Exit Planning Exchange

By David Hoffer

As a CEO in a competitive industry, you know who’s likely to buy your business. You’ve been watching these companies since the day you opened. You’ve tracked their every move. You’ve followed their successes and failures. You may even know their senior managers personally. And why not? There are only a few of these companies — the leaders in the very same industry you’ve staked out. If anyone’s going to buy your business, it’s one of these companies.

If you’ve been thinking along these lines, you’re not alone. Nearly every CEO who considers selling his or her company starts by assuming that potential acquirers will come from inside the industry. In reality, buyers from outside your immediate line of business may offer a better deal. In this month’s Viewpoint, we’ll talk about why strategic buyers from outside your industry may, in fact, significantly outbid your competitors, present some case studies of successful cross-industry transactions and show you how to increase the rewards of selling your business by widening the pool of potential buyers.

Bulls-eye! An expanded approach to targeting buyers

At Mirus, we think of potential buyers as a series of concentric circles — like a bullseye target. However, unlike in archery, it’s often the periphery, not the center, that’s the most interesting part of our target.

That’s because the center of the target contains the most obvious acquirers, companies that are in the same industry as yours, serving the same kinds of clients with the same sorts of products and services. You already know these companies. You can probably draw up a short list of these firms off the top of your head. Yet even though these candidates are easy to identify, you do your company a disservice if you do not consider other kinds of companies.

So to expand the circle, we ask a series of questions. We look at our clients’ customers and think about what other sorts of companies might like to get access to that customer base, even if they don’t have the same sort of product or service offerings. We think about the products or services our client provides and try to identify companies that might want to offer those products and services to their customers. We also think about geography. A company with a strong presence in, say, Boston, might be attractive to an acquirer looking to raise its profile in New England. In these cases, the businesses should be complementary, but do not necessarily have to be the same.

You might wonder why we spend so much time looking for a wider pool of buyers. Essentially there are two reasons. First, and most obviously, more buyers mean more competition for any given target and, in general, higher prices. Yet there is another even more important difference. Buyers within a target’s industry generally expect to pay a multiple on earnings or multiple on revenues that is consistent with industry standards. Buyers from outside the industry, however, are not merely buying more of what they have. They are making a strategic inroad into another area of business, whether it is an entrée into a new market or access to a valuable customer base. As a result, these buyers may not be constrained by an industry consensus on appropriate multiples as they value a target. They are making an acquisition that they hope will transform their business, and that may be worth more to them than the going price within the industry.

Creating demand for core products

Now let’s look at how this kind of exercise might work with regard to a specific company. We’ll start with Daticon, a well-established provider of electronic discovery and document conversion services based in Norwich, CT, that was recently acquired by Xiotech.

As you’ll see, litigation services companies sit at the center of this diagram. These are the “obvious” acquirers, companies in essentially the same business as Daticon. A bit further out, Mirus identified companies in related businesses, such as electronic evidence management, litigation consulting and facilities management. It is only in the third concentric ring that we get to companies in the electronic compliance management, archiving and storage industries. Further out, we have possible matches in compliance infrastructure, enterprise search and information services.

Daticon is an interesting case because it was sold in a public auction process, which allows Mirus to disclose bids from various companies. It attracted a bid from Xerox Corporation, a document management company which would fall quite near the center of our diagram. However, the winning bid came from Xiotech, a storage equipment company that Mirus identified as a potential buyer even though it had not previously been actively involved in electronic discovery or litigation support.

The critical point was that Daticon’s electronic discovery services required a great deal of disk storage, to archive vast quantities of emails, memos, documents and other data sources. It also demanded a good way to manage and selectively retrieve documents out of this enormous pool of information. Xiotech saw Daticon’s core business as an opportunity to enter a higher value added business than disk manufacture — and, as a side benefit, to generate additional demand for its data storage products. As a result, it was willing to pay more than companies directly involved in Daticon’s business, outbidding all competitors with a $30 million offer. Its bid exceeded Xerox’s final offer by $3 million.

Enhancing offerings to existing customers

Now let’s look at another company that was recently acquired by a firm outside its industry, DxCG, a health care software company. DxCG’s main business was developing software that helps healthcare providers, payers and employers to forecast healthcare costs. By understanding these costs, companies can more effectively negotiate insurance premiums, set rates for treatments and budget for care. DxCG had grown rapidly. When it came up for sale in 2004, it had more than 175 clients, including Blue Cross Blue Shield of Michigan, Highmark Blue Cross Blue Shield, Kaiser Permanente, and Pacific Business Group on Health.

About a year before it was sold, Mirus had advised DxCG on an offer from another health care software company, but the deal had not been consummated. Interest in DXCG’s software remained strong, however, and we continued to evaluate and communicate with a wide swath of potential acquirers — health care companies, software companies, and other more tangentially-related businesses.

Eventually, through these efforts, DxCG received an offer from Insurance Services Office (ISO), a company started to serve a consortium of insurance companies. ISO had emerged as a leader in providing risk management tools to a broad spectrum of clients not just in the insurance industry, but in finance, real estate, government and human resources. Even though the company had not, up to that point, operated in the health care space, DxCG’s health care cost models seemed like a natural fit into its suite of data analytics offerings.  Buying DxCG would give ISO a foothold in risk management in an area that had become increasingly important to its clients: health care cost management.  Because of the deal’s strategic importance, ISO was willing to pay a premium over the original same-industry bid, allowing DxCG shareholders to maximize the value of their holdings.

