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 Sarah C. Richmond

The day you dreamed of has arrived: SuperCo has just offered big bucks to purchase your company. Before buying the Porsche, keep in mind that the purchase price is only one factor that determines how much money you will get out of the deal. The founder who is aware of the pitfalls will best be able to maximize her value in the sale.

I. Be Careful Along the Way.

A company that has reached the point of sale after one or more venture rounds will have negotiated preferred stock terms with its venture capitalists along the way. A founder who does not pay careful attention to the VC’s liquidation preference may be in for a rude awakening when the VC walks away from the sale with a lot more than the founder expected.

The liquidation preference is the amount the VC gets upon a liquidation, merger or sale of the company before any payments are made to common stockholders. The most typical liquidation preference (and most appealing to founders) is one where the VC receives his original investment back if it is more than he would get by sharing in the sale proceeds on a percentage basis. This way the VC gets his money out first if the company is sold in a fire sale.

A more aggressive VC may try to impose what’s called a “participating preferred” liquidation preference, which is much worse for the founders. With this stock, the VC gets his original investment back in a sale of the company (or even a multiple of his original investment), and then also shares in the remaining sale proceeds on a percentage basis. If you hit a home run, the participating preferred benefit will be lost in the rounding error. If you only hit a single or a double, it can dramatically shift the benefits of the sale from the founders to the investors. Since you can never be sure about where you will end up, try to avoid giving a participating preferred liquidation preference if you can.

II. Talk to a Tax Lawyer.

A common mistake founders make when selling their business is talking to “the tax guy” too late. There are lots of ways to structure a deal (asset sale, stock sale, merger), multiple company structures (S Corp., C corp., LLC), and various combinations of stock and cash that can be given as payment. Each structure has its own tax consequences for both the buyer and seller, and there are ways to minimize and defer the taxes if you get the structure right from the start. It’s not too early to think about these concerns when you first set up your company.

Will officers be subject to ongoing employment, consulting or non-compete agreements with the buyer? If so, it might save tax dollars to allocate some of the purchase price to these agreements. A good tax attorney can help you work through this, so talk to one before signing a letter of intent.

III. What are you Getting?

You can be paid in stock, cash or a note (which is less common). Cash is always taxable, and stock may be taxable, depending on the deal. If you are getting stock, don’t assume that you can go out and sell the stock the day after the deal closes just because it is public company stock. Why not? In order to be able to sell the stock, the stock must either be registered as of the closing, come with registration rights, or become eligible for sale under securities laws within a short period of time.

IV. When are you Getting it?

Timing of the purchase price is also key, and buyers can tinker with the timing by using an “earn-out.” This is where the seller receives part (or even all) of the purchase price after the closing, depending on the performance of the seller’s business. An earn-out is useful when the expected profitability of the acquired company is hard to assess at the time of closing. From a seller’s perspective, an earn-out has several problems: it is difficult to come up with an exact formula to measure performance, the seller is dependent on the buyer to provide the necessary resources to make the earn-out happen, and many acquisitions fail, resulting in little or no earn-out payment.

What should you do in an earn-out situation to maximize your eventual payout? Accept an earn-out only when one or more of the selling shareholders will stay on with the buyer and exercise control over development and marketing of the acquired assets. Make sure the earn-out formula directly tracks the performance of the assets acquired in the sale, rather than the seller’s overall business. Evaluate the timing of the earn-out, as well as the milestones and the likelihood of achieving them. Make sure the buyer commits to a large enough marketing and hiring budget for the entire earn-out period. Maintain as much control as possible over whether the earn-out is reached: paying attention to these details before the sale is finalized is the best way to do that.

IV. Beware of “Hidden” Liabilities.

A buyer can put mechanisms in place which can lower the value of the sale after the closing. In an asset sale context, the buyer can exclude specified liabilities of the seller, and those liabilities can reduce the purchase price post-closing when the seller is stuck with the bill. Also, many purchase agreements are drafted with such strong representations, warranties and indemnities that the selling shareholders remain exposed long after the deal is done. Review the deal documents carefully: watching your purchase price disappear after the closing can be a very painful experience.

