Chapter 11M&A Deal Structuring Process: Payment & Legal Considerations

(Closely linked to Chapters 12 and 13)

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Deal Structuring Process• Deal structuring involves identifying

– The primary goals of the parties involved in the transaction (Strategic versus financial?);

– Alternatives to achieve these goals; and– How to share risks.

• The appropriate deal structure is that which– Satisfies as many of the primary objectives of

the parties involved as necessary to reach agreement

– Subject to an acceptable level of risk

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Ethical/Legal Issues – BOD and Buyers ¹

• Delaware courts – what buyers and BOD can and should do in sale context. Losing Business? Forum & substantive law issues

• October 1, 2012, ruling in Shocking Technologies, Inc. v. Michael,² Delaware Court of Chancery held dissident director breached fiduciary duty of loyalty by sharing confidential information with third party and trying to discourage third party from investing in company.

• VC Noble significant opinions on 9/30/11

– Deal structure – OPENLANE

• BOD & majority stockholder both enter into competing deals. No good.

• Escrow arrangement w/o stockholder consent OK if fairly disclosed to shareholders.

¹ See Chapter 11 materials on website. For case details check The Harvard Laws School Forum on Corporate Governance and Financial Regulation website, http://blogs.law.harvard.edu/corpgov

² See posting Discussion Board.

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Ethical/Legal Issues – BOD and Buyers ¹

– BOD Conflict – see infoGroup & OPENLANE• infoGroup – director, Vinod Gupta, received same

share consideration as others and had no affiliation or arrangement with buyer HOWEVER $ 100M & need for liquidity = disabling conflict.

– Directors may lose independence by “domination through force or will” by conflicted party (Gupta).

– Pattern of threats, unreasonable, erratic behavior.– Emails-”dump company and run due to pain, trauma and

everything else” – Gupta wore them down stripping them of independence.

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Ethical/Legal Issues – BOD and Buyers ¹

• OPENLANE – not a conflict– Acceleration of director stock options is not alone

evidence of a conflict.– Agreement of target director to remain with new firm as

an executive is not itself a disabling conflict .– Fact that a director is “interested”, absent domination of

other members of BOD, not alone sufficient to attack objectivity of fill BOD. (Contrast to Gupta in infoGroup).

– Banker “pitch books” containing valuation does not constitute financial advice that must be disclosed to shareholders in proxy. Viewed as bank’s “self marketing” efforts and not impartial.

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Ethical/Legal Issues – BOD and Buyers ¹

– Sales process• infoGroup – where BOD conflicted, decision

favoring one bidder over another, where both are financial bidders subject to close scrutiny.

• ONELANE – where BOD is “very well informed”, possessing “impeccable knowledge of the company’s business”, the court may give additional deference to its process and decision making.

– Decision not to hire a financial advisor or to obtain “fairness opinion”, was OK.

– Decision not to seek financial buyers and to favor strategic buyers. Two BOD were affiliated with PE firms.

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Conflicts in Buyout Financing - Barclays

• LBO financed PE acquisition of Del Monte¹

– BOD received “conflicted” advice from its financial advisor Barclays = breach fiduciary duty.

– Buyout firm may have “aided and abetted.– Case settled October 2011 for $89.4M²

against buyer and Barclays. • Acting as seller’s advisor and financier for buyer

creates conflict.¹ In Re Del Monte Foods Co. S’holders Litig., C.A. No.6027-VCL (Del.Ch Feb. 14, 2011)

2. http://blogs.law.harvard.edu/corpgov /2011/1-/21/del-monte-settlement-highlights risk of conflicts-in-buyout-financing/

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Conflicts in Buyout Financing - Barclays

• DE courts recognize, in some contexts, stapled financing by sell side advisors. – Permissible if may induce prospective,

competitive bidders and ….• Good reasons and close oversight by BOD.

• Original trial found neither in Del Monte.– No need or benefit from target banker's participation and– Target BOD learned of its banker’s interest in providing

buy-side financing after the prospective buyers did.

• BOD, particularly with private equity buyers, need to pay close attention to sales process and oversee its advisor.

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Responsibilities of Controlling Stockholders¹

• DE court awarded $1.2 B breach fiduciary duty.• SPCC received proposal from majority

stockholder, GM to buy its 99.15% in MM, a non public Mexican company for $3.1B.

• SPCC formed Special Committee (SC) disinterested shareholders own advisors.

• DCF, contribution, sum of parts and relative valuation analysis ≤ $1.7B.

• SC caved, based on advisor’s fairness opinion.¹In Re Southern Peru Copper Corp. Shareholder Derivative Litig., CA No. 961-CS, October 14, 2011

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Responsibilities of Controlling Stockholders¹

• Chancellor Strine:– Fairness Standard not met.– SC must avoid operating in controlled mindset

• Review not rationalize controlling stockholder deal.• SC – Broad mandate, explore all alternatives

– SC continuously evaluate deal even post signing but pre closing. SPCC stock value ↑

– SC should be aligned with minority not majority interests.