Different companies, complementary technology

Sometimes companies acquire targets outside their industry not to gain access to products, customers or markets, but to obtain complementary technology. That was the case when PixelVision, a leading developer of LCD technology, began to look for a strategic buyer.

PixelVision’s main business was serving financial traders with high-end flat panel displays; however, in developing this business, the company had generated 26 discrete, differentiating technologies. These technologies were protected by six patents, including a patent for analog-to-digital image conversion that allowed digital display devices such as projectors and LCDs to be connected directly to the analog CRT jack on a PC. After identifying all of these technologies, many having numerous applications, Mirus brainstormed with the engineering team to identify additional applications–outside the financial vertical–for the technology. Mirus then presented these technologies in the offering memorandum.

Ultimately, the buyer for PixelVision was not a display company, but a switch company. Cybex, now Avocent (AVCT), was the leading manufacturer of analog KVM switches that allowed a single keyboard, display and mouse to operate multiple computers in a server room or network operations center (NOC). PixelVision had already developed a digital KVM for its financial application that Cybex could use in the NOC market (a multi-billion-dollar market opportunity). It was this application, teased out in the Mirus brainstorming session, that resulted in Cybex coming to the table with a strong offer.

Similarly, when Tellabs, a maker of data, voice and video transport, switching/routing and network access systems, bought DSP Software Engineering, technology was the main draw. At Mirus, we identified DSPse proprietary digital signal processing software as an important tool in Tellabs’ strategy to develop voice-over-IP communications capabilities, a dynamic and fast-growing segment of its core business. We highlighted this technology in our presentations to Tellabs and elicited an attractive winning offer for DSPse.

Looking outside the box for buyers

All these examples point towards one core principle: when looking to sell a company, the best offer may very well come from outside your immediate industry. These buyers often have compelling strategic reasons for purchasing companies peripheral to their core business — whether to access new customers, sell additional products and services to existing customers, fill gaps in proprietary technology or expand into new distribution channels and markets.  Because they are making strategic acquisitions aimed at transforming their companies, these buyers may be willing to pay more for your business than your closest competitors.

The key to identifying potential buyers is to think expansively about your company’s products, its clients, its technology and its marketplace strengths. Then you can look both within and outside your core business for companies that might benefit from what you have to offer.

At Mirus, we’ve helped dozens of companies widen their universe of potential buyers and seek out attractive offers from acquirers inrelated, complementary or even completely different businesses. If you’d like to find out more about our bulls-eye approach and how it might work in your specific situation, please contact us.

David Hoffer is a partner at Mirus Capital Advisors, Inc. Founded in 1987, Mirus Capital Advisors is a middle-market investment bank that specializes in merger advisory, capital-raising services, fairness opinions and valuations to entrepreneurs, corporations and professionalinvestors. By combining a proven process, industry and transactional expertise, and personalized service, Mirus has completed hundreds oftransactions for both public and private companies. Our affiliate Mirus Securities, Inc. is a registered broker-dealer and FINRA/SIPC member. Additional information about the firm is available on our website www.merger.com.

By Laura Kevghas and Donald Richards

Top Five Buyer Blunders and How to Avoid Them

Many of the past Viewpoints we’ve published have advised sellers on how to secure a great deal in the M&A market. In this issue, we take a seat on the other side of the conferencetable to highlight five common and sometimes critical buyer mistakes that can be fatal to a transaction.

Some of these mistakes or misunderstandings can cause a seller to mistrust a prospective buyer. Others lead a buyer to present an offer that doesn’t meet the seller’s needs or interests.  In any case, they can result in a deal that’s in serious jeopardy.

Why This Matters:

Most buyer mistakes are avoidable. Being aware of how things can go wrong will help you improve your chances of sealing the deal.

1. KNOW the Real Decision-Maker(s)

Things can get off track right from the start if you don’t take the time up front to clarify key and hidden Decision-Makers in the seller’s world. John Kenny, Executive Vice President of Corporate Development for Iron Mountain, states that one of the most important factors that needs to be uncovered early on is whether the people that you’re dealing with on the seller side are the people who can actually approve a transaction. “I’ve seen a lot of cycles wasted and deals just never get done,” he said, “because you’re talking to someone who isn’t authorized to make a decision, or the board isn’t aligned with the sale.”

Although unfortunate, it is not unheard of for someone on the seller side to overstate how much authority they have to get a deal done. Mirus once had a principal of a seller represent himself as the sole decision-maker, only to have the partner committee turn down the letter of intent the principal had negotiated because his partners did not want to sell the company at any price!

Exaggeration of authority may be difficult to ascertain, and supports the idea of asking probing questions up front . Confirming as many deal-related details as possible early in the relationship helps streamline the deal process and keep it from derailing.

2. DON’T Focus on Price Alone

Some buyers assume getting the best price possible is the only thing that matters to a seller. In reality, many sellers have other goals that are important to them. Not taking time to uncover these objectives can be a big mistake.  John Kenny also advises learning as much as possible about the complete dynamics of a seller’s situation in advance. “One of the first questions to ask is why the asset is for sale,” he adds,“…and also understand whether it’s a distress situation and whether it’s been shopped for a while. Are they shooting for the whole market, or targeting you specifically?”

