Equity Rollovers in M&A: Bridging the Finance and Valuation Gap

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Equity Rollovers in M&A: Bridging the Finance and Valuation Gap Negotiating and Structuring Rollovers; Tax Considerations for Buyers and Sellers THURSDAY, SEPTEMBER 20, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: David R. Hardy, Partner, Osler Hoskin & Harcourt, New York George H. Wang, Partner, Barton, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1.

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5 Equity Rollovers in M&A Bridging the Finance and Valuations Gap George H. Wang September 20, 2018 Partner

6 Equity Rollover Financial vs. strategic buyers Non-control, post-closing equity participation by seller s management team/founders Non-control Typically 10-40% Up to 49% Type of security Equity Same rights as buyer or junior in rights Debt - subordinated Seller Note Anchor Investment vs. Tag-on portfolio acquisition Objectives Defer tax gain to rollover participants; step up to buyer 2018 Barton, LLP SLIDE 6

7 Sample LOI Provisions Example % of the equity post transaction allocated/reserved for senior management Example 2 Pursuant to a merger, or other mutually agreeable form of transaction, (x) one or more Investor(s) will acquire all of the equity of Target currently held by Old PE Fund, (y) the Phantom Equity (defined below) of Target will be redeemed by Target so that it is no longer outstanding and (z) substantially all of the equity currently held by the management team and management companies owned by the management team (the Management Companies ) will be rolled forward so that the management team and the Management Companies will remain equity holders in Target post-transaction. (20% pre-closing management participation) Example 3 Seller Note: If the Company's ratio of indebtedness divided by LTM EBITDA will be less than 4.5 immediately as of the closing, then the Seller, or an affiliate of the Seller, will lend to the Company an amount in cash equal to the amount required to cause such ratio to equal 4.5. The definition of LTM EBITDA will be mutually agreed between the parties. Such loan shall be made pursuant to a promissory note on terms and conditions to be mutually agreed by the parties and will be subordinated to all other debt of the Company, and will be subject to a subordination agreement satisfactory to the lenders. Seller Co-Investment: Due to the importance of the Seller to Target, Seller has the option to co-invest up to 49% of the closing equity value of the Target in order to share in the future equity appreciation Barton, LLP SLIDE 7

8 Advantages Incentivizes on-going management Management participation in future appreciation Subsequent PE exit, IPO or sale Aligns management with acquirer Bridges financing and valuation gaps 2018 Barton, LLP SLIDE 8

9 Financing and Valuation Gap Representative deal terms from a recent PE term sheet: Enterprise valuation = 6.1 x LTM historic EBITDA x post-closing annualized, normalized quarterly EBITDA Note: current valuations are closer to 10x 12x EBITDA Debt financing Senior or mezzanine debt up to 4.5 x LTM EBITDA Seller note = shortfall of senior/mezz debt to 4.5 x multiple Note: current debt/ebitda ratios are closer to 6 7 x Equity roll co-invest up to 49% of closing equity value 2018 Barton, LLP SLIDE 9

10 Disadvantages Potential conflicts of interest Fiduciary duty of rolling persons Decision by conflicted members of board Alignment with buyer vs. seller Use Rep and Warranty Insurance to mitigate issue? Selection of only certain rollover participants Complication of negotiations Rights of the rolling management vs. buyer. Equity vs. non-equity members of management Equity of buyer and founders may not be of same class 2018 Barton, LLP SLIDE 10

11 Structuring of Rollover Provisions Type of equity Common vs. participating preferred (PIK dividends) Tax considerations Stock vs. asset deal Buyer s basis step up vs. taxable roll-over parties Ability to convert corporation to pass-through structure Acquisition at holdco or subsidiary level Domestic vs. cross-border considerations e.g. Luxembourg CPEC structure 2018 Barton, LLP SLIDE 11

