Endorsements for Mergers and Acquisitions from A to Z, 2nd edition

Author: Andrew J. Sherman , Milledge A. Hart
Pub Date: 2007
Your Price: $24.95
ISBN: 081440880X
Format: Hardcover

 

• Mergers and Acquisitions from A to Z, 2nd edition
• Sample Chapter
• Praise for this book
• Table of Contents
• Request an Evaluation Copy, INSTRUCTOR ONLY!

Mergers And Acquisitions, Second Edition

Chapter 7

Structuring the Deal

There is virtually an infinite number of ways in which a corporate merger or acquisition may be structured. There are probably as many potential deal structures as there are qualified and creative transactional lawyers and investment bankers. The goal is not to create the most complex, but rather to create a structure which fairly reflects the goals and objectives of the buyer and seller. Naturally, not all of the objectives of each party will be met each time-there will almost always be a degree of negotiation and compromise. Virtually all structures, even the most complex, are at their roots basically either mergers or acquisitions, including the purchase or consolidation of either stock or assets. The creativity often comes in structuring the deal to achieve a particular tax or strategic result or to accommodate a multistep or multiparty transaction. This chapter will look at some of the typical structures as well as a few alternative types of transactions such as spin-offs, shell mergers, and ESOP's.

At the heart of each transaction are the following key issues which will affect the structure of the deal:

• How will tangible and intangible assets be transferred to the purchaser from the seller?
• At what price and according to what terms?
• What issues discovered during due diligence may affect the price, terms or structure of the deal?
• What liabilities will be assumed by the purchaser? How will risks be allocated among the parties?
• What are the tax implications to the buyer and seller?
• What are the long-term objectives of the buyer?
• What role will the seller have in the management and growth of the underlying business after closing?
• To what extent will third-party consents or governmental filings/approvals be necessary?
• What arrangements will be made for the key management team of the seller (who may not necessarily be among the selling owners of the company)?
• Does the buyer currently have access to all of the consideration to be paid to the seller or will some of these funds need to be raised from debt or equity markets?

There is a wide variety of corporate, tax and securities law issues that affect the final decision as to the structure of any given transaction. Each issue must be carefully considered from a legal and accounting perspective. However, at the heart of each structural alternative are the following basic questions:

• Will the buyer be acquiring stock or assets of the target?
• In what form will the consideration from the buyer to the seller be made (e.g., cash, notes, securities, etc.)?
• Will the purchase price be fixed, contingent or payable over time on an installment basis?
• What are the tax consequences of the proposed structure for the acquisition (see Chapter 6)?

 

Stock vs. Asset Purchases

Perhaps the most fundamental issue in structuring the acquisition of a target company is whether the transaction will take the form of an asset or stock purchase. Each form has its respective advantages and disadvantages, depending on the facts and circumstances surrounding each transaction. The buyer and seller should consider the following factors in determining the ultimate form of the transaction:

 

Stock Purchases

The Buyer's Perspective: Advantages

1. Tax attributes carryover to buyer (e.g., net operating loss and credit carryforwards).
2. Avoids many of the restrictions imposed on sales of assets in loan agreements and potential sales tax.
3. Preserves the right of the buyer to use seller's name, licenses and permits.
4. No changes in corporation's liability, unemployment or workers' compensation insurance ratings.
5. Nontransferable rights or assets (e.g., license, franchise, patent, etc.) can usually be retained by the buyer.
6. Continuity of the corporate identity, contracts and structure.

 

The Seller's Perspectives: Advantages

1. Taxed only on the sale of stock.
2. All obligations (i.e., disclosed, not disclosed, unknown and contingent) and nontransferable rights can be transferred to the buyer.
3. Gain/loss is usually capital in nature.
4. If stock held by individuals is IRC Section 1244 stock and is sold at a loss, the loss is generally treated as ordinary.
5. May permit sellers to report gains from sale of stock on the installment basis.
6. Does not leave the seller with the problem of disposing of assets which are not bought by the purchaser.

