When looking to grow your company, mergers and acquisitions offer an attractive way to expand your company’s footprint and grow market share. But there is no one-size-fits-all approach that’s a ringer for success. Whether one or both companies involved in a transaction are public or private, corporations or partnerships, LLCs or S-Corps, combined with many other factors, can all combine to make M & A transactions incredibly complex—even more so now in the new normal of COVID-19.
It is true that the pandemic has caused severe disruption and uncertainty for companies across almost every industry, initially resulting in a substantial slow-down in the M&A market. Still, transactional activity is expected to accelerate in certain areas as the economy begins to recover. On the one hand, COVID-19 has likely increased the need for M&As: notably sales by sellers in dire financial straits, reorganizations to facilitate cash flow, and insolvency restructuring. What’s more, deal opportunities will arise in certain markets and industries like pharmaceutical and retail sectors, for example, and these will see increased growth and profitability during the pandemic.
As attractive as an acquisition option may be to grow your company, there are many legal factors to consider before proceeding. Prospective sellers and buyers alike should have an increased focus on specific considerations as they evaluate new opportunities during and post-COVID-19. They will need the guidance of attorneys and CPAs expert in merger and acquisition law and finance. It is critical that specific deal terms be identified at the outset of any M&A transaction that is under consideration now as potential buyers and sellers evaluate new opportunities post-COVID-19—as well as reevaluate whether new considerations will negatively impact and inspire new conditions in deals inked prior to the March 2020 economic and societal transition to a COVID-19 business environment.
In M&A transactions, special efforts must be taken to address and safeguard against the unpredictability that could result from the business and industry related effects of COVID-19.
However, three primary focus areas in all deals at any time as well as during COVID-19 include structure, tax implications, and employee compensation issues.
What Structure? Asset Acquisition or Stock
In an asset acquisition, the buyer and target company agree on a list of assets and liabilities for the buyer to acquire. The target will retain any assets and liabilities not transferred to the buyer. COVID-19 has resulted in a situation in which more companies will strive to divest non-core assets and created opportunities for companies who stand to benefit from purchases of carve-out assets.
This type of acquisition is favorable when a buyer is looking to acquire specific assets of the target that will benefit the existing purchasing company, leaving unwanted assets or liabilities involved in the target business with that business.
Asset Acquisitions: Complex and Time-Consuming
While the process sounds strategically beneficial to the acquiring company, structuring asset acquisitions can be complex and time-consuming. The assets must be identified, and often separate transfer agreements are required to make all the asset transfers.
What’s more, there’s a lot of front-end work to even set the asset transfer in motion. For example, state corporation laws will likely require stockholder approval where a corporation sells “all or substantially all of its assets not in the ordinary course of business.” Because many states do not have a bright line test for determining what constitutes “substantially all the assets” of a company, determining whether stockholder approval is required can be difficult from the outset.
The target company’s contracts may also require third-party consents to complete the transfer of certain assets. These consents might not be necessary if the deal was structured as a stock purchase.
Specific to COVID-19, contractual issues may have surfaced in connection with a target’s failure to perform all of its obligations under its existing contracts because of pandemic-related issues such as withholding rent or failing to fulfill orders within a specified timeline. Any potential liability associated with nonperformance must be addressed prior to closing. In addition, force majeure provisions contained in the target’s contracts must be evaluated to determine if they are applicable and potentially may excuse some of the target’s contractual obligations.
Stock Purchase as an Alternative Route to Asset Acquisitions
In a stock purchase acquisition, the stock of the target company is transferred to the acquiring company. In effect, the ownership of the target’s assets and liabilities are transferred to the buyer, and the target continues to operate as it did prior to the acquisition. Only now, it is owned by the buyer.
The structuring and documentation involved in stock purchases tend to be simpler than asset acquisitions because the parties do not need to identify specific assets and liabilities to be transferred to the buyer. Typically, for example, fewer third-party consents are required in a stock purchase since the target’s assets, contracts, and licenses are not being transferred to a new entity. That said, third-party consents might still be required if the applicable contracts have change-of-control provisions that are triggered by a stock sale.
But, right now in the aftermath and continuation of the pandemic, a buyer might also want to avoid a stock sale because, unlike an asset acquisition, the buyer cannot exclude unwanted assets of the target. In a time of COVID-19, when liabilities may have increased, the buyer is assuming all the target’s liabilities. At the very least, the parties should consider including coronavirus-related carve-outs in material adverse change provisions. These provisions would include language which would allow the buyer to terminate a definitive agreement due to changes in the target’s business between the signing and closing.
A good rule of thumb requires the parties to take into account how long the impact of the pandemic on the target’s business must continue in order to declare a material adverse change. That analysis should also include whether the adverse impact on a target is in line with that of other companies in the target’s industry. If the difference in the adverse impact is disproportionate to competitors in the industry, a determination must be made as to whether the difference constitutes exclusions specific to the target’s business.
Purchase Price Adjustments
As a result of the pandemic, the continued viability of a business may well be difficult to determine. This will likely create significant valuation discrepancies between buyers and sellers. Sellers may find that their underlying business model is scrutinized beyond the normal levels of due diligence. In fact, they likely will be forced to demonstrate the ways in which the pandemic’s longer-term social and economic environments will affect customers, supply chains, marketing, infrastructure, etc. In addition, deferred tax assets/liabilities and estimated tax payments will have to be evaluated in light of both new tax rules and updated financial projections that take into account the impact of COVID-19 on a business.