Mirus represented a client recently who wanted to ensure that his staff, many of whom had helped him grow the business for more than twenty years, had bright futures with the company post-acquisition. One finalist in the auction process,who didn’t believe this was a real objective of the seller, was dropped from the process despite a high proposed purchase price, when they indicated that they planned to cut employees and close facilities after the close of the sale.

Similarly, many entrepreneurs want to know that the company brand and culture they’ve spent years building–and which they believe support their company’s success–are going tobe maintained. Factors like these are often especially important when a family owned business goes on the market.

“Seller motivations are important, because if the seller cares about their brand, or their people, or their staff’s ongoing employment; and these factors don’t match up with integration into the new company, then you might as well stop–because you won’t be the preferred buyer,” adds Kenny.

3. Romance the Seller

Sellers want to believe a prospective buyer is really pursuing them and truly cares about the business the seller has built.  This is especially true if the seller is planning to stay involved with the business, but it can also be true even if the seller is planning to exit.

“You need to distinguish the different situations,” said attorney Les Fagen, a partner in the Venture Capital practice group at Cooley Godward Kronish’s Boston office. “If it’s a family-owned or founder-owned business, not spending time ‘romancing’ the seller can definitely be a problem.”

Taking time to get to know the seller, and letting the seller get to know you, are essential to building the type of personal bond that will help move a deal forward. Making sure that there are enough face-to-face meetings, spending time getting to know sellers and their key players, listening closely and asking good questions, and helping the seller learn about you are examples of the types of things a buyer can do to help a seller feel “wooed” and special.  At the end of the day, relationships buy companies.

4. BUILDING A Win-Win DEAL

Some buyers focus on winning during every negotiation with the seller, whether it’s related to the purchase and sale agreement, employment agreements or post-closing integration. Every purchase and sale agreement has numerous points that involve a give and take between buyers and sellers. Sellers can get fed up and walk away, simply due to the perception that a buyer is trying to shift all possible risks to the seller’s side.

“Being too aggressive in negotiating the indemnities in the purchase agreement is one of the more common problems,” Les Fagen elaborate(s) . “The seller wants certain limitations on liability, and the buyer wants all these protections in the document. Not wanting to intelligently assume risk on a buyer’s part is probably one of the most common reasons that deals fall apart.”

5. Organization

A seller can quickly lose confidence when a buyer doesn’t appear competent or knowledgeable in terms of how they approach the sales process. “One of the key success factors for an acquisition is earning the seller’s trust, that you will indeed be able to close the transaction,” pointed out Fagen. “The seller wants to know that the buyer has the ability, the wherewithal, and the determination to close and close promptly. I’ve seen a number of deals fall apart because the buyer took too long and didn’t keep the process moving forward.”

The due diligence process is seen by many sellers as a proxy for how they will work with the buyer post-closing.  A smooth due diligence process comforts the seller and his/her management team that the buyer’s company is also well run, and that integration and post-closing activities will be smooth and well-managed.

Planning for Success

Buying and selling a business can be challenging for those on both sides of the table. If you’re on the buyer’s side, understanding as much as you can about your seller in advance will help you anticipate and avoid the common mistakes discussed here. Through good planning, excellent listening and communication skills, understanding your seller’s motivations, and knowing your seller’s key influencers; you can become a successful buyer, and complete profitable transactions.

Laura Kevghas is a principal and Donald Richards is a partner at Mirus Capital Advisors, Inc., with a collective history of more than 150 buy-side transactions. Mirus is a middle-market investment bank that specializes in advising companies on strategic mergers and acquisitions. By combining a proven process, industry and  transactional expertise, creative thought, and personalized service, Mirus has completed hundreds of transactions for both public and private companies. Mirus is a registered broker-dealer and FINRA/SIPC Member. For more information, visit www.merger.com.

Investment Banking Services Since 1987 - 200 Wheeler Road, 4th Floor, Burlington MA 01803 • Tel: 781-418-5900 • Fax: 781-418-5999 • www.merger.com

By Charles A. Wry, Jr.

The after-tax consequences of buying or selling a business can vary dramatically depending on how the transaction is structured.  Often, what’s good for one party is bad for the other.  The structure of the transaction, therefore, can be driven by the relative bargaining positions of the parties and, in any event, should be taken into account in determining the price.  The consequences of the transaction to employees and other service providers should be considered as well.

I.          Taxable Transaction.

As described below, the owners of a business can sell the business “tax-free” if the business is organized as a corporation and the price to the owners is paid in the form of stock of an acquiring corporation. Otherwise, the sale of the business generally will be taxable to the owners.  If the transaction will be taxable, the tax consequences will depend primarily on (i) the form of organization of the business being purchased (the “Target”) and (ii) whether the buyer (the “Acquiror”) purchases (x) the equity interests in the Target from the Target’s owners or (y) the assets of the Target from the Target.

a.         Target is a Corporation.