 

The Buyer's Perspective: Disadvantages

1. Less flexibility to cherry pick key assets of seller.
2. The buyer may be liable for unknown, undisclosed or contingent liabilities (unless adequately protected in the purchase agreement).
3. No step-up in basis (i.e., seller's basis is carried over to the buyer at historical tax basis).
4. Normally does not terminate existing labor union collective bargaining agreement(s) and generally results in the continuation of employee benefit plans.
5. Dissenting shareholders' have a right of appraisal for the value of their shares with the right to be paid appraised value or remain a minority shareholder.

 

The Seller's Perspective: Disadvantages

1. Offer and sale of the company's securities may need to be registered under certain circumstances.
2. Seller cannot pick and choose assets to be retained.
3. May not use the corporation's net operating loss and credit carryforwards to offset gain on sale.
4. Loss on sale of stock may not be recognized by corporate shareholder who included the company in its consolidated income tax return.

 

Asset Purchases

The Buyer's Perspective: Advantages

1. The buyer can be selective as to which assets of target will be purchased.
2. The buyer is generally not liable for seller's liabilities unless specifically assumed under contract.
3. Step-up in basis of assets acquired equal to purchase price allowing higher depreciation/amortization deductions.
4. Buyers are generally free of any undisclosed or contingent liabilities.
5. Normally results in termination of labor union collective bargaining agreement(s) and employee benefit plans may be maintained or terminated.
6. Buyers may elect new accounting methods.

 

The Seller's Perspective: Advantages

1. Sellers maintain corporate existence.
2. Ownership of nontransferable assets or rights (e.g. licenses, franchises, patents, etc.) are usually retained.
3. Corporate name and goodwill can generally be maintained.
4. Corporation's tax attributes (e.g., net operating loss and credit carryforwards) are retained.

 

The Buyer's Perspective: Disadvantages

1. No carryover of seller corporation's tax attributes (e.g., net operating loss and credit carryforwards).
2. If a bargain purchase, step-down in basis of assets.
3. Nontransferable rights or assets (e.g., license, franchise, patent, etc.) cannot be transferred to buyers.
4. Transaction more complex and costly in terms of transferring specific assets/liabilities (i.e., title to each asset transferred and new title recorded; state sales tax may apply).
5. Lender's consent may be required to assume liabilities.
6. Loss of corporation's liability, unemployment or workers' compensation insurance ratings.

 

The Seller's Perspective: Disadvantages

1. Double taxation if the corporation also liquidates.
2. Generates various kinds of gain or loss to sellers based on the classification of each asset as capital or ordinary.
3. Transaction more complex and costly in terms of transferring specific assets/liabilities (i.e., title to each asset transferred and new title recorded; state sales tax may apply).
4. Bill of Sale must be comprehensive with exhibits attached in order to ensure that no key assets are overlooked and as a result not transferred to the buyer.
5. A variety of third-party consents will typically be required to transfer key tangible and intangible assets to the buyer.
6. Seller will be responsible for liquidation of the remaining corporate "shell" and distributing the proceeds of the assets sale to its shareholders, which may result in a double taxation unless a Section 338 election is made.
7. Asset acquisition requires compliance with applicable state bulk sales statutes, as well as state and local sales and transfer taxes.

 

Tax and Accounting Issues Affecting the Structure of the Transaction

In a given merger or acquisition, there is a wide variety of tax and accounting which must be considered and understood as part of the negotiation and structuring of the transaction. These issues will affect the valuation and pricing as well as the structure of the deal and may be a condition precedent to closing. This section will provide an overview of the basic tax and accounting issues to be addressed in a merger or acquisition, but will be limited to a summary because the tax laws are very complex and constantly changing. You should discuss the accounting issues with the Certified Public Accountant (CPA) who will serve as a part of the acquisition team.