V. Be Smart.

Evaluate your buyer. Most deals these days are paid for with at least some stock, and the selling shareholders will thus become partial owners of the acquiring company for at least some period of time. Also, many (if not all) of the seller’s employees will typically continue on with the acquiring company. Do your homework and carefully evaluate the strength of your buyer. Make sure you are joining forces with a company you believe in.

Bring a knowledgeable lawyer into the process early on. The farther along in the process you get, the less room there is for the lawyer to help.

Last but not least, don’t forget to run your business while negotiating the sale. Deals crash for all sorts of reasons, and you don’t want to be left holding less than what you started with.

 

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

By Andrew Crain

The purchase agreement documents the legal sale of the company’s assets or the shareholders’ company stock to the buyer, and the terms of the purchase agreement are just as important as the purchase price in determining the seller’s economic benefit from a transaction.  To help you better understand the purpose and contents of the purchase agreement, this paper describes the major provisions including (1) what is being sold, (2) payment amount and payment terms, (3) assurances from the seller regarding the stock or assets being sold and assurances from the buyer regarding the purchase, (4) remedies of each party if the other breaches the agreement, (5) if the agreement is to be signed in advance of the actual sale (rather than simultaneously) a list of conditions that must be met in order for the sale to occur, and, (6) if appropriate, a provision that the seller will consult for the buyer, and/or a promise that the seller will not compete with the buyer, for a period of time after the sale.

(1)        The list of what is being sold will specifically identify the shares of stock or the assets (and liabilities) to be included in the transaction.  In an asset sale, this list typically includes customer lists, business records, bills of material or formulas, goodwill, equipment, intellectual property, and working capital.  Working capital includes inventory, accounts receivable and accounts payable.  The amount of working capital is negotiated, but typically is set as the 12-month average of inventory plus receivables, minus payables.  For seasonal businesses, the seller may be required to include enough working capital for the buyer to operate the business at its seasonal peak.

(2)        The payment amount and terms will list the purchase price to be paid at the closing of the transaction, the method of payment, and the details of any seller financing and any royalty or earn-out provisions.

(3)        The assurances made by the seller in the purchase agreement are called representations and warranties.  These typically include statements that: The company exists and is in good standing in the states where it does business

• The transaction has been authorized by and will be legally binding on the seller
• The transaction will not breach any law or any other agreement
• The seller owns the stock or assets free and clear of any creditors’ liens (or will pay off its debts and clear those liens at the closing of the transaction)
• The company’s financial statements fairly present its financial condition
• The seller has filed all tax returns and paid all taxes owed on the stock or assets
• There is no litigation, either pending or threatened, regarding the stock or assets
• The company has all permits, licenses and approvals needed to operate its business
• There has been no recent material adverse change in the company’s business
• If the company owns trademarks, copyrights or patents, a variety of representations and warranties regarding this intellectual property
• If the sale includes real estate, a variety of representations and warranties concerning the description of the property, proper title to the property, and compliance with environmental laws

Most of these representations cover facts and circumstances that the seller knows to be true.  Often, however, the seller is also required to give representations and warranties regarding problems that already exist but are unknown at the time of the transaction and become known later, only after the transaction has occurred.  Sellers sometimes ask, how can I represent and warrant a fact that is not yet known to me?  The answer is that representations and warranties are a method of allocating risk between the buyer and seller:  if existing but unknown circumstances come to light after the closing and reduce the value of the company, buyers typically require that the sellers bear those costs.  In order to limit exposure, the seller can often limit certain representations and warranties “to the best of seller’s knowledge” or to a “material” level.

As the representations and warranties are negotiated and discussed, the seller should alert its investment banker and attorney to any facts or circumstances that are inconsistent or contrary to a requested representation.  Those facts and circumstances are then listed in exhibits to the purchase agreement as exceptions to the representations and warranties, and because the buyer is thus made aware of those exceptions, the seller has no liability to the buyer for those facts and circumstances.

(4)        The buyer bases its purchase decision in part on its due diligence review of the company, and in part on the seller’s representations and warranties.  If a representation turns out to be untrue, the buyer has not received what it bargained for, and will want a remedy from the seller.  The purchase agreement typically provides that the seller will indemnify the buyer for any losses resulting from a misrepresentation, breach of warranty or fraud.