1.         Stock Purchase.

If the Target is a corporation, the shareholders of the Target will generally prefer to structure the transaction as a purchase and sale of their stock in the Target.  That way, the gain on the transaction is taxed only once (at the shareholder level) and at capital gain rates.  The Acquiror, on the other hand, may not want to purchase stock because, except as described below under “Stock Purchase Treated as Asset Purchase,” a stock purchase has no effect on the tax bases of the Target’s assets.  Instead, the Acquiror takes a basis in the stock purchased equal to the amount it pays for the stock (and the taxable income inherent in Target’s assets remains inherent in the assets).  Stock is not amortizable.

The Target shareholders may also prefer a stock sale from a non-tax standpoint because the Acquiror assumes the economic burden of any Target liabilities except to the extent that the Target shareholders agree to remain responsible.

A stock purchase may be effected by a direct purchase of the Target’s stock or by a “reverse subsidiary merger.”ⁱ In a reverse subsidiary merger, the Acquiror forms a transitory subsidiary, capitalizes the transitory subsidiary with the cash or other assets to be used as the purchase price (including any borrowed money if the purchase will be leveraged), and then merges the transitory subsidiary into the Target.  When the dust settles, the Target shareholders have the cash or other assets used as the purchase price, and the Target is a subsidiary of the Acquiror.

If the Target stock is “qualified small business stock,” individual Target shareholders who have held their shares for more than five years may be able to exclude portions of their gains.ⁱⁱ

If the Target is an S corporation and owns “collectibles,” a portion of the gain may be taxable at a higher capital gain rate than would otherwise apply.

A stock sale may also be desirable if the Target has assets (such as non-assignable contract rights) that would be difficult to transfer.

2.         Asset Purchase.

If the Target is a corporation, the Acquiror generally prefers (at least for tax purposes) to structure the transaction as a purchase and sale of the Target’s assets so that the Acquiror may “write up” the tax bases of the assets.  By writing up the bases of the purchased assets, the Acquiror can report greater depreciation and amortization deductions with respect to, and smaller amounts of gain (or greater amounts of loss subject to any applicable limitations) upon re-sales of, the purchased assets.  The Target shareholders, on the other hand, may not want to structure the transaction as an asset sale because (i) if the Target is a C corporation  (or an S corporation with assets acquired while it, or any corporation it acquired in a tax-free transaction, was a C corporation), the gain on the sale may be taxable to both the Target and the Target shareholders, and (ii) if the Target is an S corporation, some or all of the gain may be reportable by the shareholders as ordinary income (depending on the Target’s assets and the allocation of the purchase price).

The Acquiror may also prefer an asset purchase from a non-tax standpoint so that the economic burden of the Target’s liabilities remains with the Target’s shareholders.

An asset purchase may be effected by a direct purchase of the Target’s assets or by a merger of the Target into the Acquiror or a subsidiary of the Acquiror.

In an asset purchase, the Target is treated as selling, and the Acquiror is treated as buying, the various Target assets separately for allocable portions of the aggregate purchase price.  The aggregate purchase price is allocated among the various Target assets in accordance with certain tax rules (essentially, by class and fair market value).  Particularly if the Target is an S corporation, the Target’s shareholders will prefer to allocate the purchase price so as to maximize the amount of long-term capital gain to be reported by them on the sale.  The Acquiror, on the other hand, will likely want to allocate as much purchase price as possible to assets that are likely to turn over in the short term or that have short depreciation or amortization schedules.

3.         Stock Purchase Treated as Asset Purchase.

If the Acquiror is a corporation, the Target is an S corporation or a subsidiary of another corporation, and the Acquiror purchases at least 80% of the outstanding stock of the Target, the Acquiror and the Target shareholders may join in making a special tax election to treat a purchase and sale of the stock of the Target as a purchase and sale of the Target’s assets.

Although making such an election allows the Target to step up its bases in its assets, the election may be disadvantageous to the Target’s shareholders for the reasons noted above (possible taxabililty of the Target if the Target is a C corporation or an S corporation with assets acquired while it, or any corporation it acquired in a tax-free transaction, was a C corporation; possibility of ordinary income for the Target’s shareholders if the Target is an S corporation).  In addition, if the Acquiror is not purchasing all of the outstanding stock in the Target, the Target is nonetheless treated as having sold all of its assets.

b.         Target is a Tax Partnership.

1.         Purchase of Interests.

If the Target is a limited liability company (“LLC”) or other form of entity classified as a partnership for tax purposes and the Target’s owners sell their equity interests in the Target to the Acquiror, the Target’s owners are required to report the ordinary income they would have had to report if the Target had sold any “unrealized receivables” (which include, among other things, depreciable property to the extent of any inherent depreciation recapture) or “inventory” (which includes, in addition to traditional inventory, property income from the sale of which would be ordinary) it may have at fair market value.ⁱⁱⁱ Any remaining gain or loss a selling owner of the Target may have on the sale is generally capital gain or loss.  The Acquiror, on the other hand, is treated as having purchased the Target’s assets if the Acquiror purchases all of the outstanding interests in the Target.  Alternatively, if the Acquiror does not purchase all of the outstanding interests in the Target but the Target has a special tax election in effect, the Acquiror will be able to write up its share of the basis of each of the Target’s assets.

