equity rollovers in m&a: bridging the finance and valuation...

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Presenting a live 90-minute webinar with interactive Q&A

Equity Rollovers in M&A:

Bridging the Finance and Valuation Gap Negotiating and Structuring Rollovers; Tax Considerations for Buyers and Sellers

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JUNE 7, 2017

David R. Hardy, Partner, Osler Hoskin & Harcourt, New York

George H. Wang, Partner, Barton, New York

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Financial vs. strategic buyers

Non-control, post-closing equity participation by seller’s management

team/founders Non-control

○ Typically 10 - 40%

Up to 49%

Type of security ○ Equity

Same rights as buyer or junior in rights

○ Debt - subordinated Seller Note

Anchor Investment vs. Tag-on portfolio acquisition

Objectives – Defer tax gain to rollover participants; step up to buyer

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Example 1

8-12% of the equity post transaction allocated/reserved for senior management

Example 2

Pursuant to a merger, or other mutually agreeable form of transaction, (x) one or more Investor(s) will acquire all of the equity of Target currently held by Old PE Fund, (y) the Phantom Equity (defined below) of Target will be redeemed by Target so that it is no longer outstanding and (z) substantially all of the equity currently held by the management team and management companies owned by the management team (the “Management Companies”) will be “rolled forward” so that the management team and the Management Companies will remain equity holders in Target post-Transaction. (20% pre-closing management participation)

Example 3

Seller Note: If the Company's ratio of indebtedness divided by LTM EBITDA will be less than 4.5 immediately as of the closing, then the Seller, or an affiliate of the Seller, will lend to the Company an amount in cash equal to the amount required to cause such ratio to equal 4.5. The definition of LTM EBITDA will be mutually agreed between the parties. Such loan shall be made pursuant to a promissory note on terms and conditions to be mutually agreed by the parties and will be subordinated to all other debt of the Company, and will be subject to a subordination agreement satisfactory to the lenders.

Seller Co-Investment: Due to the importance of the Seller to Target, Seller has the option to co-invest up to 49% of the closing equity value of the Target in order to share in the future equity appreciation.

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Incentivizes on-going management

Management participation in future appreciation Subsequent PE exit, IPO or sale

Aligns management with acquirer

Bridges financing and valuation gaps

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Representative deal terms from a recent PE term sheet:

Enterprise valuation = 6.1 x LTM historic EBITDA + 6.1 x post-closing

annualized, normalized quarterly EBITDA

Debt financing

○ Senior or mezzanine debt – up to 4.5 x LTM EBITDA

○ Seller note = shortfall of senior/mezz debt to 4.5 x multiple

Equity roll – co-invest up to 49% of closing equity value

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Potential conflicts of interest Fiduciary duty of rolling persons

Decision by conflicted members of board

Alignment with buyer vs. seller

○ Use Rep and Warranty Insurance to mitigate issue?

Selection of only certain rollover participants

Complication of negotiations Rights of the rolling management vs. buyer.

Equity vs. non-equity members of management

Equity of buyer and founders may not be of same class

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Type of equity Common vs. participating preferred (PIK dividends)

Tax considerations Stock vs. asset deal

Buyer’s basis step up vs. taxable roll-over parties

Ability to convert corporation to pass-through structure

○ Delaware vs New York entity

Acquisition at holdco or subsidiary level

Domestic vs. cross-border considerations e.g. Luxembourg CPEC structure

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Maintain percentage of equity

Maintain percentage of debt equal to equity percentage

Exceptions: Options and incentive plans to directors, employees and consultants

Redemption from majority shareholder (not to exceed 10%) for resale to new investors

Minority may not have financial wherewithal to buy

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Priority of Payment to Rollover participants Pari passu

Preferred return to PE fund/Fund and management ○ On IPO, Fund typically receives preferred return

“Promote” style compensation to management?

Liquidation preference to preferred?