The seller, of course, wants to limit its exposure and to know that the proceeds of the sale are safe.  To balance the interests of the buyer and the seller, most purchase agreements provide for both a time limit (the “survival period”) and a dollar limit (the “cap”) on the seller’s indemnification obligations.

The survival provision typically provides that most representations and warranties will expire after 12 or 18 months following the closing; beyond that date, the buyer cannot seek indemnification for the representations and warranties.  Certain fundamental representations and warranties (such as organization, authority, title, taxes and environmental matters) typically do not expire.

The cap provision typically provides that the seller’s maximum liability to the buyer is limited to a percentage of the purchase price.  Depending on the circumstances of the transaction, that percentage may be as little as 10% or as much as 100% of the purchase price.  Fundamental representations and warranties and fraud by the seller may be subject to a higher cap or may even be uncapped.

In some transactions, the purchase agreement provides that a portion of the purchase price – often equal to the indemnification cap – will be paid by the buyer into an escrow account rather than directly to the seller.  The escrowed money is held by an escrow agent for an agreed-upon period during which the money is available to the buyer to cover any indemnified losses, and then at the end of the escrow period the balance is released to the seller.  Escrows are typically used when the buyer cannot easily enforce the indemnification provision – for example, when an entire company is sold and the proceeds are immediately distributed to multiple stockholders.

In other transactions where a portion of the purchase price is to be paid over time as a contingent “earnout” measured as a percentage of future sales, gross profits or net income, the purchase agreement sometimes provides that, in lieu of an escrow, the buyer may set off future earnout payments to cover any indemnified losses

(5)        If the purchase agreement is signed in advance of the closing, the agreement will contain a list of closing conditions that must be met in order for the closing to occur.  These conditions will be specific to each transaction.  Sellers should seek to limit this list, as any unmet condition will provide the buyer with the opportunity to terminate the planned transaction.

(6)        In some transactions the seller’s industry expertise will be valuable to the buyer and may also be valuable to competitors.  In these cases, the buyer may request that the seller enter into a consulting agreement so that the buyer will benefit from this expertise.  Conversely, the buyer may insist that the seller enter into a non-competition agreement so that competitors may not benefit from this expertise with resulting harm to the buyer.  In deals that include a consulting agreement or a non-competition agreement, and depending on the corporate organization of the company, in order to minimize tax obligations the seller may prefer to allocate a greater portion of the total transaction price to the consulting fee and/or the non-competition payment and to reduce the purchase price of the stock or assets accordingly.

The terms of the purchase agreement are just as important as the purchase price in determining the seller’s economic benefit from a transaction.  The form and timing of payment, the scope of the seller’s representations and warranties (and thus the allocation of risk between buyer and seller), the indemnification provisions, and the tax implications of the transaction structure all affect the transaction value for the seller.  For example, consider Deal 1, an all-cash transaction with limited representations and warranties and minimal indemnification obligations, versus Deal 2, a transaction involving cash plus seller financing with numerous representations and warranties and indemnification obligations that include a lengthy survival period, a large cap and an escrow.  Because of the terms of the purchase agreement, the seller may choose the beneficial terms and relative certainty of Deal 1 over the less-favorable terms of Deal 2, even if Deal 2 is priced at $100 and Deal 1 is priced at $90, $80 or even $70.  Just as the purchase price is negotiated between the buyer and seller, the terms of the purchase agreement are also negotiated between the parties with the assistance of their investment bankers and attorneys.  We are well-informed regarding current market norms for both price and terms and very experienced at negotiating favorable transactions for our clients, and we look forward to assisting you in successfully negotiating and closing your transaction at advantageous price and terms.

Andrew Crain is a Managing Director at Briggs Capital, LLC, 858 Washington Street, Suite 100,Dedham, MA 02026, tel. 781.493.6581 ext 207 andy@ briggscapital.com; www.BriggsCapital.com

 

By Joseph J. Rahal

Introduction

Many of today’s world conflicts emanate from a clash of cultures. The same can be said of conflicts that occurred during the mergers of the Mercedes and Chrysler, Coke and Snapple and many other similar transactions.

Are these cultural issues any different when merging two established and successful smaller or mid-sized companies?

Are the challenges and obstacles the same?

How much of the success of any of these examples is based solely on the formal review, analysis and integration of financial and legal matters?

