does not?  What if one decides they have had enough of the rat race and wants to move to the mountains or, even better, St. Somewhere?   What if the partners come to a fork in the road that doesn’t?   If you have no buy-sell agreement addressing these issues, can you really expect two or more unhappy partners to casually agree?  In my experience, that is asking a lot.

Have you truly planned your retirement?    Do you plan to sell the business?   Gift or sell it to your kids?   Set up on employee stock option plan (“ESOP”) to have the company/the employees buy you out?   Shut the doors?  Hopefully you have a qualified retirement plan such as a 401K, IRA or SEP plan, but is that really enough?   Have you had your business appraised recently to understand what it is really worth?   I will assure you that Uncle Sam has great interest in the value of your business, not only for income tax purposes, but also for estate and gift taxes, which are frequently overlooked by business owners.   Granted, these options may morph a bit with the years moving on, such as the case when suddenly one’s offspring mature into intelligent and, possibly, good business owners themselves.

What about your sudden death through accident or illness?   Have you recently updated your will?   DO YOU HAVE A WILL?  Do you have a power of attorney in case of your incapacity?   If you have partners and have insured your death and backed the same with a solid buy-sell agreement, some of these issues may be addressed.   But what about you solo business owners that also work as a fundamental part of your business?   We have worked with savvy solo owners to set up succession plans for both their businesses and their personal lives.   For that matter, for many entrepreneurs, it becomes challenging if not impossible to separate those two things, and a skilled legal counsel and team of professionals can make a great deal of difference to assure that your business will indeed outlive you.   I can absolutely assure you that your failure to plan in these areas will prevent your goals in these areas from being attained.

If any of these issues are ones that you have not considered or properly nailed down, then I advise that you immediately consult a competent business lawyer.   We at Musgrove Law Firm, P.C. would be pleased to discuss the issues with you to avoid the potential catastrophic consequences of failing to plan.