12 Preemptive Rights Maintain percentage of equity Maintain percentage of debt equal to equity percentage Exceptions: Options and incentive plans to directors, employees and consultants Redemption from majority shareholder (not to exceed 10%) for resale to new investors Minority may not have financial wherewithal to buy 2018 Barton, LLP SLIDE 12

13 Distribution Waterfalls Priority of Payment to Rollover participants Pari passu Preferred return to PE fund/fund and management On IPO, Fund typically receives preferred return Promote style compensation to management? Liquidation preference to preferred? Example 1 First, PE fund receives return of equity investment without any return on capital Second, co-investors receive return of co-investment (based on closing value) without return of capital Third, distributions pro rata Example 2 First, PE fund and co-investors receive pro rata distributions until capital and deemed capital is returned Second, PE fund and co-investors receive distributions equal to 10.1% IRR Third, co-investors receive a promote of 17.5% and PE fund and co-investors share pro rata in 82.5% balance Example 3 Pro rata distributions to PE fund and management 2018 Barton, LLP SLIDE 13

14 Tag-Along, Drag-Along & Other Rights Tag along with debt or equity pro rata Substantially all deals Bear pro rata price adjustment, indemnity obligations Exceptions to Tag Sale to shareholders, less than 10% Equity or Debt, per registered offer Drag along on sale of company or substantially all assets Any minimum price to require drag Rights of first refusal / first negotiation More limited than Tag along / drag along Possible lock-up period Three years, except for Permitted Transfers, vs. immediate right to sell Board/Observer Seats 2018 Barton, LLP SLIDE 14

15 Registration Rights S-1 Demand Number By whom When anytime, after qualified IPO Piggyback Against whom anyone, issuer only Proper notice Priority S Barton, LLP SLIDE 15

16 Voting and Dividend Rights Voting Rights Board seat Supramajority rights Amend charter or capital structure Change business Change auditors or accounting principles Make non cash distributions of profits Merger or sale of business Enter contracts or capital expenditures in excess of $ Veto rights Wind-up or liquidate Merger or sale of business Dividends Rarely paid currently, accumulated and paid at liquidity event Voting with majority on transfers of assets, acquisitions, election of Board 2018 Barton, LLP SLIDE 16

17 Transfer Restrictions and Covenants Vesting say three years Permitted transfers Right to initiate sale, including engage advisors and require rollover to participate in marketing efforts Right to force partial sale of a development project Rights regarding corporate opportunities: Side by side fund Non-compete and customer/employee non-solicit covenants Term following rollover equity no longer having securities Buyer having de minimus amount (10%) Rights of redemption Equity transfer restrictions Access to financial statements and other information and personnel 2018 Barton, LLP SLIDE 17

18 Seller Note Subordination Fully subordinate vs. pari passu Secured Second lien Unsecured note Acceleration on sale or change of control AHYDO (accelerated high yield discount obligations) interest provisions Avoid adverse tax effect 2018 Barton, LLP SLIDE 18

19 PE Advisory Agreement Mechanism for Fund to charge fees to target Term ten years, thereafter automatic renewal but terminable by PE fund Consulting fee 2% EBITDA or annual minimum Expense requirement including counsel and auditor fees Transaction fees 1% of consideration for refinancing s, equity or debt offering, dividends recaps Fees violative of financing agreements will accrue and be payable when allowable 2018 Barton, LLP SLIDE 19

20 Documentation Mechanism for Fund to charge fees to Letter of Intent Rollover Agreement Securityholders Agreement Registration Rights Agreement Certificate of Incorporation Rights, Preferences and Designations Seller Note Non-solicit and non-competes 3-4 year average non-compete Consulting Agreement for Fund 2018 Barton, LLP SLIDE 20