Mergers and acquisitions may be completely tax-free, partially tax-free or entirely taxable to the seller. Each party and their advisors will have their own, often differing, views on how the transaction should be structured from a tax perspective, depending on the non-tax strategic objectives of both buyer and seller in the transaction and the respective tax and financial position of each party. In some cases the tax consequences will be the primary driving force in the transaction and in other cases the tax issues are secondary or even a non-issue. In addition to the taxable aspects of the structure of the transaction, there will be a wide variety of other tax issues to be considered, such as the tax basis of the assets acquired, the impact of the imputed interest rules on the transaction, and the tax aspects of any deferred consideration and/or incentive compensation to the seller.

It is relevant to highlight an example that conveys the degree to which tax can be an impediment to a transaction. In one situation the CEO of the seller had negotiated a "carve-out" with his board, and received some of the new combined company's stock as personal income. That income, however, created over a million dollars in cash tax liability. This tax liability presented a significant challenge to getting the deal done. The CEO, who deserved credit for the deal, now had a strong incentive to prevent the deal from happening. Navigating tax liability issues, like the one in this example, are critical steps to successful deal closure.

The general tax-related goals of the seller usually include:

• Deferring the taxation of the gain realized on the sale of the business to a future date (such as if the seller acquires the buyer's securities, which may appreciate in value, but the seller need not generally pay taxes on these gains until these securities are sold).
• Classifying the income which is recognized as capital gain and not as ordinary income.
• Ensuring that cash is available to pay for taxes as they become due, and to avoid the "double tax" at both the corporate and the shareholder level.

Again, the strategic objectives must be balanced against the tax consequences. If the seller has an immediate need for liquidity or has no desire to receive the buyer's securities (the seller may not accept the buyer's post-closing vision and plans for the combined entities), then it will be difficult to achieve nontaxable status.

Over the years, the changes to the federal tax laws have chipped away at the buyer's motivations for having the transaction characterized as tax-free. The buyer's ability to "carry over" favorable tax attributes of the seller has been diminished such that the buyer's use of its own securities as consideration to pay the seller often have to do more with preservation of cash than with applicable tax laws.

If the transaction is taxable, then the "stepped-up" basis will be increased to equal to the fair market value of the consideration paid to the seller. If the transaction is non-taxable, the buyer is able to "carry over" the seller's tax basis to its own financial statements. If the buyer would prefer to carry these assets on the balance sheet at the stepped-up tax basis (such as if the buyer is paying much more than the seller's tax basis) or if the buyer would prefer not to issue securities to the seller to prevent dilution of ownership, then the buyer should opt for a taxable transaction. Based upon our experience, resolving the tax issues effectively between the parties is critically important. This issue directly impacts the price of the transaction and each party's perception of the fair value.

 

 

Most corporate acquisitions will be deemed to be taxable transactions if structured as either a purchase of stock or assets in exchange for cash, promissory notes or other forms of consideration. Nontaxable transactions usually fall more into the category of a merger in that they involve an exchange of the target company's stock or assets for the purchaser's equity securities or of a subsidiary created by the purchaser, coupled with some direct or indirect continuing relationship between the buyer and the seller and their respective shareholders. These nontaxable transactions must fall within one of several reorganization categories contained in IRS Code Section 368.

 

Tax-Free Reorganizations

If the parties choose to structure the transaction as a tax-free reorganization, then the requirements set forth below must be followed:

The three principal forms of "Tax-Free Reorganizations Under the Internal Revenue Code" are: (a) Type A Statutory Merger, (b) Type B "Stock-for-Stock" Merger, and (c) Type C "Stock-for-Assets" Merger.

 

"A" Reorganizations

A Type A reorganization is a statutory merger or consolidation under state law. No express limitations are imposed on the type of consideration that can be used in the transaction or on the disposition of assets prior to the merger. This is a very flexible acquisition device that permits shareholders to receive property including cash in addition to stock of the acquiring corporation.

 

"B" Reorganizations

Type B reorganizations are an acquisition by one corporation, in exchange solely for all or part of its voting stock or that of its controlling company. If, immediately after the acquisition, the acquiring corporation has control (at least 80 percent of the total combined with power of all classes of stock and at least 80 percent of the total number of shares of all other classes of stock) of such other corporation (whether or not the acquiring corporation had control immediately before the acquisition). Counsel to the buyer, however, must be particularly sensitive to any cash payment, such as a finder's fee or the payment of appraisal rights to dissenting shareholders.