Tax Implications are Critical
Tax implications will be a critical factor in the choice of deal structure. Only a few of the tax implications are highlighted here as a comprehensive discussion of all tax factors is not possible in a single article. It is imperative that the buyer and target consult a CPA early in the transaction to ensure optimal deal structuring for tax purposes to ensure tax-advantageous structuring in line with the ever-changing tax laws and regulations.
For Buyers: Asset Sale Comes with More Benefits
Generally, many buyers prefer a sale of assets to a sale of stock from a tax point of view. Under the Internal Revenue Code, when the target sells its assets to the buyer, the buyer gets a “step up” in basis if the value of the assets has appreciated in value. This step-up in cost basis would generally reduce the buyer’s tax burden, for example, by lowering the gain realized on the buyer’s later disposition of those assets. Buyers also often prefer asset sales because this structure presents more opportunities for depreciation and deductions.
But for Sellers, Stock Sales Reap More Tax Advantages
In contrast, sellers generally prefer stock sales because the amount of equity that they sell receives treatment as capital gain rather than ordinary income. Historically, capital gains generally receive a much lower tax rate than ordinary income tax rates, sometimes a difference of as much as 20 percent. However, recent legislation has impacted the relative ordinary income and capital gains tax rates and those rates are likely to be impacted again by future legislation.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law March 27, 2020, is a $2 trillion omnibus spending package that contains a wide range of pandemic-related economic relief as well as significant tax law changes. Many of these tax changes affect not only the 2020 tax year but also tax returns for earlier tax years, including 2019 returns that may still be in process.
According to the CARES Act, taxpayers who incurred net operating losses (NOLs) between 2018 and 2020 can now generally carry back those losses to the prior five years. Additionally, NOLs carried forward into 2019 and 2020 are not subject to the usual 80 percent taxable income limitation, and taxpayers may now use those losses against the full amount of gross income.
Employee Matters Also an Issue
Determining the effect of an M&A transaction on existing employee agreements and compensation plans is a crucial part of your deal. Both the buyer and target company will need to review the terms of all employment agreements and equity incentive plans, such as stock options, Employee Stock Purchase Plans and restricted stock, to determine whether existing options, restricted stock awards and other equity awards will accelerate, be assumed by the buyer, terminate, or require modification.
The buyer will need to review the existing employment or severance agreements to address what obligations the buyer would be assuming under the agreements, if continued, after the completion of the acquisition. The buyer will also want to identify what sort of non-compete provisions, if any, are imposed on target employees who might be terminated or leave following the transaction and who might seek to join a competitor company.
When it comes to officers, highly compensated individuals and certain shareholders of a target corporation, the buyer will need to determine whether the acquisition would trigger change and control provisions in each agreement. Triggering of such language could cause, among other things, target employee options to accelerate, or could result in certain payments being considered “golden parachute payments” under the Internal Revenue Code, which subject the recipient to a 20 percent excise tax.
The buyer must consider how to integrate the target’s benefits plan coverage with its own, or whether to keep the plans separate. The buyer should compare the benefits provided by the target with those provided by the buyer. If significant disparities in the plans remain post-closing, this could have a negative impact on employee relations and lead to significant employee turnover.
The CARES Act also creates several new employee tax issues that buyers and sellers involved in M&A transactions should address. These include whether the buyer or the seller will pay the 2020 payroll taxes that have been deferred under the Act. Similarly, the parties must also determine whether the buyer or seller will be entitled to claim the employee retention credit or if a split of the credit between the parties is appropriate.
Also, as a result of the CARES Act and the Paycheck Protection Program (PPP) outstanding loans have received increased attention. The PPP provisions require broad oversight that includes public disclosure requirements. Buyers may derive benefit from the increase disclosure requirements as they carry out their due diligence process.
As importantly, buyers must review the risks associated with a target that has a PPP loan, including whether the loan was properly acquired and whether the target company has complied with the loan covenants. There are no free rides with the PPP loans as the U.S. Treasury has indicated the government will review all loan grants in excess of $2 million. The parties will have to decide who will take responsibility for oversight: the buyer or the seller. A buyer’s liability is clear in a stock deal, but it is possible that liability will not change in an asset deal. It is likely, however, that the government will place the burden of proof on the buyer.
As PPP loan recipients are prohibited from substantially reducing employment levels and from using loan proceeds to fund stock buybacks, buyer face a high duty of care in creating efficiencies for resale within a target. They may have to think twice about their strategies to avoid being noncompliant with PPP requirements.
A buyer that does not need loan proceeds held by a potential target can return the funds or pay off the loan in order to avoid having to comply with the various PPP rules and loan covenants. In this way, they can avoid any inherent risk.
In this uncertain time, some M&A deals have become impractical or unattractive. Therefore, each party must make its own determination and choose how to proceed. Some will want to merely delay the transaction and make a decision when more information becomes available. Indefinite or long delays, however, are often impractical, and the buyer and seller may decide that it makes more sense to terminate the transaction, in which case they will have to work with their respective lawyers to work out suitable terms.
An acquisition or business sale can be complex and involve many legal areas including those discussed above as well as the intricacies of corporate and employment law, securities law, executive compensation, antitrust, and other areas. Though M&A activity has been on hold as businesses grapple with the impact of the pandemic, transactions will soon resume. With new considerations from the pandemic, the deals of the future will no doubt include new considerations from pre-pandemic deals. It is crucial to retain an attorney who understands all legal facets pertaining to laws governing M & A transactions.
At Garza Law, LLC, we understand the complexity and comprehensiveness required throughout the transaction process from due diligence to completion of your M & A transaction.
Call us at 208.557.8705 to schedule an appointment so that we can provide you with the multidisciplinary approach that will best serve your needs, whether you are the buyer or target company.