“60% of mergers, acquisitions, and joint ventures fail to perform up to expectations in their first year, often because of cultural incompatibilities between the two prospective partners. The losses in shareholder value are in the hundreds of millions of dollars in many of these star-crossed liaisons. Cultural Due Diligence is a technique for keeping both eyes wide open when approaching an attractive prospect, whether for a merger, joint venture, or offshore vendor.”  (Source: Wayne State University, Institute for Information Technology and Culture, Detroit, MI)

60% – 70% of all mergers fail because of a lack of cultural integration

What must be done to insure a successful blending of companies? Large and Small.

Consider the following ……

• 60% – 70% of all mergers fail because of a lack of cultural integration
• Culture is ranked higher than salary as a criterion in job selection, satisfaction and employee retention
• Customer service is a direct reflection of a company’s culture – how it treats its employees and the expectations it has on how clients should be treated

This document will provide:

• Further rationale and value to conducting a cultural due diligence as a necessary complement to the standard financial and legal due diligence  
• Components of cultural due diligence
• A practical outline for conducting cultural due diligence
• Role of Rahal Consulting in conducting, and implementing strategies resulting from cultural due diligence

This document also presents Rahal Consulting’s philosophy and approach toward defining Cultural Due Diligence and heightening its awareness and relevance in today’s business world. Additionally, Rahal Consulting seeks to challenge conventional thinking, educate business leaders, and to re-affirm the critical value of conducting Cultural Due Diligence along with tradition financial and legal due diligence.

Description

In describing cultural due diligence, there are many positive examples in business, and they stand out among the many negative situations. The over-riding theme in evaluating true corporate culture is “walking the talk”. Here are two specific comparative examples whereby the company may espouse a cultural value but either “walks the talk” or is inconsistent in what is actually done:

Cultural value description	Positive example	Negative example
We are a family culture that cares about our people.	A collaborative initiative to help a peer in distress when co-workers transfer personal time off to the needy, and the company matches the cumulated funds.	Elimination of celebration parties and token bonuses while senior management collects large bonuses
We are open and innovative and respect everyone from top to bottom.	Monthly “straight talk” sessions open to all employees Quarterly and equal bonuses for all employees based upon corporate performance	Executives reside in a secluded office suite separated by dark wooden doors Executives seldom mingle with work force (minions)

Why is culture so often overlooked when two companies merge?

If so much that has been written and discussed specific to culture and its importance, why then is culture so often overlooked when two companies merge, especially during the due diligence process?

There are two primary reasons:

1. It’s all about the numbers and value to the shareholders, public or private
2. The perception of cultural due diligence is that of “soft stuff” with limited impact on shareholder value

… proven the critical value of human capital to the success of businesses.

Clearly, research in all forms, has proven the critical value of human capital to the success of businesses.

Outcomes of Cultural Due Diligence

Conducting cultural due diligence, along with the legal and financial components of traditional due diligence, will:

• Provide better understanding of who you are
• Streamline the integration
• Expedite operational success
• Improve marketplace acceptance
• Retain key employees, clients and revenue

To make the merger successful, there are three distinct steps to cultural due diligence:

1. Conducting an objective, formal and thorough analysis, evaluation and comparison of the two companies
2. Accepting the findings as a pathway to a smoother transition
3. Creating and executing the right strategies for a speedy and successful merger and integration

Important Merger / Acquisition Considerations

Within these steps are critical questions pertaining to successfully merging cultures that must be asked.

What are you really buying when you purchase a company and how do you establish value?

What assets are you buying when you join two companies, regardless of size or industry?

• How do you establish and value these assets?
• How will you measure the success of the merger and integration?
• When will you measure the success of the integrated companies?
• What are the contributing factors to the success or failure of the merger?
• What are the inhibiting factors to the success or failure of the merger?
• What role does human capital play in the merger and subsequent success or failure of the merger?
• What are the consequences of incompatibility?