 

"C" Reorganizations

Type C reorganizations are an acquisition by one corporation, in exchange solely for all or part of its voting stock (or that of its parent) and of "substantially all" of the properties of another corporation. The transferor corporation must distribute the stock, securities, and other properties it receives from the acquiring corporation, as well as any retained assets, as part of the plan of reorganization.

The tax aspects of the proposed transaction are among the most important issues to be addressed by the acquisition team. These laws are complex and are constantly changing. Therefore, knowledgeable advisors should be carefully consulted.

 

Accounting Issues

The pooling-of-interests method of merger accounting ended on June 30, 2001, almost without fanfare. Companies, especially financial firms and those in the high technology and pharmaceutical industries, often chose pooling as their way of avoiding the long-term earnings dilution from the amortization of goodwill against earnings. Goodwill was defined as the excess of cost of an acquired entity over the net of the amounts calculated for assets acquired and liabilities assumed.

The elimination of pooling has been muted to a large degree because of the new rules for treating acquired goodwill and intangibles in a purchase acquisition. Instead of the old approach of amortization of goodwill for up to forty years, companies now must subject the acquired goodwill to a complex annual "impairment test" aimed at determining whether there has been a decline in the value of that goodwill. Write-offs would be required only if the value has been impaired. The impact will be initially positive because of the goodwill aspect no longer requiring automatic amortization.

The new approach of the Financial Accounting Standards Board (FASB) is more complicated than amortization. Under the new FASB goodwill and intangible-asset measurement standards, companies generally must perform an impairment test yearly for each reporting unit. It is a two-step test that first determines whether the book value of acquired assets of the reporting unit exceeds the unit's so-called fair value-typically measured through discounted cash-flow estimates. If fair value is lower than book value, the company then must determine whether the fair value of the unit's goodwill is less than the goodwill's book value, which would necessitate an impairment loss being recognized. Companies have six months after adopting the new rules to perform the first step.

Since companies do not know in what year goodwill may become impaired, financial personnel may be challenged to predict earnings internally to a greater degree. Further, tension of FASB's new criteria for determining whether some acquired intangible assets, like patents, should be recognized separately from goodwill, and perhaps amortized over the asset's perceived life span, is created as a result of the new rules.

 

One Step vs. Staged Transactions

Another key issue regarding the structure of the deal is whether the entire transaction will be completed in one step or whether it will occur over a series of steps. The parties may want to get to know each other better before considering a full-blown merger or there may be some contingencies affecting the value of the company which are driving the buyer, or even the seller, to want to slow things down and consider a preliminary transaction as the first step. It is also plausible that the seller believes that the long-term value of the company may be much higher and as a result would prefer to keep "some of his chips still on the table."

 

 

For example, from the buyer's perspective, there may be certain governmental approvals needed which affect the seller's valuation, such as the approval of the Food and Drug Administration (FDA) for a new line of pharmaceutical or medical devices. These approvals may be two years away and if not obtained would significantly affect the value of the seller's business. In such a case, the buyer may want to consider an alternative and more preliminary initial structure, such as a strategic alliance (as a first step towards a merger) or a technology licensing agreement (as a first step towards an acquisition). There may even be certain shares exchanged to allow cross-ownership or the buyer may want to purchase a minority interest in the seller with an option to purchase the balance within six months after obtaining FDA approval.

Even the seller may have certain reservations about the buyer or want to see certain contingencies met before it commits to selling 100 percent of its business. The buyer may be waiting for some key third-party approval or event to take place, before which the seller is reluctant to commit, such as the buyer being in the process of filing for approval of an initial public offering (IPO) of its securities. If these securities are to serve as part of the seller's compensation, then it may be wise to wait to ensure that there will be a secondary market (and hence liquidity) for the shares before moving forward. In such cases, the parties would enter into a letter of intent but there would typically be a clause that allows the seller to walk away from the deal if the offering is unsuccessful.