Example 1 First, PE fund receives return of equity investment without any return on capital

Second, co-investors receive return of co-investment (based on closing value) without return of capital

Third, distributions pro rata

Example 2 First, PE fund and co-investors receive pro rata distributions until capital and deemed capital is

returned

Second, PE fund and co-investors receive distributions equal to 10.1% IRR

Third, co-investors receive a promote of 17.5% and PE fund and co-investors share pro rata in 82.5% balance

Example 3 Pro rata distributions to PE fund and management

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Tag along with debt or equity – pro rata Substantially all deals

Bear pro rata price adjustment, indemnity obligations

Exceptions to Tag-Along Sale to shareholders,

less than 10% Equity or Debt,

per registered offer

Drag along on sale of company or substantially all assets Any minimum price to require drag

Rights of first refusal / first negotiation More limited than Tag along/ drag along

Possible lock-up period

○ Three years, except for Permitted Transfers, vs. immediate right to sell

Board/Observer Seats 14

S-1 Demand Number

By whom

When – anytime, after qualified IPO

Piggyback Against whom – anyone, issuer only

Proper notice

Priority

S-3

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Voting Rights Board seat

Supramajority rights

○ Amend charter or capital structure

○ Change business

○ Change auditors or accounting principles

○ Make non cash distributions of profits

○ Merger or sale of business

○ Enter contracts or capital expenditures in excess of $

Veto rights

○ Wind-up or liquidate

Merger or sale of business

Dividends Rarely paid currently, accumulated and paid at liquidity event

Voting with majority on transfers of assets, acquisitions, election of Board

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Vesting – say three years

Permitted transfers

Right to initiate sale, including engage advisors and require rollover to participate in marketing efforts

Right to force partial sale of a development project

Rights regarding corporate opportunities: Side by side fund

Non-compete and customer/employee non-solicit covenants Term following rollover equity no longer having securities

Buyer having de minimus amount (10%)

Rights of redemption

Equity transfer restrictions

Access to financial statements and other information and personnel

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Subordination Fully subordinate vs. pari passu

Secured Second lien

Unsecured note

Acceleration on sale or change of control

“AHYDO” (accelerated high yield discount obligations) interest provisions Avoid adverse tax effect

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Mechanism for Fund to charge fees to target

Term – ten years, thereafter automatic renewal but terminable by PE fund

Advisory fee – 2% EBITDA or annual minimum

Expense requirement including counsel and auditor fees

Transaction fees – 1% of consideration for refinancing’s, equity or debt

offering, dividends recaps

Fees violative of financing agreements will accrue and be payable when

allowable

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Mechanism for Fund to charge fees to Letter of Intent

Rollover Agreement

Securityholders’ Agreement

Registration Rights Agreement

Certificate of Incorporation Rights, Preferences and Designations

Seller Note Non-solicit and non-competes

○ 3-4 year average non-compete

Advisory Agreement for Fund 20

George H. Wang is a corporate transactions attorney who focuses his

practice on mergers, acquisitions, joint ventures, investments and broad-

scope business transactions on behalf of clients in North America, Asia and

Europe. He has represented domestic and multinational clients on numerous

domestic and cross-border merger and acquisition, private equity, venture

capital and related transactions.

George has led several large cross-border private equity and merger and

acquisition transactions, including a transaction which was awarded 2013

Domestic Deal of the Year by LatinFinance.

George has represented strategics, private equity funds, their portfolio

companies and family offices in acquiring North American, Asian and

European targets, completing serial acquisitions, multi-continent M&A

transactions, acquisitions of United States public companies and “going

private” transactions and joint ventures.

George was recently named Cornell Asian Alumni Association Honoree of the

Year by his alma mater, Cornell University (B.S.) and The Cornell Law School

(JD). For more than a decade, George served as an Educational Counselor to

the Admissions Committee of The Massachusetts Institute of Technology

(S.M. in Engineering). He is the immediate past Board Chair of the Asian

American Federation, the leading pan-Asian Advocacy organization in the

New York metropolitan area working to advance the civic voice of Asian

Americans.

413906.1

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Seller Equity Rollovers in M&A

Tax Considerations

David R. Hardy, Partner

Osler, Hoskin & Harcourt LLP

New York City

[email protected]

Stafford Webinar June 7, 2017

LEGAL_1: 44339532.1

Tax Considerations Agenda

1. Deal Objectives

2. Basic Tax Consequences of Middle Market Acquisition Transactions

3. Requirements for Stepped-Up Basis to Buyer

4. Requirements for Tax-Free Rollover to Sellers

5. Restructuring Opportunities to Harmonize Buyer and Sellers Objectives

Equity Rollovers Tax Considerations

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a. Buyer’s Objectives

• Acquire Control

• Maximize After-Tax Returns – Stepped-Up Asset Basis

• Minimize Fiduciary Complexities or Impediments to Resale

• Preserve Historic Licenses Without Tax Contingencies

• Retain Key Management Personnel

b. Seller’s Objectives

• Achieve Liquidity Event

• Maximize After-Tax Proceeds – One Level of Tax

• To Retain a Participation in Post-Transaction Appreciation

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1. Deal Objectives

1. Deal Objectives (con’t.)

c. Structuring Tax Free Rollovers – With Basis Step-Up

• For Partnerships and Flow Through Entities

• For S Corporations

• For C Corporations

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2. Basic Tax Consequences

a. Share Sale of Taxable C Corporation

• Seller’s Sell Shares – Realize a Capital Gain on Shares Taxed 20% Rate – One Level of Tax