2.         Asset Purchase.

As described above, in an asset purchase, the Target is treated as selling, and the Acquiror is treated as buying, the various Target assets separately for allocable portions of the aggregate purchase price.  Thus, because the Target’s owners report their shares of the Target’s income or loss directly, the mix to the Target’s owners of capital gain and ordinary income will depend on the Target’s assets and the allocation of the purchase price.  Like S corporation shareholders in an asset sale, the Target’s owners will prefer to allocate the purchase price so as to maximize the amount of long-term capital gain to be reported by them on the sale.  The Acquiror, on the other hand, will likely want to allocate as much purchase price as possible to assets that are likely to turn over in the short term or that have short depreciation or amortization schedules.

II.         Tax-Free Transaction.

If the Acquiror and the Target are corporations, the transaction may be “tax-free” entirely or in part to the Target shareholders if it qualifies as a “reorganization.”  In that case, the Target shareholders generally report their gains only to the extent of any of their purchase price that is not paid in the form of stock of the Acquiror (or the Acquiror’s parent corporation).  Any gain they avoid reporting remains inherent in the Acquiror stock they receive in the transaction.  The Acquiror writes up the tax bases of the Target’s assets only to the extent of any gain reported by the Target.^iv

There are a limited number of ways for a transaction to qualify as a reorganization.  A detailed discussion of those ways is beyond the scope of this article.  Each way, however, requires (among other things) that a minimum percentage of the price paid for the Target be paid in the form of qualifying stock of the Acquiror (or its parent).  The minimum percentage ranges from 50% (or even lower under judicial authorities) for a straight (i.e., not a reverse subsidiary) merger (an “A” reorganization) to 100% for a simple stock-for-stock swap (a “B” reorganization).

If the Target stock is “qualified small business stock,” the stock of the Acquiror (or its parent) received by a Target shareholder in the reorganization is also treated as qualified small business stock (if it otherwise would not have been) received by the Target shareholder on the date he acquired his Target stock.  The amount of gain that may be treated as gain from the sale of qualified small business stock upon the subsequent sale of the stock of the Acquiror (or its parent) by the Target shareholder, however, is limited to the amount of gain built into the Target stock as of the time of the exchange of the Target stock for the Acquiror stock.

III.       Deferred or Contingent Payments; Holdbacks and Escrows.

It is not uncommon for a portion of the purchase price to be paid over time or as certain performance goals are met (the deferred payment obligation may be evidenced by a note or by the purchase and sale agreement.) In addition, a portion of the purchase price may be held back or placed into escrow to secure obligations of the Target or its shareholders to indemnify the Acquiror for breaches of representations, warranties and covenants.

a.         Original Issue Discount.

If a deferred portion of the purchase price does not bear an adequate interest rate, part of the deferred portion may be re-characterized as interest.  In addition, interest that is not payable at least annually as it economically accrues may have to be reported as it accrues on the basis of a constant yield to maturity rather than as it is actually paid (so that the Target or its shareholders may have to report interest income for a year in which they receive no payments).

In the case of a contingent deferred payment, the portion of the payment that is interest is generally the amount by which the payment exceeds the present value of the payment discounted back to the closing date at a “test rate” applicable to the sale (with the present value of the payment being principal).  Contingent interest is generally reported as it becomes fixed (subject to some special rules that apply when the contingent interest is payable more than six months after becoming fixed).

b.         Installment Method.

Generally, a taxpayer’s gain on a deferred payment sale is reported under the installment method unless the taxpayer elects not to use the method.  Under the installment method, the taxpayer computes the percentage which his overall profit on the transaction represents of the overall amount he will receive in the transaction (other than from the purchaser’s assuming or taking subject to certain “qualifying indebtedness”).  He then multiplies each “payment” he receives by that percentage to determine the portion of the payment that is gain.  Payments of interest (including amounts re-characterized as interest) are disregarded in applying the installment sale rules.

The contingent payment provisions of the installment sale rules make some unfriendly assumptions (including that the full amount of any capped contingent payments will be received).  Accordingly, they may distort the reporting of the gain on the sale.

Care must be taken to ensure that escrow and other security arrangements do not result in deemed “payments” to the Target or its shareholders.

Recapture and gains from sales of inventory and publicly traded stock are not eligible for reporting under the installment method.  Care must be taken in structuring deferred payment sales of interests in LLCs and other entities classified as partnerships for tax purposes that hold assets to which the installment method would not apply.

A taxpayer who holds more than $5 million in installment obligations may be subject to an interest charge on the deferred tax liability with respect to the balance in excess of that amount.

Deferred payment sales of stock or assets of S corporations may raise certain special issues or present certain special opportunities related to installment method reporting.  For instance, in an asset sale by an S corporation for cash and an installment obligation of the purchaser, it may be more advantageous to have cash that would otherwise be paid at the closing of the sale instead be paid on the installment obligation shortly after the S corporation has sold its assets and liquidated.

c.         “Tax-free” Reorganization.

If the transaction is intended to qualify as a “tax-free” reorganization, care must be taken to ensure that the arrangement does not jeopardize that qualification.

IV.       Outstanding Options and Restricted Stock.

Often, employees and other service providers of the Target have Target options or shares of restricted Target stock.  The consequences of their participation in the purchase and sale transaction can vary significantly depending on the circumstances.^v

a.         ISOs.

The tax consequences of the transaction to a holder of an incentive stock option (“ISO”) of Target will depend on what the holder receives for the option.

