Helpful M&A Tips for Entrepreneurs
Following the unprecedented COVID-19 Pandemic, 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, calling it a day, or simply “taking some chips off the table” for their estate planning. Now may be an excellent time to package and sell businesses, with a still-lively mergers and acquisitions (“M&A”) market predicted for the balance of 2022 and even into 2023. However, savvy entrepreneurs understand that the process is not a simple one, rather it takes years of planning and sound management decisions 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, I 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 a 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 to make the proposed M&A transaction as tax efficient as possible for the Target and its shareholders.
TYPES OF M&A DEALS.
There are two fundamental types of M&A transactions: asset purchases and stock purchases, although there are multiple variations of these transactions. The former structure is widespread in the middle market, as savvy buyers pay particular care to isolate and specifically name 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 a buy/sell transaction between the buyer and the shareholders of the Target, who in turn sell their shares of stock from 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 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 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 shareholders 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 been avoided by better planning in conjunction with one’s legal and tax advisors. Don’t wait to plan!
EXCELLENT DEAL FOR THE SELLER.
In contrast with the inefficient sale of appreciated assets by a C Corp described above, multiple types of M&A deals 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 and may even achieve better results if the selling shareholder(s) qualify for nonrecognition under IRC Section 1202) 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 a 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 clawback) 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 THE BUYER.
Although most of this discussion has focused on the seller side, our Firm represents a significant number 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 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 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. In contrast to the ideal seller deal, I am not a fan of all-cash upfront 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 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 clawback rights for my buyer clients.
I have had the privilege on multiple occasions to speak about the legal perspective of M&A transactions with other 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 in virtually every case, despite our differences in backgrounds and approaches, the presenters 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 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, then 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 concerning a possible M&A transaction. Happy negotiating!
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