What risk factors are hiding in your business that could sabotage a sale or merger?
Mergers are a common goal for growing companies – whether it’s a sale of their business or acquisition of another one. But what you may not realize is that prospective buyers or sellers will look deep under the hood of your business, and often they don’t like what they find. We work with companies early on to determine what risks are hiding in plain sight – and how to mitigate them well ahead of a merger.
In a mergers and acquisitions (M&A) transaction, there are several key considerations from legal, financial, strategic, and operational perspectives – as well as pitfalls both big and small. Below, we’ll discuss the main considerations when considering an M&A deal, and options for structuring the transaction once you’ve decided to move forward.
Determining Whether a Merger is a Good Fit
There are countless factors that go into deciding whether to buy a company, or sell your own company. Here are a few that tend to be fairly universal, regardless of the size or industry of the relevant parties:
- Synergy: An assessment of potential synergies that can be realized from the merger or acquisition, including cost savings and revenue enhancements.
- Strategic fit: An evaluation of how well the target company aligns with the acquiring company’s long-term strategy.
- Market position: An examination of the effects on market position and competitive landscape.
- Financial considerations:
- Valuation: Determining the appropriate value of the target company using various valuation methods.
- Financing: Securing the necessary funding and deciding on the mix of cash, debt, and equity.
- Return on investment: Analyzing the expected financial return and the time horizon for realizing those returns.
- Tax implications: Understanding the tax consequences of the transaction for both buyers and sellers.
- Due diligence:
- Financial audit: A detailed review of the target’s financial statements, tax records, liabilities, and forecasts.
- Legal compliance: An assessment of the target’s legal compliance and potential legal risks, including ongoing litigation or regulatory issues.
- Operational review: Scrutiny of the operations for inefficiencies or risks in supply chains, IT systems, and workforce.
- Cultural assessment: Identification of cultural differences that might affect post-merger integration.
- Legal and regulatory considerations:
- Contract review: An examination of material contracts, including customer and supplier agreements, leases, and employment contracts.
- Intellectual property: Assessment of the ownership and potential risks related to intellectual property.
- Antitrust issues: Addressing potential antitrust concerns and obtaining required regulatory approvals.
- Legal structure: Deciding on the legal structure of the transaction – for example, asset purchase, stock purchase, or merger.
- Risk assessment:
- Risk analysis: An evaluation of the potential risks involved, including market risks, regulatory changes, and integration risks.
- Contingencies: Planning for contingencies, including setting aside reserves for unexpected liabilities or unforeseen challenges post-acquisition.
- Human resources:
- Key personnel: Identifying and retaining key executives and staff of the target company.
- Employment matters: Addressing employee benefits, compensation, potential layoffs, and integration of human resources policies.
- Cultural integration: Ensuring a smooth cultural integration to retain talent and maintain morale.
- Post-merger integration:
- Integration planning: Developing a detailed plan for integrating operations, cultures, and systems.
- Communication strategy: Crafting a strategy to communicate effectively with all stakeholders, including employees, customers, and investors.
- Execution: Executing the integration plan while maintaining business continuity.
Understanding and carefully managing these considerations is crucial for the success of an M&A transaction. Any oversight can lead to integration difficulties, a failure to realize synergies, cultural clashes, and value destruction. Successful M&As are those where all aspects are thoroughly vetted, and there is a clear plan for not only combining businesses but also for future growth and profitability.
Structuring the Merger
There are many different ways to structure a merger or integration of two businesses. But the most common arrangements are an asset or stock sale. Below, we’ll examine the differences between these two structures, and the advantages and disadvantages of each.
In an asset sale, the buyer purchases individual assets of a company, such as equipment, inventory, licenses, and customer lists, as well as assumes certain liabilities. The selling company retains possession of the legal entity and pays off any remaining liabilities not assumed by the buyer.
This structure has both advantages and disadvantages for each party – let’s explore those a bit below.
