There are a number of steps — and many potential complications — in any merger or acquisition. And whether you’re buying or selling, there are plenty of legal, financial, tax, and post-closing considerations.
While some of the buyer’s initial letters to the seller may seem simple, it’s important to properly draft documents so you don’t unintentionally have a binding agreement. That’s just one area of negotiations and contracts where expert counsel is crucial. The fit between two companies and the resulting true value can also be a factor in determining the final sale price. A strategic synergy can add to the value of a company that’s changing ownership.
What’s the best route — debt financing, equity financing, or an independent sponsor? Understanding the ins and outs of the various financing options requires expertise and guidance, and transferring a business has tax consequences. Sound tax advice can help with structuring the deal, and maximize profit if you’re on the selling side. Post-closing, buyers can weigh operational improvements and insurance can limit post-closing liability to the seller.
Insight from those monitoring the pulse of the M&A market indicate that low interest rates and the availability of private equity should continue to fuel activity. The following experts can provide direction on the many nuances involved, if such a transaction is in your future.
Q: What are the tax implications of selling my business?
A: For federal tax purposes, the sale of a business is treated as the sale of each individual asset the business owns. There may also be tax implications at the state and local levels. The types of assets and the allocation of the selling price to those assets, including any liabilities a buyer may assume, determines tax treatment.
The difference between the selling price and your basis in each of the assets will be taxable, either as ordinary income or capital gain. Long-term capital gains are taxed at a rate that’s significantly lower than that for ordinary income. Gains on assets that have been held for one year or less, on inventory, and on accounts receivable will be taxed as ordinary income, as will depreciation recapture and amounts paid under noncompete agreements. Thus, it’s advantageous to allocate the selling price predominantly to capital assets that have been held for longer than one year and are still productive.
You may be able to defer the recognition of gains and payment of taxes if you’re willing to receive payments in installments, or if you can structure the deal as a tax-free reorganization between your corporation and a larger one.
Q: How do I sell my business at my price, on my terms?
A: Consider selling a few years before you’re ready to leave the business. Agree to stay on for a period to ensure a smooth transition, and negotiate an “earn-out” tied to profits. Earn-outs can bridge the gap between the buyer’s offer and your asking price.
Avoid quickly signing a buyer’s “standard,” nonbinding letter of intent. Negotiate key business terms that are important to you before signing. After you sign and give the buyer an exclusivity period and they begin their due diligence, the leverage shifts to the buyer.
Plan ahead by reviewing and organizing your company’s key contracts, corporate records, and other information that will be material to the buyer. This will enable you to anticipate and avoid issues that may derail your sale.
Take control of the initial drafting of the definitive purchase agreement. By having your M&A attorney control the drafting, you can more effectively limit your post-closing indemnification and liability exposure, and sell on your terms.
Q: I’m considering acquiring a business. What are my financial options?
A: A key issue in a merger or acquisition transaction is financing. Senior debt, mezzanine, seller financing, and equity are the most common forms for private companies. According to recent estimates, more than 80 percent of private transactions rely on various layers of debt and equity.
In terms of financing cost, senior debt is the least expensive, but it has the lowest risk profile — and typically has financial performance requirements. Unless the post-transaction entity will generate substantial provable and sustainable EBITDA and free cash flow, senior debt will require collateral.
Mezzanine and seller financing is a bridge between debt and equity financing, with a note that is subordinate to the senior debt. Mezzanine financing usually has an equity component due at maturity, and seller financing often has an earn-out based on meeting or exceeding future expected performance of the company. Because of these characteristics, it’s involves higher risk and higher costs than senior debt. Equity requires the highest return and is the highest risk, but it’s the most flexible component of the financing package.
A banker with experience structuring deals in the scope of your transaction can be invaluable in structuring financing that will fit within the expected cash flow and your long-term plans. Balance sheet, EBITDA, industry, and type of collateral will play a role.
Q: I’m selling my business and have heard about representations and warranties insurance. Is it worth the cost?
A: One of the hottest trends in the mergers and acquisitions industry is the use of representations and warranties insurance policies to backstop a seller’s post-closing indemnification exposure. The total cost is usually between 3 percent and 5 percent of the face value of the policy, with the applicable percentage decreasing as the face value increases. Given its price, a representations and warranties policy is typically viable in transactions with a value of $20 million or more.
Representations and warranties policies provide a great deal of personal assurance and protection to sellers. In a typical transaction, a seller may have basic indemnification obligations and be required to escrow between 10 percent and 20 percent of the transaction value. With a representations and warranties policy, the basic indemnification obligations and escrow typically drop to approximately 0.5 percent of the transaction value, and have a matching deductible paid by the buyer. This helps sellers close the figurative “barn doors” behind them when they sell their business. Some of the fee is also saved in the form of easier negotiations.
Finally, it’s important to note that the cost of a representations and warranties policy is usually split between the buyer and seller.
Q: How do you achieve operational improvement post-acquisition?
A: Achieving operational improvement in an acquisition is an imperative. This must be carefully planned, as it doesn’t happen on its own. Three key factors provide a useful framework to guide transformational operational improvement. They are:
Change your pricing strategy through analysis of customer and product profitability, improve your sales force effectiveness, or optimize your marketing efficiency.