21 George H. Wang is a corporate transactions attorney who focuses his practice on mergers, acquisitions, joint ventures, investments and broadscope business transactions on behalf of clients in North America, Asia and Europe. He has represented domestic and multinational clients on numerous domestic and cross-border merger and acquisition, private equity, venture capital and related transactions. GEORGE H. WANG Partner GWANG@BARTONESQ.COM Practice Areas Capital Markets and Securities Corporate Transactions Energy, Power and Natural Resources International Investment Management Mergers and Acquisitions Private Equity Public Company Transactions U.S. Inbound Investment Venture Capital and Emerging Companies George has led several large cross-border private equity and merger and acquisition transactions, including a transaction which was awarded 2013 Domestic Deal of the Year by LatinFinance. George has represented strategics, private equity funds, their portfolio companies and family offices in acquiring North American, Asian and European targets, completing serial acquisitions, multi-continent M&A transactions, acquisitions of United States public companies and going private transactions and joint ventures. George was recently named Cornell Asian Alumni Association Honoree of the Year by his alma mater, Cornell University and The Cornell Law School. For more than a decade, George served as an Educational Counselor to the Admissions Committee of The Massachusetts Institute of Technology. He is the immediate past Board Chair of the Asian American Federation, the leading pan-asian Advocacy organization in the New York metropolitan area working to advance the civic voice of Asian Americans Barton, LLP SLIDE 21

22 Osler, Hoskin & Harcourt LLP Tax Considerations for Equity Rollovers in M&A Transactions David Hardy September 20, 2018 LEGAL_

23 Agenda I. Deal Objectives II. III. IV Tax Reform Increased Incentives for Asset Purchases Basic Tax Consequences of Middle Market Acquisition Transactions Requirements for Stepped-Up Basis to Purchaser V. Requirements for Tax-Free Rollover to Sellers VI. Structuring Opportunities to Harmonize Buyer and Sellers Objectives Examples 23

24 24 I. Deal Objectives

25 I. Deal Objectives Buyer s objectives Acquire control Maximize after-tax returns stepped-up asset basis Minimize inherited liabilities, tax, and commercial Preserve historic licenses Provide or preserve economic incentives to existing management Minimize fiduciary complexities or impediments to resale 25

26 I. Deal Objectives (con t) Seller s objectives Achieve liquidity event Maximize after-tax proceeds one level of tax tax deferral on rollover equity Potentially (secondarily) to retain participation in post-transaction appreciation 26

27 I. Deal Objectives (con t) Harmonize objectives of buyer and seller Achieve one level of tax to sellers (or tax-free rollover) with basis stepup to buyer Ability to harmonize objectives depends on entity classification of the target company partnership and flow-through entities C corporations S corporations 27

28 II Tax Reform Increased Incentives for Asset Purchases 28

29 II Tax Reform Tax Cut and Jobs Act of 2017, Public Law , Enacted Major Changes to Corporate Income Tax Significant Changes include: 21% corporate tax rate - reduces relative importance of tax expense 100% expensing of tangible property new or used tangible property eligible for 100% depreciation if placed into service on or before December 31, 2022 asset sales and stock sales eligible for Section 338(h)(10) more attractive NOL (100% to 80%) NOL can only offset 80% of income corporations with pre TJCA NOLs use prior law (full offset) TCJA Increases Incentive for Asset Purchases Deal price allocable to tangibles can be immediately deducted 29

30 III. Basic Tax Consequences of Middle Market Acquisition Transactions 30

31 III. Basic Tax Consequences Sale of Flow-Through Entities Sale of partnerships, branches, or disregarded entities Transparent or flow-through entities for tax purposes Buyer may buy ownership interest or assets purchase price treated as paid for assets. stepped-up asset basis increases depreciation and amortization deductions allowing tax-sheltered cash flow. Sellers sell assets or ownership interest in the entity sellers realize capital gain on assets (except certain items taxed at ordinary rate, e.g., receivables or depreciation recapture) one level of tax 31

32 III. Basic Tax Consequences C Corporation Stock sale of C corporation Sellers sell shares realize capital gain on shares one level of tax Buyer buys shares obtains a cost basis in shares share investment not depreciable (reducing after tax cash flow); share basis will only produce a tax benefit when resold corporate tax attributes (e.g., NOL, stay with the entity) Sale of C Corporation s assets C corporation sells assets, then distributes after-tax proceeds to shareholders 32