The holder of a Target ISO is generally not taxable on his exchange of the ISO for a new option of the Acquiror unless (i) the value of the stock underlying the new option exceeds the exercise price of the new option (that is, the new option is “in the money”) when he receives the new option and (ii) the new option fails to qualify for treatment as an ISO.^vi

For the new option to qualify as an ISO, (i) with certain exceptions, the terms of the new option must not be more favorable to the option holder than those of the old option, (ii) the spread (the amount by which the value of the underlying stock exceeds the exercise price) on the new option as of the time immediately after the exchange must not be greater than the spread on the old option as of the time immediately before the exchange, and (iii) the value of the shares subject to the new option as of the time immediately after the exchange must not be greater than the value of the shares subject to the old option as of the time immediately before the exchange.

If the holder receives cash or stock for the option, he reports the amount of cash and the value of any stock he receives (less any amount he pays to exercise the option) as ordinary income (unless he receives the stock in a “tax-free” reorganization in exchange for stock of the Target acquired by exercising the option).^vii If any new stock received by the holder is restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.

If the holder exercises the option for stock of the Target and then exchanges the Target stock for stock of the Acquiror in a “tax-free” reorganization, the holder has only a potential alternative minimum tax liability based on the spread at the time of exercise if he holds the stock of the Acquiror for at least a year after exercising the option (and for at least two years after being granted the option).

b.         NQSOs.

Like the consequences to a holder of a Target ISO, the tax consequences of the transaction to a holder of a non-qualified stock option (“NQSO”) of Target depend on what the holder receives for the option.^viii

The holder is generally not taxable on his exchange of the Target NQSO for a new Acquiror option unless (i) the Acquiror option is in the money upon its grant to the holder and (ii) the Acquiror option fails to satisfy the substitution test that would be applicable in determining its qualification as an ISO if the Target NQSO were an ISO.^ix

If the holder receives cash or stock for the option, he reports the amount of cash and the value of any stock he receives (less any amount he pays to exercise the option) as ordinary income.^x If any new stock received by the holder is restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.

c.         Restricted Stock.

The consequences of the transaction to a holder of restricted Target stock will likely depend on whether or not the holder made a timely Section 83(b) election with respect to the Target stock.

If the holder did not make a timely Section 83(b) election with respect to the restricted Target stock, he reports ordinary income on the transaction equal to (i) the amount of cash and the value of any stock he receives for the restricted Target stock less (ii) the amount he paid for the restricted Target stock.  If any new stock received by the holder is itself restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.

If the holder made a timely Section 83(b) election with respect to the restricted Target stock, he generally reports capital gain equal to (i) the amount of cash and the value of any stock he receives for the restricted stock less (ii) the amount he paid for the restricted Target stock plus the amount of any income he reported upon his receipt of the restricted Target stock.  If, however, the transaction is a “tax-free” reorganization, the holder reports gain on the transaction only to the extent of any purchase price he receives other than in the form of stock of the Acquiror (or the Acquiror’s parent corporation).

d.         Golden Parachute Issues.

Special rules apply to payments (referred to as “parachute payments”) in the nature of compensation by a corporation to a “disqualified individual” that (i) are contingent on a change of control of the corporation and (ii) have an aggregate present value equal to at least three times the disqualified individual’s “base amount.”  A “disqualified individual” is an individual who performs personal services for the corporation and who is either an officer or shareholder of the corporation or is among the highest paid 1% or, if less, 250 employees of the corporation.  An individual’s “base amount” is his average annualized compensation from the corporation during the five year period before the year of the change of control.  Under the rules, an “excess parachute payment” (the amount by which any parachute payment exceeds an allocable portion of the disqualified individual’s base amount) is non-deductible by the corporation and is subject to a 20% excise tax in the hands of the disqualified individual.

The acceleration of the vesting of Target options or restricted stock can give rise to parachute issues.  Often, however, the amount that must be taken into account as a payment contingent on the change of control of the Target is limited to the time value of the acceleration (plus an amount reflecting the lapse of the obligation to continue performing services).

If the Target is a private company, the applicability of the parachute rules can be avoided by subjecting what would otherwise be parachute payments to approval by the Target’s shareholders.  Unfortunately, for the approval to achieve its purpose, the right of the disqualified individual to receive the payment must be made contingent on the approval.

V.        Covenants Not to Compete; Consulting and Employment Arrangements.

Key personnel of the Target may be asked not to compete, either individually or on behalf of another entity.  Alternatively, they may be asked to remain employed or available for consulting.

a.         Consequences to the Acquiror.

The Acquiror amortizes the amount payable for any non-compete agreement over fifteen years.  Any employment or consulting payments are deductible by the Acquiror under its regular method of accounting so long as the payments are bona fide and reasonable in relation to the services the Acquiror receives for them.  The Acquiror is generally required to amortize any employment or consulting payments that are not bona fide and reasonable over fifteen years.

In Massachusetts, reasonable non-compete agreements are generally thought to be enforceable so long as legitimately necessary to protect the interest of the payor.  Reasonableness is usually measured in terms of geography and duration.

b.         Consequences to the Recipient.