 

Yes	No	Category	Details
X		Corporate	The entity: name, business, structure, etc
X		Legal	Governance,  intellectual property, contracts
X		Financial	Balance sheet, revenue, receivables and payables, leases
X		Operational	Equipment, technology distribution channels, clients, market share, processes and methods of doing business Products or services
X		Cultural	Human capital (people) and talent, values, standards and expectations, management style, measurements of performance for the company

 

Traditional Due Diligence

Due Diligence has been defined as ‘the independent investigation of a company, its management team and its prospects for success by an investor before funding is provided’. A more terse but no less accurate definition describes it as ‘a well-established mating ritual … which allows [the parties] to explore the benefits of the marriage’. (a)

Conducted primarily by lawyers and accountants, it focuses on:

• Financial structure and performance
• Product portfolio
• Customer base
• Marketing, sales and distribution structure
• Research and development
• Management and personnel
• Legal matters

Consider this: Seventy-five percent of all mergers, acquisitions, and general corporate change initiatives fail within the first three years. One of the major culprits contributing to this failure rate is the lack of attention to organizational culture — the Human System.  Listen to what a former Wall Street insider has to say about Cultural Due Diligence™… Is culture a factor when it comes to business integration activities? According to an independent study conducted by New York based law firm, Wachtell, Lipton Rosen & Katz on merger and acquisition activity in the banking industry, 4 of 7 common factors that affected M&A success were culturally related. Organizations do a great job of conducting legal due diligence and financial due diligence.  In fact, deals would not get done if not for these in-depth and significant processes.   The missing link in M&A activity is “Cultural Due Diligence” where the human systems of both organizations are assessed, diagnosed and integrated. (Source / EMERGE International, Huntington Beach, CA)

The link between orchestrating the deal and realizing the potential of the new organization is not the responsibility of lawyers and accountants,

Traditional Due Diligence occurs between the signing of letters of intent and the closure of the deal, covering typically a ninety-day period during which the parties are still negotiating even as the lawyers and auditors are gathering their information. It can be a draining process. As Charles Crosthwaite, Partner at Bird & Bird, observes, “Due Diligence reports are usually compiled and delivered to extremely tight deadlines. Lawyers cannot, however, guarantee that their reports will be read or acted upon. Professionals should strive to collaborate with clients to create a more effective intelligence gathering and assessment process.”

Many of the components of Due Diligence – the warranties and disclosures which have to be supplied by the legal entity being acquired – are statutory and formula driven. Focus throughout is on evaluating the evidence which will allow the transaction to be concluded. The link between orchestrating the deal and realizing the potential of the new organization is not the responsibility of lawyers and accountants, who may well have no further role to play after the agreement has been signed.

A New Component

Despite the assumption that there is only one component to the due diligence process, there are actually two primary components of Due Diligence –

1. The more recognized and traditional “Confirmatory” process outlined above
2. The less considered “Operational or Business” due diligence process to understand the practical issues that are the day-to-day  heart beat – strategies, structure, practices, people, i.e. the Cultural Due Diligence

Organizational culture is defined as the human side, the operational component and the personality or so called “fabric” of the organization.Culture is comprised of the history, values, norms, standards and tangible signs (artifacts) of an organization’s members and their behaviors – both past and present. Members of an organization soon become an integral part of the culture of the company by their participation in the organization in which they work.

Defining Cultural Due Diligence

Cultural Due Diligence, with its focus on the future

Cultural Due Diligence, with its focus on the future life of the company, integration of the entities and practical operations of the new organization, has much to offer. As Richard Lee, Partner at Clarks Solicitors, observes, ‘Many companies are extremely unsophisticated in their approach to the cultural aspects of their Due Diligence. Family businesses, in particular, can be hard to integrate”.

Cultural Due Diligence differs from standard Due Diligence procedures in that:

• It is not mandatory in law
• It may be variously conceived and implemented
• It may be conducted by a range of parties

Organizational culture is the personality of the organization. Culture is comprised of the assumptions, values, norms and tangible signs (artifacts) of organization members and their behaviors. “Culture can best be described as what people do and how they act when no one is watching.” (Source: Richard Kovacevich, Chairman, Wells Fargo & Co.)