Focus on ensuring your operations are correctly sized for your company. Strategies to optimize include implementing shared services models, strategic vendor sourcing, and applying lean principles to your
Improve working capital by focusing on inventory management, cash flow management, and reducing your-order-to cash cycles.
Achieving operational improvement requires a strategy that’s supported by financial and human capital. When done within the context of the framework above, transformational improvement can, indeed, be accomplished.
Q: Describe recent M&A activity in the retail sector.
A: We’re continuing to see strong M&A activity in the retail sector, thanks to continuing downward pressure on interest rates and the combination of a large amount of private equity looking to be placed, along with successful retailers having strong cash positions. More affordable capital available for deals, combined with tax reform benefits and a low unemployment rate, has created a favorable environment for major retailers to creatively realign themselves with today’s customer.
A great example is CVS Health’s $1.9 billion acquisition of Target’s 1,672 pharmacy and clinic businesses. This unique “store-within-a-store” format gives CVS a small footprint presence in Target stores, drives incremental sales volume for both companies, and ultimately benefits the customer through a convenient, one-stop-shop model.
Imperium Property Group says the outlook calls for these trends to continue for the foreseeable future against a slowing but positive economic backdrop. Brick-and-mortar retailers will look for more creative ways to compete with e-commerce and drive traffic to physical store locations. Walmart recently acquired two women’s apparel brands, Eloquii and Bare Necessities, in deals valued at more than $100 million. This strategy expands Walmart’s portfolio of specialty brands, as these brands were formerly available only online, and it will drive incremental traffic to Walmart stores.
Q: I’m an experienced executive and would like to someday buy a company. I hear a lot about “fundless sponsors” buying companies. How can I do that?
A: This is a frequently asked question. “Fundless sponsors,” more commonly known as “independent sponsors,” are acquirers lacking a committed pool of capital. These are usually groups comprised of one to three professionals with backgrounds in management and/or corporate finance who seek to acquire companies with the assistance of a private equity backer. They utilize their knowledge of an industry or unique relationships to originate and negotiate acquisitions, and then partner with a private equity firm to complete the deal.
Typically, the independent sponsor receives a closing fee for originating the transaction, a management fee based on the degree to which they’re involved after closing, and a contingent share of any common equity appreciation after certain threshold rates of return have been achieved by the cash investors. In most cases the PE backer is the controlling investor, based on capital investment, but the sponsor usually has a board seat. In some cases the sponsor assumes a management role post-closing, if the selling shareholder(s) is/are seeking to exit the business. Peninsula Capital Partners was a pioneer in supporting independent sponsors and remains a market leader in such transactions.
Q: What’s the difference between an Indication of Interest and a Letter of Intent?
A: Indications of Interest (IOI) and Letters of Intent (LOI) are two examples of the numerous documents required for M&A transactions.
An IOI represents a buyer’s interest in the target. The fundamental purpose is to show the seller the range of valuation that the buyer’s potentially willing to pay, and to reflect the buyer’s serious intent. IOIs are requested early in the process and are never intended to be a binding offer; therefore, counsel should be consulted before their submission.
An LOI is submitted by the buyer to the seller after the buyer has conducted some due diligence and engaged in preliminary conversations. LOIs typically are in a letter format and are usually signed by the seller and buyer, and used as a guide for further negotiations. While an LOI summarizes the material terms of the proposed deal, it’s usually not intended to be a binding offer. Thus, it’s important that counsel be involved in drafting the LOI.
Q: How important is synergy in an M&A transaction?
A: Properly understanding synergies is significant to both buyer and seller in an M&A transaction. the idea is that two companies, when combined, are worth more than when valued separately. For the buyer, synergies influence the maximum price they can afford to pay for a company. Buyers frequently build significant revenue, cost, and financial synergies into financial projections they provide to their boards, lenders, and investors
For the seller, recognizing and properly understanding synergies that potential buyers may be able to derive from a transaction should provide a basis for negotiating the highest and best possible offer. Unfortunately, the converse is true: If a seller does not understand such synergies, they may “leave money on the table.”
Strategic buyers (companies in the same industry as the seller) are generally willing to pay a higher price than private equity firms because of their belief that they can unlock synergies in a combined operation. Most strategic buyers already have existing operations within a seller’s industry and are frequently able to institute cost-cutting measures from an acquisition.
Truly understanding synergies is a skill that plays a valuable role in the purchase and sale of any business. Management and professional advisers involved in any transaction should fully comprehend such items before recommending any course of action.
Q: What are some best practices for retaining talent during mergers and acquisitions?
A: The impact of a merger or acquisition is felt far and wide, but perhaps nowhere is it felt more acutely than by employees of the merging firms. Here are some tips on retaining talent:
• Be proactive in providing employees with information. There are admittedly questions that can’t always be answered specifically during the M&A process, but giving employees a sense of company direction, company culture, and a prospective timeline for transition will help fill potential voids in information and build trust during the process.
• Understand what motivates employees to stay.
• Share your company story to build employee engagement. People want to know there’s a plan and that they’re part of it. Seeing — and hopefully understanding — the holistic concept may make the merger process more palatable in general.
• Identify key personnel. Building an environment where these employees can be successful is a priority well beyond the merger. Engaging them directly shows respect and communicates that they’re more than mere names to be airlifted into a new organizational chart.
• Ask for insights. Communication is a two-way street. The acquired firm’s employees should be asked what’s important to them, so you can gain more insight and identify areas of commonality.