33 III. Basic Tax Consequences C Corporation (con t) two levels of tax to sellers selling corporation pays taxes on asset gains at 21%; then shareholders pay taxes on their share gains when after-tax proceeds are distributed by selling corporation to them (assuming Section 332 not available) alternatively, may look to shareholder non-compete or personal goodwill to reduce two levels of overall taxes, if available Buyer purchases assets buyer gets stepped-up (i.e., cost) basis in assets, value allocated to goodwill and going concern amortizable over 15 years (tangible property fully deductible) generally does not inherit target C corporation s historic and contingent liabilities 33

34 III. Basic Tax Consequences S Corporation Sale of S corporation Treated as modified flow-through Sale of assets by S corporation buyer receives stepped-up basis in assets generally only one level of tax to selling shareholders. Asset gains may flow through and increase outside basis, eliminating the second level of tax (gains may be taxed at ordinary rates for receivables and depreciable assets) consider Section 1374 entity level tax for S corporation that converted from C corporation or acquired assets from C corporations in a referenced basis transaction during the prior 5 years Stock sale of S corporation selling shareholders subject to one level of tax buyer has cost basis in shares no stepped-up basis in assets Asset v. stock sale for selling shareholders deferred revenue differences between inside v. outside basis 34

35 III. Basic Tax Consequences Section 338 Elections Section 338 Election If election made in connection with a taxable stock sale, then transaction treated as a hypothetical asset deal for tax purposes Section 338(g) election Unilateral election by the acquirer Acquirer generally bears the tax burden from the deemed asset sale Generally results in two levels of tax; only used when Target has NOL Section 338(h)(10) Joint election by acquirer and sellers Seller bears tax burden from the deemed asset sale Only applies to acquisitions of corporate subsidiaries from consolidated group or S Corporations Only a deemed asset sale buyer inherits target s commercial liabilities Similar results may exist under Section 336(e) 35

36 IV. Requirements for Stepped-Up Basis to Purchaser 36

37 IV. Requirements for Stepped-Up Basis Asset basis step-up requires: Asset purchase A constructive asset purchase (purchase of flow-through entities such as partnership, branch or disregarded entities) Deemed asset purchase under Section 338 or 336(e) Asset purchase may be prohibitively expensive if: Seller is a C corporation with substantial asset gains For example, self-created goodwill has a zero basis Seller is a C corporation without a large NOL 37

38 IV. Requirements for Stepped-Up Basis Section 338 Election Section 338 Requirements Buyer acquires 80% of vote and value of shares Share acquisition obtained by purchase (not non-taxable share contribution or tax-free reorganization) Share acquisition must occur within a 12-month acquisition period Buyer election 338(g) or mutual election by buyer and seller under Section 338(h)(10) with agreed upon purchase price allocation Difficult for tax free rollover because all target s assets will be treated as having been sold, so all selling shareholders will recognize proportionate share of taxable gain 38

39 V. Requirements for Tax-Free Rollover to Sellers 39

40 V. Requirements for Tax Free Rollover Generally all sellers will be taxed on cash received for target entity Compensatory shares will generate ordinary income to employees. Post closing vesting requirements may be inconsistent with rollover treatment Sellers either: Don t sell (some or all sellers retain some or all equity) or Exchange old equity for new equity in a tax free incorporation transaction Other potential tax deferral options 40

41 V. Requirements for Tax-Free Rollover (con t) Consistency with buyer s asset step-up objectives Targets that are classified as partnerships are most consistent with competing objectives Sellers subject to one level of tax Rollover opportunity Asset basis step-up for buyer Sellers retaining equity in excess of 20% can prevent Section 338(h)(10) election Leveraged acquisition or rollover equity into buyer could cause transaction to flunk the 80% acquisition test required for 338(h)(10) election Target S corporations and C corporations certain structures exist 41