Non-compete, employment and consulting payments are ordinary income in the hands of their recipients.^xi

“From a standpoint, the reverse subsidiary merger generally allows for the purchase of all of the Target’s stock without the approval of all of the Target’s shareholders.  Generally, though, dissenting shareholders have “appraisal” rights entitling them to receive a judicially determined fair price.

ⁱⁱ The maximum excludible portion has historically been 50%.  The recently enacted American Recovery and Reinvestment Tax Act of 2009, however, increased the maximum excludible portion to 75% for “qualified small business stock” acquired after February 17, 2009 and before January 1, 2011.  Currently, the portion not excluded is taxed federally at a rate of 28%.

ⁱⁱⁱEntities classified as partnerships for tax purposes include LLCs, limited partnerships, limited liability partnerships and general partnerships (so long, in each case, as they have more than one owner and that have not elected to be classified as corporations).

^iv Because any gain is usually reported by the Target’s shareholders rather than by the Target, the Acquiror generally gets no basis increase in the Target’s assets.

^v To keep things simple, unless otherwise noted, we’ll assume that holders of options will receive only new options, cash and/or stock, and that holders of restricted stock will receive only cash and/or stock, of the Acquiror in the transaction.

^vinThe potential taxability of the receipt of an in-the-money option is the result of the enactment of Section 409A of the Internal Revenue Code by the American Jobs Creation Act of 2004.  Among other things (and with an exception for ISOs), Section 409A subjects a service provider who is granted an option at an exercise price below the then fair market value of the underlying stock to tax and a 20% penalty as the option vests.

^viiSection 409A of the Internal Revenue Code should be considered in structuring deferred option cancellation payment arrangements.

^viii It is assumed that Target NQSOs were not already subject to Section 409A of the Internal Revenue Code.

^ix Again, the potential taxability is the result of the enactment of Section 409A of the Internal Revenue Code.

^x Again, Section 409A of the Internal Revenue Code should be considered in structuring deferred option cancellation payment arrangements.

^xi Care must be taken to avoid Section 409A of the Internal Revenue Code in structuring deferred payment arrangements.

For more information, please contact Charles Wry at cwry@ mbbp.com.

By William A. Duratti

Recent changes to Mergers and Acquisitions accounting has given rise to new questions, confusion, and sometimes even hesitation over completing a deal. Requirements under FAS141R are behind it all, and companies will have to comply beginning in calendar year 2009 – a date that looms large for many who are considering business combinations.  However, the challenges presented by FAS141R should not stand in the way of intelligent deal making. Buyers and sellers alike will adapt to the salient changes and base their decisions on whether an acquisition is a good deal at the right time for them.  Even as their accounting and valuation teams make the necessary adjustments, they know that advantages can be gained from the new system. The changes under FAS141R complete a joint effort by the FASB and the IASB to improve financial reporting for business combinations and to promote the international convergence of accounting standards.

FAS141R will cause some major changes and fluctuations to post-merger balance sheets. Understanding the new guidance, modeling deals accordingly and gauging impact on the financial statement before closing the transaction will help reduce any potential negative effects.  Complications arise due to the tricky nature of fair value and deal modeling, especially when estimating intangibles like unresolved contract contingencies. Calling in valuation specialists mitigates the damage that can result from poor assessments. When financial analysts evaluate transactions and earnings, they’ll be looking for how fair value was applied and what normalized earnings will look like on a forward looking basis.  This is especially timely as fair value under FAS141R will follow the guidance of FAS 157 and is defined as: “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measure date.”

Major changes to this definition include the marketparticipant perspective, exit price and more reliance on observable inputs, all of which create more difficulty in financial reporting for business combinations.

When all is said and done, these revisions mean that company leaders can expect ups and downs. When it comes to M&A activity, an acquired entity will likely cause turmoil in financial statements until the merger stabilizes over a number of reporting cycles.

The most significant changes coming under FAS141R include:

1. TIMING OF DEALS AND REPORTING

The biggest challenge for financial departments may come with the increased emphasis on timing and a growing list of disclosure requirements. FAS141R provides a more stringent timeline for reporting business combinations, and if deadlines are missed then provisional amounts must be reported for incomplete terms. That means not having the most qualified information, which can lead to more serious issues down the road.  There is a grace period of one year after the deal is closed – called the “measurement period” – during which provisional items can be adjusted.

Also, the expanded disclosure requirements make meeting the deadlines even more difficult and often will force a company to speed through the process. A deeper planning process and having the right team in place early will help avoid sacrificing quality and accuracy for speed.

2. CONTINGENT CONSIDERATION

Perhaps the most significant accounting change is the requirement that the purchase price of a business combination now include the fair value of contingent consideration. This change could significantly increase the upfront purchase price recorded on deal transactions, as well as increase the volatility of subsequent accounting.  The contingent consideration will be recorded by the acquirer as a liability at fair value as of the transaction date and will need to be adjusted to fair value at each subsequent reporting period. Given the major uncertainties as to future amounts and timing of payments of the contingent consideration, the fair value of this liability may materially fluctuate over time as more information is obtained.

Companies putting contingent payments into the deal structure will need to closely assess fair value of the 2 contingency. There is no predicting the future, but modeling and understanding the shapes that a deal can take will help mitigate the potential fluctuations in reporting.