• Buyer Buys Shares – Obtains a Cost Basis in Shares. Share Investment is not Depreciable; Share Basis Will Only Produce a Tax Benefit When Resold.

b. Sale of C Corporation’s Assets

• Selling Corporation Pay Tax on Asset Gains at 35%; then Distributes Cash to Shareholder Who Pay Tax on Their Share Gains at 20% – Two Levels of Tax (But Consider Shareholder Goodwill and Non-Competes)

• Buyer Get Stepped Up Asset Basis, Including Goodwill and Going Concern Value Amortizable Over 15 Years; Avoids Historic and Contingent Liabilities.

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2. Basic Tax Consequences (con’t.)

c. Sale of Partnerships, Branches, or Disregarded Entities

• All Transparent or Flow-Through Entities.

• Buyer May Buy Ownership Interest or Assets; Purchase Price Treated as Paid for Assets. Stepped-Up Asset Basis Increases Depreciation and Amortization Allowing Tax Sheltered Cash Flow to Pay Down Acquisition Debt.

• Sellers Sell Assets or Ownership Interests in the Entity. Sellers Realize a Capital Gain on Assets – One Level of Tax at 20% Rate (Except Depreciation Recapture Taxed at Ordinary Rates).

d. S Corporation – Treated as Modified Flow Through.

• Sale of Assets Gives Buyer Stepped Up Asset Basis – Selling Shareholders One to Level of Tax (Asset Gains May Flow Through at Ordinary Rates for Receivables and Depreciable Assets).

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2. Basic Tax Consequences (con’t.)

• Consider §1374 Entity Level Tax for S Corporations That Have Converted From C Corporations During the Prior 5 Years.

• Sale of Shares Gives Buyer a High Share Basis, No Asset Step-Up; Sellers have one Level of Tax.

e. Section 338 Election (Similar Results May Exist Under 336(e))

• 338(g) Allows Sale of Shares to Be Treated as an Asset Sale by the Target Company (Tax Obligation Retained in the Entity).

• 338(h)(10) Allows Shares Sale to be Treated as an Asset Sale But Asset Gains are Taxed to Selling Consolidated Group or Selling S Corp Shareholders (Tax Thrown Back to Sellers).

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3. Requirements for Step-Up

a. Buyer’s Asset Step-Up Requires

• Asset Purchase

• A Constructive Asset Purchase – Purchase of Transparent Entity (Partnership, Branch or Disregard Entity)

• Deemed Asset Purchase Under Section 338

b. Asset Purchase is Prohibitively Expensive if:

• Seller is a C Corp. with Substantial Asset Gains (Self Created Goodwill Has a Zero Basis)

• Seller is a C Corp. without a Large NOL

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3. Requirements for Step-Up (con’t.)

c. Section 338 Requirements

• Buyer Acquires 80% of Vote and Value of Shares

• Share Acquisition Obtained by Purchase (Not Non-Taxable Share Contribution or Tax-Free Reorganization)

• Share Acquisition Must Occur Within a 12-Month Acquisition Period

• Buyer Election 338(g) (Basic 338) or Mutual Election by Buyer and Seller Under 338(h)(10) with Agreed Upon Purchase Price Allocation (i.e., Tax Thrown Back to Sellers)

• Difficult for Tax Free Rollover Because All Target’s Assets Have Been Sold All Selling Shareholders Will Recognize Proportionate Share of Taxable Gain

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4. Requirement for Tax Free Rollover

a. Generally All Sellers Will Be Taxable on Cash Received for Target Equity

b. Compensatory Shares Will Generate Ordinary Income to Employees. Post Closing Vesting Requirements are Inconsistent with Rollover Treatment

c. Sellers Either: (i) Don’t Sell (Some or all Sellers Retain Some or all Equity), or (ii) Exchange Old Equity for New Equity in a Tax Free Incorporation Transaction

