Mergers and Acquisitions Q&A
Mergers and acquisitions is a complicate subject. Fortunately, our tax pros can guide you through some of the basics. Our resident M&A tax expert, Ryan Mas, met with our Director of Business Strategy & Advisory, Ashton Chanana, in a recorded discussion to answer the most common questions on mergers and acquisitions strategies that we get from clients.
You can find their answers in the videos below, along with an in-depth written explanation of each answer.
1. Q: What are rollover equity and earn-out payments in Mergers and Acquisitions?
A: There are occasions when a seller will take some proceeds of mergers and acquisitions and re-invest them in the purchasing company. These funds represent rollover equity and could constitute from five percent interest to just under 50 percent, generally. Among the reasons for this action is the fact that it instills more confidence regarding the future prospects of the acquiring company. In addition, partnering with a seller aids a buyer in creating a positive image around the entire enterprise.
Earn-out payments are contracted disbursements from buyer to seller, i.e., the seller’s shareholders, that are based on the successor company achieving specific financial benchmarks. Such pay-outs only occur after the acquisition is complete and certain milestones are met. You regularly use earn-out payments when the seller and buyer cannot reach a consensus over the value of the transaction. In these instances, earn-out payments can bridge the gap, so to speak, and satisfy the selling party by coming closer to its desired price over time rather than upfront. Like rollover equity, earn-out payments give the seller an interest in the company’s success even after the sale.
More often than not, earn-outs negotiations are between privately held businesses. They are not without problems. Since they are grounded in a company’s subsequent financial performance, sellers sometimes suspect that earn-out payments do not accurately reflect how well a firm is doing and, thus, are minimized. For this reason and others, any acquisition that includes earn-outs should include clear contractual agreements and processes for determining any earn-out payment and/or metrics to determine that payment.
The key to remember is that earn-out payments are taxable income in most circumstances. Earn-outs are often adjustments to purchase price and increase the total cost of the previous purchase.
2. Q: What historical information do you need from an M&A?
A: Historical research is an essential component of due diligence in M&A. Knowing a company’s origins, its previous mergers, acquisitions, asset sales, and divestitures help establish a chain of property and liability. For example, old, unpaid judgments against a predecessor company can turn up. In addition, information regarding atmospheric emissions or sustainability problems will sometimes invite greater IRS scrutiny. Historical research seeks to disclose liabilities that can adversely affect the value of a business. This is why such inquiry is especially painstaking by its very nature.
Researchers answer pertinent questions. How and why was the company formed originally? The charter will often explain this. How often was it bought and sold, and why? What were the motivating factors? How often was the company in court? What were the facts and outcomes of those lawsuits? Was there government involvement? Did the company always occupy the same market segment? Has the range of offerings in goods or services grown or shrunk over its lifetime? Has the workforce expanded, contracted, or remained relatively stable? Answers to such questions highlight strengths and weaknesses, helping buyers to make an informed decision.
Some of the documentary evidence that assists historical examiners in the process of discovery includes: certificates of incorporation, by-laws with dated amendments, business and professional licenses with renewals, executed power of attorney letters, legal case summaries with final dispositions, title certificates to all land and possessions bought and sold and every contract entered into. Contractual agreements that affect assets, place parameters on doing business, and present conflicts of interest are necessary for a buyer to know about in advance. Tax returns and bank statements demonstrate ebbs and flows in revenue, also necessary information before acquiring or merging with another company
3. Q: What are indemnifications in an M&A?
A: Even with great due diligence, issues relating to the target company’s past might arise after the closing. Without indemnification clauses in the M&A agreement, the successor company has no recourse. In other words, the buyer owns the company, warts and all. These warts may be tax liabilities, undischarged liens, or other matters that could cost the successor significant amounts of money. Therefore, the indemnification language allows the buyer to legally pursue the seller for restitution. The seller is on notice that its company should have no financial skeletons in the proverbial closet.
Liabilities are of particular importance. When an acquisition occurs, the business’s mistakes and evasions become the new owner’s problem. Indemnification clauses allow the buyer relief if the target company fails to fulfill its contractual obligations. Case in point, the target company, owns a property that it improved but never compensated the contractor. As a result, the contractor puts a mechanic’s lien on the property that the selling company ignored, and a title search was missed. If the lien surfaces post-acquisition, the purchasing company, which paid the lien to get it discharged, can sue the seller for reimbursement.
Other examples include unpaid unemployment insurance premiums and federal or state tax liens. Yes, proper due diligence would sniff such issues out, but indemnification clauses in the purchase agreement cover the unlikely event of such obligations falling through the cracks. It is not a guarantee of recompense. More accurately, indemnification confers the legal right to pursue it.
4. Q: What are representations and warranties (R&W) insurance in Mergers and Acquisitions?
A: The purchase agreement contains certain representations and warranties pertaining to both parties to the transaction. Financial condition and legal compliance are but two areas in which the companies make representations and warranties. For example, they will assert that they carry assets of a certain category in a certain quantity. Similarly, they tell one another what they owe and to whom. Basically, representations and warranties are truth claims about the health and integrity of each company.
Sometimes these claims turn out to be false or, at least, unsubstantiated. As demonstrated in previous answers, indemnification clauses and escrow accounts give the wronged party room to offset any losses incurred because of any breaches committed. However, their benefits notwithstanding, these avenues for protection also have their negatives.
Studies show that 9 out of 10 buyers obtain representations and warranties insurance ahead of a deal. Typically, these policies have terms range from three to six years.
The elements of R&W insurance coverage typically include:
- The Premium: The insurer charges two to three percent of the coverage amount, e.g., the cost of a $30 million policy could be $900,000. The good news is that more providers are getting into the M&A arena so that the competition could force premiums downward.
The policy amount is routinely 10 percent of the M&A purchase price.
- The Deductible: Amount paid before coverage kicks in, about one percent of the purchase price.
Exceptions and exclusions can result in a covenant breach by the seller. Covenants serve as collateral to the purchase agreement, price adjustments, or anything specifically designated by the policy.
Insurers want to identify all parties participating in the transaction, the coverage amount requested, the structure of the M&A agreement, its nature and the breadth of the seller’s representations and warranties, the online data room the seller maintains for due diligence, the buyer’s due diligence report, and the seller’s disclosure schedule.
Insurers often require buyers to demonstrate they have performed appropriate due diligence. In most circumstances, insurers will refuse coverage if they deem the due diligence insufficient. Insurers also won’t cover known liabilities, such as sales tax exposure or deviations from GAAP.
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