- Advantages of asset sale for the buyer:
- Selective acquisition: The buyer can pick and choose which assets to acquire and which liabilities to assume.
- Depreciation: Purchased assets can potentially be stepped-up to their current fair market value, offering a new basis for depreciation.
- Fewer liabilities: The buyer can generally avoid inheriting the seller’s previous liabilities (except for those explicitly assumed).
- Disadvantages of asset sale for the buyer:
- Complications: Asset sales can be complex, requiring new titles and transfers for each asset.
- Potentially higher costs: Asset purchases may incur higher taxes since they often involve the transfer of tangible assets subject to sales tax.
- Advantages of asset sale for the seller:
- Control over assets: The seller has the ability to retain certain assets they do not wish to sell or which are personally valuable.
- Partial sales: They can sell off parts of the business in an asset sale, thereby potentially continuing operations with reduced scope if desired.
- Flexibility: Transactions can be structured to exclude unwanted liabilities, although buyers generally resist assuming liabilities.
- Disadvantages of asset sale for the seller:
- Taxation: Asset sales can result in higher taxes for the seller. This situation typically occurs when the assets sold are depreciated and their sale results in recapture taxes, which are taxed as ordinary income.
- Retained liabilities: The seller might retain certain liabilities that the buyer does not agree to assume, which can become a burden post-sale.
- Complex contracts: The sale and transfer of contracts and agreements (especially those without assignable clauses) can be complex and may require third-party consent.
In a stock sale, the buyer purchases the selling company’s stock directly from the shareholders, thereby acquiring the company as a whole, including all assets and liabilities.
- Advantages of stock sale for the buyer:
- Simplicity: Transfers of ownership are straightforward; the buyer purchases the stock of the company, and in turn, takes over the company as it stands.
- Continuity: Contracts, licenses, and other agreements typically remain in place since the legal entity does not change.
- Disadvantages of stock sale for the buyer:
- Liabilities: The buyer inherits all liabilities of the company, including known and unknown.
- Potentially lower depreciation: The tax basis of assets remains the same; therefore, the buyer does not benefit from stepping-up assets to their fair market value.
- Advantages of stock sale for the seller:
- Simplicity in liabilities: In a stock sale, the seller can pass all liabilities associated with the business onto the buyer, which can result in a cleaner exit.
- Potential tax benefits: Sellers may benefit from capital gains treatment on the sale, which can lead to lower tax rates compared to the ordinary income rates that might apply in an asset sale.
- Whole entity sale: Selling the entire entity can be simpler logistically and less time-consuming than an asset sale that involves individual assets and negotiations.
- Disadvantages of stock sale for the seller:
- Price adjustments: Buyers may demand a lower price in a stock sale to compensate for the additional risk they take on by acquiring all the liabilities.
- Minority shareholders: If not all shareholders are on board, a stock sale could be complicated or blocked by those holding minority interests.
- Warranties and indemnities: Sellers might have to provide extensive warranties and indemnities about the state of the company to the buyer, which can have financial implications after the sale.
Determining the best approach depends heavily on the specific tax implications for the seller, the structure of the business’s assets and liabilities, and the goals of the seller post-transaction. Sellers often prefer stock sales due their potentially favorable tax treatment and cleaner exit strategy, while buyers may prefer asset sales to minimize risk and gain tax advantages. It’s a complex decision that should be made with careful consideration of the legal and fiscal ramifications, ideally with the advice of legal, tax, and financial advisors.
When determining whether to proceed with an asset sale or a stock sale, both parties will consider such factors as the tax implications, liability exposure, complexity of the transaction, and the specific goals of the buyer and seller. The choice between an asset or stock sale is a strategic decision that can significantly impact the overall success and final terms of the deal.
Whether you’re preparing to buy or sell a business, or want to plan for the future, an acquisition involves months if not years of planning. Book an exploratory call with us to make sure you’re prepared.