 A Cultural Comparison

A parallel can be drawn between the merger of cultures between nations and the merger of cultures between corporations and businesses of all sizes. Elements in this comparison are numerous but often not considered in the business world. Examples of these elements are:

Nations	Businesses examples
Language	Acronyms, slang, department specific language, swearing tolerance
Dress	Dress code, difference among levels
Governing policies / laws	Management, where are decisions made – hallways or formally in meetings, by consensus or dictatorial, feedback, each department has separate process
Infrastructure	Levels of staff, office structure, cubicles, technology, pay structure
Hierarchy	Decision making, matrix or hierarchical, centralized decentralized
Social standards	Interrelation among levels, social activities (bowling, etc.)
Ethics	Work ethic and expectations and performance measurements Ethics and values, consistency, token or actual
Artifacts, music, art	Technology, company signage, awards, failed new endeavors
Celebration	Rewards and recognition, appreciation , compensation

organizational change must include not only changing structures and processes, but also changing the corporate culture

As analogous as this comparison is, the culture of a business is more difficult to distinctly express, yet everyone knows the importance of culture in the success of a business For example, the culture of a large, for-profit corporation is quite different than that of a hospital that is quite different than that of a university or a strong entrepreneurial business.

You can often identify the culture of an organization by looking at the arrangement of furniture, what the employees and management brag about, what people wear, etc. — similar to what you can use to determine an individual’s personality.

It is not just about what you want to achieve but rather “HOW” to get it done.

The concept of culture is particularly important when attempting to manage organizational change. Practitioners are coming to realize that, despite the best-laid plans, organizational change must include not only changing structures and processes, but also changing the corporate culture as well.

It is essential to consider that when creating change, the critical components are not setting forth what the goals are but rather the “HOW’ to achieve the desired outcome. The “HOW” is all about implementation and execution. It requires understanding obstacles, outcomes, ramifications, planning and the impact of change on the people who must execute the strategies and tactics.

(a) – Source: Written by Carter McNamara, MBA, PhD, Authenticity Consulting, LLC. Copyright 1997-2007.Adapted from the Field Guide to o Leadership and Supervision.

Done simultaneously with traditional confirmatory due diligence, Cultural Due Diligence is a practical, step-by-step approach for making rapid, cost-effective cultural assessments of both the acquirer and the target. It can make the difference between deal success and disappointment.

Culture and Change

Because cultural change involves hard and soft issues, it requires both qualitative and quantitative analysis of a corporate culture, including visible manifestations such as:

• Dialogue between levels
• Decision making process
• Accessibility to decision makers and leaders
• Sales process and positioning
• Channel management, and “go-to-market” strategies and tactics
• Market positioning
• Client interaction
• Dress codes
• Office layout
• Annual reports
• Recruitment brochures and employee interaction
• Less tangible corporate values and assumptions about how a company does business

Traditional M&A due diligence has consisted mostly of crunching numbers, securing intellectual property, examining executive compensation plans, reviewing legal document, etc

Traditional Mergers and Acquisition (M&A) due diligence has consisted mostly of crunching numbers, securing intellectual property, examining executive compensation plans, reviewing legal document, etc. There are several reasons for this:

• Tradition has established a mystic around the “confidentiality” surrounding the legal and financial undertakings
• It is a more specific and easier route to gather and analyze numbers
• Acquisition teams are comprised mostly of financial analysts and attorneys
• Top managers are generally more comfortable with “hard,” easily quantifiable issues than softer ones like culture
• The due diligence team is rewarded and recognized for the accomplishment of the process and seldom, if at all, involved with or tied to the successful integration and future outcome of their assessment
• Less emphasis has been placed on the actual integration and implementation of the merger
• These same managers may have believed they already understand the cultural differences between their companies and prospective partners, particularly if they operated in the same industry and feel that a formal analysis is superfluous
• Managers may have undertaken a kind of implicit or intuitive cultural assessment that lacked documentation and objectivity and therefore defied replication
• Many simply choose to ignore potential conflicts even a rudimentary cultural assessment may reveal.

Cultural Due Diligence: The Process

Cultural Due Diligence can be explicit and measurable. It provides a discipline … to recognize culture as a critical ingredient in deal success ….

Cultural Due Diligence can be explicit and measurable. It provides a discipline that compels senior managers to understand it own culture and to subject their gut perceptions and conclusions to tough scrutiny as well as to recognize culture as a critical ingredient in deal success.

Indeed, it takes a fair amount of courage for leadership to submit their preconceived notions of their own corporate cultures, or that of their prospective partners, to such a test. Moreover, if conducting a rigorous cultural assessment up front might be regarded as courageous, failing to do so could conceivably be considered a breach of fiduciary duty, particularly if a deal turns sour.