Some transactions are multi-staged for strategic reasons and some may be structured to be one stage with the possibility of being multi-staged if certain post-closing contingencies are not met.

 

Method of Payment

The way in which the seller will be paid is quite clearly one of the most important aspects of structuring the deal. The method of payment for the acquisition of stock or assets ordinarily involves a balancing of business and tax considerations. Often a particular fact or set of circumstances will outweigh the others and determine the method of payment. Although the personal, strategic and tax needs of all parties must be considered, there are a wide variety of forms of payment which should be considered before a final decision is determined. These include cash, marketable securities, parcels of real estate, the rights to intangible assets (licenses, franchises, etc.), secured and unsecured promissory notes, the common and preferred securities of the purchaser (or their affiliates) (and often with the promise that these securities will one day be publicly-traded), earn-outs, consulting and employment agreements, royalty and license agreements or even the exchange of another business. All of these tools should be considered in structuring the elements of the purchase price.

For example, a seller concerned about the financial and/or business viability or the creditworthiness of a buyer will demand payment in cash for assets or stock being sold. Alternatively, a seller reluctant to completely dispose of an interest in a business or who wishes to defer tax to a later taxable year may be willing to take the buyer's stock and/or take back a promissory note as part of the consideration. Tax considerations may dictate the form of payment. From a buyer's perspective, debt is often preferable to stock since interest may be tax deductible. For example, in a leveraged acquisition the business assets acquired are expected to generate sufficient cash flow to pay off the debt incurred to acquire the assets.

 

Cash

It is often said that "cash is king." Although at first blush, most sellers envision that an all-cash deal is the preferred route, sellers must consider a wide variety of payment methods which in the long run may result in a much greater total price. There are certain circumstances, however, when an all-cash transaction makes sense, such as when the seller suspects that the buyer will be unable to honor the types of consideration mentioned above, which may rely on the buyer's long-term viability and credibility. From a buyer's perspective, an all-cash transaction can be internally financed, financed through an equity raise or in conjunction with a private equity fund, or financed through the cash flow of the combined companies and/or the acquired company, or even financed through asset-based lending, to be collateralized by the business assets or stock acquired.

 

Debt

If the creditworthiness of the buyer is high, then sellers may be willing to accept promissory notes from the buyer as part of the consideration. These promissory notes may be secured by the assets of the buyer, or by the seller's assets, or not at all. It is also possible that the notes will be subordinated to a senior commercial lender if the buyer borrows money from a bank as part of its capital to acquire the seller's business.

 

Stock

The securities of the buyer may constitute all or part of the payment to the seller for the business assets or stock. In some situations, common stock of the buyer or the newly-formed subsidiary (or even a new class of preferred stock) will be issued to encourage a seller to maintain an economic interest in the ongoing viability of the business assets or stock being sold. Under this type of payment structure, a seller can participate as a shareholder in any future growth in value or profits derived from the combined entities and is motivated to ensure the success of the business.

 

Convertible Securities

Convertible debt securities often enable buyers and sellers to obtain the benefits of both the stock and debt form of payment. From a seller's perspective, convertible debt securities provide "downside" protection and a fixed return while allowing the opportunity to reap the benefits of growth in value or profits derived from the combined entities. From a buyer's perspective, they provide the tax advantages of interest deductions while enabling buyers to avoid payments of principal at maturity should such instrument be converted into equity.

 

Contingent Payments

Often buyers and sellers will be unable to agree on the determination of the value of the assets or stock being sold or may want to reserve the right to adjust the terms of transactions in light of changes in circumstances or expectations. Contingent consideration provides for additional payments based on factors such as revenue targets, cash flow goals, or synergies achieved.

Similarly, the parties to an acquisition may provide for the repayment of cash or other considerations, through the use of escrows or other security arrangements, upon the occurrence of specified contingencies.

 

Nontraditional Structures and Strategies

There is a wide variety of nontraditional deal structures and acquisition strategies that are not as straightforward as a stock or asset purchase, such as spin-offs, roll-ups, leveraged buy-outs, and employee stock ownership plans. These deal structures are often a smaller slice of an overall corporate restructuring but nevertheless have grown as an increasingly larger part of the annual merger and acquisition activity.