3. IN-PROCESS R&D (IPR&D)

Under previous regulations, companies could record the fair value of IPR&D as a period cost of a transaction.  FAS141R, however, requires that the fair value of IPR&D be recorded as an intangible asset on the balance sheet. If the IPR&D does not come to fruition, it will subsequently need to be written down to its fair value, potentially zero, resulting in an impairment charge to the income statement.

4. DEAL COSTS

Acquisition-related costs such as negotiations that involve banking and legal fees were traditionally reflected as deal costs that could be capitalized along with the purchase price, but FAS141R calls for these items to be expensed immediately as period costs.

5. ASSETS AND LIABILITIES ARISING FROM CONTINGENCIES

FAS141R improves the completeness of the information reported about a deal by changing the requirements for recognizing assets and liabilities that arise from contingencies. An acquirer is now required to recognize these elements as they arise from both contractual contingencies and noncontractual contingencies as of the acquisition date, measured at their acquisition-date fair values. Again, post-merger adjustments to the fair value of these contingencies can create significant fluctuations in reported earnings.

ACTION ITEMS

With these items and others looming large at the beginning of 2009, companies that are pursuing acquisitions should take a few important steps to solidify their position.

• Re-assess current deals to determine the impact that FAS141R might have, and consider if it will be beneficial to close after the deadline passes.

• Be certain that the right teams are in place to understand and apply new fair value concepts to aspects of a transaction.

• Instruct teams to prepare for the new guidelines and adjust their approach as best as possible to minimize impact on the balance sheet and fluctuations in future reporting.

Despite the changes and action items that accompany FAS141R, the reasons for sourcing and completing deals should remain the same. Company leaders will still strive to make decisions that are strategically sound for their business or come at a good investment price at the right time. The fact is, pre-141R accounting was already a mystery to many. Adjustments will come from the valuation and accounting side to ensure that deals go through smoothly and under the best possible terms.

Material Discussed in this Insight is meant to provide general information and should not be acted on without obtaining professional advice tailored to your firm’s individual and specific needs. This information is for general guidance only and is not a substitute for professional advice.

by Sarah Richmond

The media is filled with reports of the red hot merger-and-acquisition market. In the technology sector in particular, the volume and transaction value of 2007 M&A deals are both forecast to approach levels not seen since 2000. And despite improvements in the IPO market in recent years, M&A remains the liquidity event of choice for venture-backed companies.

These trends bode well for entrepreneurs hoping for a sale to a strategic buyer. However, for many of these aspiring sellers, a deal will never be concluded even though their business’s fundamentals are solid and buyer interest is strong. These “M&A casualties” occur because too often entrepreneurs do not exercise sufficient planning, realism and creativity.

An early mistake that sellers make is not having a realistic picture of how much their business is really worth. Much as many parents overestimate the intelligence and beauty of their own children, many founders overestimate the value of their own company, causing them to expect an unrealistic price. If you are a seller thinking about your exit, finding comparables in the marketplace will help you arrive at a realistic valuation. Much of this type of data is available online, and there are also outside advisers who can assist you.

Even realists sometimes find that their expectations are out of sync with a buyer’s willingness to pay, so thinking of creative solutions that can bridge the gap is important. One solution that is frequently employed is an earnout, which defers some of the sale price to future payments, which are contingent on sales targets, product developments or other milestones. An earnout satisfies the seller’s desire to be compensated for the expected future value of its assets, while also satisfying the buyer’s desire not to overpay for value that has not yet been realized at the time of the sale. However, sellers should be mindful that earnouts are only successful for the seller when very careful attention is paid to the structuring of the earnout when negotiating the deal.

The due diligence process is another contributor to deal failure. Major problems result when a seller fails to disclose important information about the company, and this information is later ferreted out by the buyer or its attorneys in their due diligence review. This can result in a purchase price reduction midstream, or even the suspension of negotiations. At the very least, because the “trust factor” has been impaired, the buyer will now feel the need to dig deeper and spend more time on due diligence than they otherwise would have.

Entrepreneurs can help smooth the way by doing their own due diligence on their company before the negotiations even begin. This will provide an opportunity to fix problems in advance, and even if this is not possible, at least it allows the seller to frame the issue for the buyer with the appropriate context, while retaining the buyer’s trust.

Many things outside the entrepreneur’s control can kill a deal midstream, and reducing the time-span of the due diligence period minimizes the likelihood of these events occurring. Priorities at the acquiring company may change during the process, making the acquisition seem less compelling. In addition, market conditions can change at any time, and a drawn-out process is the seller’s enemy.

Lastly, the acquisition period is an intense and distracting time for the entrepreneur and the company’s senior management team. Since a significant amount of time and effort is typically required to negotiate the deal documents and coordinate the due diligence review, many of the seller’s key people may not be able to focus as tightly on their day-to-day responsibilities. If this impairs the business’s performance leading up to the closing, the buyer will get nervous and the acquisition itself may be jeopardized. Management should be sure to keep its eye on the ball and continue to focus on running the company despite the distractions of the deal.

Deals fall through for a number of reasons. Anticipating the types of things that can go wrong, and working to address them with creative solutions, will contribute to ultimate deal success.

Sarah C. Richmond is a partner at Gesmer Updegrove LLP, a Boston law firm focused on entrepreneurial companies and their investors. She can be reached at sarah.richmond@gesmer.com.