42 42 VI. Structuring Opportunities to Harmonize Buyer and Sellers Objectives - Examples

43 VI. Harmonizing Buyer and Seller Objectives Flow-Through Entities Partnerships and disregarded entities are generally not taxed as entities. Instead, taxable income follows through to owners Flow through entities most easily accommodate harmonization of buyer s stepped-up basis objective with seller s tax-deferred rollover objective Seller rollover can be proportionate or disproportionate 43

44 VI. Harmonizing Buyer and Seller Objectives Flow-Through Entities Flow-through Entities Shareholders Target Private Equity Partnership Management 70% Cash Buyer obtains a basis step-up in partnership assets for its purchase price (Sections 754 and 743) Sellers retained rollover shares can be proportionate or disproportionate Introducing new holdco can complicate analysis (see Sections 708 and Rev. Rul. 99-6) 44

45 VI. Harmonizing Buyer and Seller Objectives C Corp C Corporation Target - Rollover and Step-Up Together are Difficult Shareholders Target Holdco New Target Private Equity Rollover without step-up - shareholders sell some shares to P.E. fund in taxable transaction; some shareholders retain (or contribute to holdco) rollover equity No offset basis step-up to buyer or holdco!! (Might consider interest expense on acquisition debt at holdco offset or shareholder level goodwill) Rollover can be proportionate or disproportionate 45

46 VI. Harmonizing Buyer and Seller Objectives C Corp C Corporation Target - Basis Step-Up But With Two Levels of Tax Shareholders 46 Target Target Assets Private Equity Target transfers assets to a wholly owned LLC Part sale/partretained ownership. Assume P.E. fund purchases 70% of the LLC for cash P.E. fund buyer gets asset step-up Selling shareholders have two levels of tax on cash portion of the transaction

47 VI. Harmonizing Buyer and Seller Objectives S Corp S corporation target Section 338(h)(10) election available to treat stock sale as an asset purchase Buyer must acquire 80% by purchase ; all assets deemed sold S corporation s taxable gain allocated to selling shareholders on a pro rata basis. Sellers seeking rollover will be subject to tax Buyer acquires historic entity with any tax contingencies F reorganization structure Preserves historic licenses Buyer avoid tax contingencies from the sale and mitigates inheritance of historic tax contingencies 47

48 VI. Harmonizing Buyer and Seller Objectives S Corp Shareholders Target Holdco New S Target LLC Private Equity Cash Target LLC Units F reorganization steps: o Sellers drop target S corp into new holdco and elect Q sub status for target tax free Section 368(a)(1)(F) reorg o Target merges or converts into an LLC Buyer purchases all or most of LLC. Not a Section 338, but an asset purchase by buyer followed by contributions by Holdco and Buyer to a partnership (Rev. Rul. 99-5). Can acquire less than 80%) Buyer gets stepped-up basis; sellers get one level of tax (pro rata). Proportionate rollover opportunity 48

49 David R. Hardy Bio David s practice focuses on corporate and international tax including the tax issues affecting corporations in the energy industry. He has been involved in cross-border merger transactions, including public company stock acquisitions, joint ventures, project financings, cross-border security issuances, inbound and outbound securities, real estate and private equity partnerships. David is the past President of the International Tax Institute in New York, past chair of the Taxation Committee of the International Bar Association and a longtime member of the Executive Committee of the NYS Bar Tax Section. In addition, he is a frequent speaker at tax conferences and frequently writes on various topics. He has been the principal author of a number of NYS Bar Tax Section reports on subjects including the base erosion and anti-abuse tax, the anti-double dip finance provisions, the anti-hybrid provisions of the U.S.-Canada treaty, the non- recognition rules regarding the outbound transfers of intangible property, and the consistency principle in tax treaty interpretation. Education New York University Law School, LL.M. Georgetown University Law School, J.D. Reed College, B.A. (Phi Beta Kappa) 49

50 Takeaway/Questions Recent trends Questions 50