Process of Mergers and Acquisitions: Top-4 FAQs

process of mergers and acquisitions

We put together a series of videos to answer the most common questions about the process of mergers and acquisitions. You can view the videos directly from this page, or use the links below to watch them on YouTube. We hope you this series can answer your toughest M&A questions. However, if you’re still unsure, set up a one-on-one strategy session with one of our enterprise tax experts here.

1. What is M&A compliance?

Mergers and acquisitions (M&A) refers to a process whereby two or more businesses combine operations, holdings, or assets.

In an acquisition, one company agrees to buy another. In a merger, two companies agree to combine businesses in some fashion.

Other types of M&A deals include a partial purchase of assets, a tender offer for the company’s stock, or a hostile takeover to acquire a company. Each of these deals qualify as M&A transactions.

M&A transactions range from very simple to extremely complex. Furthermore, the cost of an M&A transaction can vary widely. However, all M&A activities are governed under rules set by the U.S. Internal Revenue Service (IRS) and other regulators.

With respect to M&A, regulatory compliance comes in many different forms. It could take the form of an acquisition of stock or LLC interests, an acquisition of assets, or a merger of two legal entities. Depending on the specifics, numerous compliance factors can come into play.

For example, is the company organized as a C corporation, S corporation, limited liability company (LLC) or general partnership (GP)? The Internal Revenue Code (“IRC”) treats each of these entities differently, although there are some universal rules.

For example, a C corporation, where shareholders are taxed separately from the entity itself absent any special elections, selling the stock of a C Corporation generally results in a tax at the shareholder level.

However, if a C corporation purchases assets, the entity incurs taxes as a result of the transaction, and shareholders incur taxes from any distributions.

Regulators have specific rules for virtually every type of entity under the IRC. Furthermore, state regulations can also affect M&A transactions.

M&A transactions involve many complex factors, so you should seek out professional advice before committing to any decisions.

2. What is the difference between a stock and an asset purchase in an M&A?

Simply stated, purchasing stocks gets the buyer ownership of the shares of a corporation, whereas purchasing assets delivers specific possessions ranging from bank accounts and investments to copyrights and patents to real estate, furniture and computers.

In a sense, an asset purchase is narrower than a stock purchase. In effect, the selling entity, though retaining immediate ownership of the company, is slowly dissolving in an asset purchase. Still, there are reasons for taking this route as opposed to a stock purchase.

Generally, a buyer will prefer to purchase assets due to the stepped up basis they will obtain in each asset acquired.

This could result in additional depreciation and amortization deductions that otherwise would not be available in a stock purchase.

On the other hand, sellers prefer selling stock of their company, as it usually results in capital gain treatment on the entire gain.  In asset sale, sellers will not only recognize capital gain income, but could also recognize ordinary income to the extent items such as cash basis receivables are sold.

The above usually results in a tax equalization payment being requested from the seller(s).  A tax equalization payment is a mechanism that makes the seller whole from a cash flow standpoint as if they sold stock.

This is generally determined by calculating the net after-tax cash proceeds that would have resulted from both an asset sale and a stock sale.  Then, the difference is grossed up to account for taxes and that’s the additional purchase price paid by the buyer.

These are very tricky calculations, but, remember, a buyer will benefit in as asset purchase, but it could be detrimental to a seller from a tax standpoint.

3. Why is due diligence so important in an M&A?

In layman’s terms, due diligence is just doing one’s homework. Yet, the words carry major weight in the M&A world.

If you get a mortgage to buy a house, you must make certified statements regarding employment, income, assets and overall financial fitness. Then, the lender performs due diligence to verify the info you provided.

Likewise, parties in an M&A transaction need to investigate the assets they’re acquiring. Adequate due diligence should include research on debts, litigation, contracts, warranties, and many other areas.

The due diligence phase often goes on for several months. Buyers usually assemble teams to undertake this meticulous process.  Usually, they leave the job to specialized consultants.

A company’s due diligence team assists with verifying information provided by the acquisition target, and they also look for potential red flags that could affect the deal.

Some examples of potential problem areas include financial health, quality of earnings, tax liabilities and legal position.

Proper due diligence is the foundation of any well-executed M&A deal. Buyer should have a full understanding of the assets they’re acquiring and any potential issues waiting for them on the other side of the deal.

Oftentimes, due diligence alerts buyers to unseen problems and gives them ammo to negotiate a more favorable valuation.

In some cases, companies will even abandon a deal entirely as a result of new information uncovered during the due diligence stage.

4. What are escrows in an M&A?

Escrows accounts hold a down payment of assets in advance of an M&A deal. These arrangements guarantee good faith between a seller and a buyer in an M&A transaction.

Basically, escrow accounts hold a partial deposit of the assets that will be transferred when the deal is closes.

These funds are held by third parties, attorneys, who maintain the monies in non-interest-bearing accounts. They are used most often with privately-held firms, but are growing in overall usage.

M&A deals with purchase price adjustment contingencies, frequently set up escrows in the event that the adjustment is negative. Funds are also held in escrow if the target company is awaiting the resolution of litigation.

Another common usage of escrows are related to off-balance sheet liabilities, such as tax matters that have not been addressed by the seller.

Sellers appreciate escrow mechanisms because it assures them that their proceeds will be available when the time comes. While escrows can be appreciated or welcomed by the sellers, it also reduces their up-front purchase price and subjects the remaining funds to contingencies.

If a buyer makes a claim post-closing, it can only collect what’s left in the escrow fund. Buyers agree to them because they can actually cause a transaction to close more quickly.

If the conveyance is closed for full value without adjustment, the buyer doesn’t have to scramble for additional funds. As you can imagine, escrows make both parties much more comfortable.

If a deal doesn’t have M&A insurance, escrow balances typically total 10% of transactional value. With insurance, the escrow can be as small as 0.5%.

Escrow accounts allow both parties to undertake an M&A deal with confidence. You can utilize various asset types to fulfill an escrow obligation, but you should know about all the factors in play in advance.

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The enterprise tax experts at Tax Hack can answer your toughest M&A compliance and tax questions. If you have questions about an M&A deal on your radar, connect with us now for a complimentary one-on-one strategy session with one of our tax pros.


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