• Massachusetts – majority is “fiduciary” 10

Fairness Opinions ¹• Formal written form of valuation analysis• Often used in M&A, particularly closely held to:

– Assist conflicted BOD– Objectively consider other options– Establish a record sustainable in court

• Value acquired company or new entity• Not a substitute for fiduciary judgment• Not evaluation of rationale, insurance policy or recommendation to proceed1. For a concise discussion of Fairness Opinions see Fairness Opinions Summary Guide, http://www.marshall-stevens.com/index.php?content=fairness-opinions

http://issuu.com/marshallstevens/docs/fairness_opinion_summary_guide?mode=embed&viewMode=presentation&layout=http%3A%2F%2Fskin.issuu.com%2Fv%2Flight%2Flayout.xml&showFlipBtn=true

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Major Components of Deal Structuring Process

1. Acquisition vehicle – Entity type

2. Post-closing organization - integrate ?

3. Form of payment – to tax or not

4. Form of acquisition – type consideration

5. Legal form of selling entity – convert?

6. Accounting Issues – GAAP/CPA issues

7. Tax considerations- both seller & buyer

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Factors Affecting Alternative Forms

of Legal Entities1. Control by owners2. Management autonomy3. Continuity of ownership 4. Duration or life of entity5. Ease of transferring ownership 6. Limitation on ownership liability7. Ease of raising capital8. Tax Status – flow through or not,taxable?

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Form of Payment

• Cash (Simple but creates immediate seller tax liability)• Non-cash forms of payment

– Common equity (Possible EPS dilution but defers tax liability)– Preferred equity (Lower shareholder risk in liquidation)– Convertible preferred stock (Incl. attributes of common & pref.)– Debt (secured and unsecured) (Lower risk in liquidation)– Real property (May be tax advantaged through 1031 exchange)– Some combination (Meets needs of multiple constituencies)

• Closing the gap on price– Balance sheet adjustments (Ignores off-balance sheet value)– Earn-outs or contingent payments (May shift risk to seller)– Rights, royalties, and fees (May create competitor & seller tax

liability). CVRs etc.

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Sanofi/Genzyme materials – Chapter 1 website

Form of Acquisition: Buyer’s Perspective• Cash purchase of assets (Permits “cherry picking,” asset write-up; limits

liabilities, & no minority owners; but lose tax attributes and assets not specified in contract and incur transfer taxes)

• Cash purchase of stock (Assets transfer automatically but responsible for all liabilities and minority shareholders; avoids shareholder approval (buying from target shareholders); contracts and licenses may require consent to assignment)

• Mergers (More flexible payment terms, assets transfer automatically, no minority shareholders (potential “cramdown”) or transfer taxes but responsible for all liabilities and subject to shareholder approval)

• Alternatives to mergers – may be tax free– Stock for stock (By operating as subsidiary avoid need for contract &

license consent as continuity of ownership maintained; avoids target shareholder approval; possible EPS dilution)

– Stock for assets (Similar to cash purchase of assets)• Staged transactions (Provides greater strategic flexibility but postpones

synergy realization) – Creeping acquisition – Icahn raider & Genzyme

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Legal Form of Selling Entity

• A seller’s concern about the form of acquisition (i.e., sale of assets or stock) may depend on its own legal structure.

• C-corporations are subject to double taxation, while subchapter S, limited liability companies, and partnerships are not.

• C corporation shareholders generally prefer a stock for stock transaction to defer their tax liability. IRC § 368

• Subchapter S, limited liability companies, and partnership investors may be indifferent to a sale of assets or stock.

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Accounting Considerations

Considerations• Contingent payouts valued at

acquisition date (closing) and revalued as new data becomes available

• Deals valued at closing rather than announcement date

• Goodwill periodically reviewed for impairment. Should be done prior to deal being finalized on the Seller’s dime.

Implications• Potential increase in earnings

volatility may make earn-outs less attractive as form of payment - Genzyme

• Value of equity-financed deals can change significantly between announcement and closing

• Threat of major write-downs may discourage overpayment for targets

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Tax Considerations: Impact on Seller Shareholders

• Business combinations may be – Tax free– Partially taxable– Wholly taxable

• Non-taxable transactions occur when mostly acquirer stock is used to buy substantially all of the target’s stock or assets.

• Taxable transactions occur when the acquirer uses– Something other than its own stock. i.e. cash or boot– Buys an insufficient amount of the target’s stock or

assets.

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Tax Considerations: Impact on Combined Businesses’ Shareholders

• Avoiding double (i.e., by firm and shareholder) or triple taxation (i.e., by firm; shareholder on sale proceeds & possible liquidating dividend)

• Allocating losses to owners

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