Source: Accenture / Mergers & Acquisitions: Irreconcilable Differences)

The procedures of Cultural Due Diligence cannot be “owned” in the way that accountants and lawyers own the statutory preserve of Financial and Legal Due Diligence. There is, however, a strong case for external specialists to conduct this work in close liaison with internal teams, as is the case with conventional due diligence. This ensures rigor of methodology, impartiality, and also adherence to agreed objectives and deadlines. Often, this team, or portions of the team, can transition to the integration process to insure continuity and accountability.

• Obtaining an impartial view of the organizations being merged in order to maximize the business benefits deriving from the deal
• Developing an integration plan that insures a rapid and successful merger

Cultural Due Diligence investigates the values, perceptions, procedures and motivators to insure collective effectiveness

It is the task of Cultural Due Diligence, core areas include an objective view of:

• Profiles of senior management and their actual philosophies and styles
• The management and employees of an organization
• Talent
• Organizational structure
• Historical and projected headcount
• Personnel turnover patterns
• Operational patterns
• Compensation arrangements
• Organizational culture
• Industry culture
• National/regional culture
• Leadership style
• Corporate values
• Interaction among departments and divisions
• Brand values
• Knowledge behavior
• Market position
• Position of the client
• Training
• Sales process
• Territory and account management
• Customer relations
• Sales performance against market indicators
• Assessment of product compatibilities.

The following lists a sampling of the most crucial cultural due diligence questions:

Acquisition

• Why do you want to buy the company? What is the objective?
• What do you expect to gain?
• What makes the target company attractive – product, management, operations, financial, sales, subject matter expertise, people, products, strategic value, etc?
• How did they get where they are?

Values

• How are values defined and lived in practical terms?
• What are the official values of the organization to be acquired?
• What are its unofficial values?

Perceptions

• How do employees perceive their own company?
• How do they perceive the other company?

Procedures

• On what basis are decisions made (top-down, consensus-based, rapid, slow)?
• Is the organization relationship-focused or deal-focused?

Motivators

• How are managers motivated and rewarded?
• How are employees motivated and rewarded?

Uncomfortable questions

• What is regarded as absolutely unacceptable behavior?
• What subjects are regarded as taboo?
• Who is likely to embrace change, and who to obstruct it?

Sales

• What are the market and industry variables and trends?
• How are products and services presented to the marketplace: as commodities or value-added?
• What are the customer service dynamics?

… diversity can benefit the new organization, but only if it is fully harnessed.

Cultural differences can manifest themselves in the way people dress, communicate, use e-mail, and make decisions and more. The irony in all this is that such diversity can benefit the new organization, but only if it is fully harnessed. The most successful companies make concessions and combine the strengths of both companies to develop a new organization. And that must begin in the Cultural Due Diligence process.

Cultural Due Diligence was created to meet the growing need for a comprehensive “user friendly” process for assessing and analyzing organizational culture and also for integrating and transforming cultures successfully.

Summary

This document presents Rahal Consulting’s philosophy and approach toward defining Cultural Due Diligence and, in doing so, heightening its importance and relevance in today’s business world. Additionally, Rahal Consulting seeks to challenge conventional thinking, educate business leaders, and to re-affirm the critical value of conducting Cultural Due Diligence along with tradition financial and legal due diligence.Cultural Due Diligence has yet to reach the top of the agenda in the board room despite the extensive research on the topic, and the volumes of information written about the impact of culture in business. By presenting and offering this text, Rahal Consulting seeks to initiate a dialogue on the subject of Cultural Due Diligence and to present itself as proficient on the topic. The objective is to engage with client companies and to objectively assist them as they work through the process of actual planning and implementation of strategies and tactics insuring merger success. Rahal Consulting, with its extensive and successful business experience accrued over numerous engagements across multiple industries, is poised to assist mid-tier clients in the Cultural Due Diligence requirements associated with a successful merger or acquisition. To initiate a more in-depth discussion and for additional information, please contact: Joseph J. Rahal, Rahal Consulting, www.rahalconsulting.com, jrahal@rahalconsulting.com 617 999 7262/402 960 0348