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4. Requirement for Tax Free Rollover (con’t.)

d. Consistency with Buyer’s Asset Step-Up Objectives

• Target Partnerships are Most Consistent with Competing Objectives – Sellers One Level of Tax with Rollover Opportunity and Buyers Step-Up

• Sellers Retaining Equity in Excess of 20% can Prevent §338(h)(10) Election

• For Target S Corporations and C Corporations – Certain Structures Exist

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5. Harmonizing Buyer and Seller Objectives

a. Flow Through Targets

• Partnerships, LLC Treated as Partnership, and Disregarded Entities are not Taxed as Entities. Taxable Income Follows Through to Owners

• Flow Through Entities Most Easily Accommodate Harmonization of Buyer’s Stepped-Up Basis with Seller Rollover Opportunity

• Seller Rollover Can Be Proportionate or Disproportionate

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5. Harmonizing Buyer and Seller Objectives

b. Flow Throughs

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Shareholders

Private

Equity

Partnership

Target

Management

70%

• Example

• Buyer obtains a

Basis Step-Up in

Partnership Assets

for its Purchase

Price (§§754 and

743)

• Sellers Retained

Rollover Shares can

be Proportionate or

Disproportionate

• Introducing New

Holdco Can

Complicate

Analysis. (See

§§708 and Rev.

Rul. 99-6)

Cash

5. Harmonizing Buyer and Seller Objectives (con’t.)

c. C Corporation Target – Rollover and Step-Up Together are Difficult

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Shareholders

Target

Private

Equity

Holdco

New

Target

• Rollover Without Step-

Up – Shareholders Sell

Some Shares to P.E. in

Taxable Transaction;

Shareholders Retain (or

Contribute to Holdco)

Rollover Equity

• No Tax Basis Step-Up to

Buyer or Holdco!!

(Might Consider Interest

Expense on Acquisition

Debt at Holdco Offset or

Shareholder Level

Goodwill)

• Rollover can be

Proportionate or

Disproportionate


d. C Corporation Target – Basis Step-Up But With Two Levels of Tax

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Private

Equity

Shareholders

Target

Target

Assets

• Part Sale / Part Retained

Ownership. Say P.E.

Fund Contributes Cash

for 70% of Targets

Assets

• P.E. Fund Buyer Gets

Asset Step-Up for Its

Benefit Only (§743)

• Selling Shareholders

Have Two Levels of Tax

on Cash Portion of the

Transaction


e. S Corporation Target

• Section 338(h)(10) Election Available to Treat Stock Sale as an Asset Purchase (Buyer Gets Step-Up)

• Buyer Must Acquire 80%; All Assets Deemed Sold

• S Corp.’s Taxable Gain Allocated to Selling Shareholder’s – Pro-Rata. (Target Sellers Seeking Rollover will be Taxable)

• Buyer Acquires Historic Entity with any Tax Contingencies

f. F Reorganization Structure – Preserves Historic Licenses,

but Buyer Avoids Historic Tax Contingencies 37



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Private

Equity

Shareholders

Target

Target

LLC

• F Reorganization Steps:

• Seller’s Drop Target S

Corp. into New

Holdco and Elect Q

Sub Status – Tax Free

• §368(a)(1)(F)

• Sellers – Merge Target into

LLC

• Buyers Purchase all or

Most of LLC. Not a 338,

but a Partnership Purchase

(Can Acquire Less than

80%)

• Buyer gets Stepped Basis;

Sellers gets One Level of

tax and Proportionate

Rollover Opportunity.

Holdco C

New S

Cash

Target LLC

Units

Bio

David’s practice focuses on corporate and international tax including the tax issues affecting corporations in the energy industry. He has been involved in cross-border merger transactions, including public company stock acquisitions, joint ventures, project financings, cross-border security issuances, inbound and outbound securities, real estate and private equity partnerships. David is the past President of the International Tax Institute in New York, past chair of the Taxation Committee of the International Bar Association and a long time member of the Executive Committee of the NYS Bar Tax Section. In addition, he is a frequent speaker at tax conferences and frequently writes on various topics. He has been the principal author of a number of NYS Bar Tax Section reports on subjects including the anti-double dip finance provisions, the anti-hybrid provisions of the U.S.-Canada treaty, the non-recognition rules regarding the outbound transfers of intangible property, and the consistency principle in tax treaty interpretation.

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