 

An Introduction to Spin-Offs

Spin-offs are transactions designed to divest non-core operating divisions or assets (or divisions which have matured to the point of deserving or requiring standalone status) into their own independent operating company.

Although some respectable companies have been created as a result of spin-offs, it has also been said that "you don't spin off your crown jewels for no reason." Many spin-offs have been criticized by the IRS as trying to dump liabilities to spin-off entities which then have balance sheets laden with debt and a core focus with limited potential.

To qualify for favorable tax treatment, the transaction must meet the rigorous Internal Revenue Service business-purpose test designed to ensure that a spin-off has a valid business reason. Among the purposes which are acceptable to the IRS are that a deal will help with access to capital markets, debt-financing prospects, competitive position, management direction, or retention of key employees.

 

Leveraged Buy-Outs

A leveraged buy-out (LBO) is a transaction in which capital borrowed from a commercial lender is used to fund a large portion of the purchase. Generally, the loans are arranged with the expectation that the earnings of the business will easily repay the principal and interest. The LBO potentially has great rewards for the buyers who, although they frequently make little or no investment, own the target company free and clear after the acquisition loans are repaid by the earnings of the business. LBOs are often arranged to enable the managers of subsidiaries or divisions of large corporations to purchase a subsidiary or division which the corporation wants to divest, known as an "MBO," or management buy-out.

The LBO transaction will generally take one of two basic forms: the sale of assets or the cash merger. Under the cash merger format, the acquired company disappears upon merger into the acquiring company and its shareholders receive cash for their shares. Under the sale of assets format, on the other hand, the operating assets become part of the buying company but the selling company will generally be given the option of either receiving cash or continuing to hold their shares in the selling company.

At the heart of the LBO transaction are the dynamics of financing the acquisition by employing the assets of the acquired company as a basis for raising capital. Large unused borrowing capacity is the characteristic which typically enables a purchaser to use the seller's assets to borrow the purchase price. Specific factors which may exist to enhance borrowing capacity are: (1) large amounts of excess cash and cash equivalents such as certificates of deposit and other short term paper; (2) a limited amount of current debt; (3) demonstrated ability over a number of years to achieve substantial earnings; (4) substantial undervalued assets, which, when taken individually have a market value in excess of the depreciated value at which they are carried on the seller's balance sheets, sometimes called "hidden equity;" (5) subsidiaries with operations in unrelated industries which possess large amounts of excess properties that can be readily liquidated for cash without detriment to ongoing operations; and (6) the potential for "hidden cash flow" for the purchaser arising from income sheltered by depreciable property, the basis of which is readjusted upward as a consequence of the sale. Because of the complexities and uncertainties associated with arranging financing of this nature, the purchase agreement should provide that the obtaining of the financing by the purchaser is a condition precedent to the purchaser's obligations under the agreement.

 

Consolidations/Roll-Ups

Another major structural trend or strategy that became popular during the 1990s has been the consolidation or "roll-up." Under such a strategy, the buyer is a holding company which has targeted an industry which may be ripe for consolidation within a given region or market niche. The roll-up strategy may be horizontal or vertical in nature, but typically involves the aggressive acquisition of competitors in a given market to achieve operating efficiencies, synergies and market dominance. Obviously, antitrust laws are an issue (see Chapter 6) and some acquisitions will be friendly and some hostile. The consideration paid to the seller is usually the securities of the buyer. It is best to devise a plan and compensation strategy that provides incentive for the current management to stay in place and build up the value of their equity in the consolidated entity. The roll-up buyer must look at each deal to see how the target fits into the overall strategy and to look at the impact of the given acquisition on the earnings, valuation and taxes of the consolidated entities. If the consolidator (the buyer in a roll-up strategy) is public or close to an initial public offering, they must also consider the reaction of Wall Street, the business media and the investment bankers to each transaction.

Some "roll-up" companies are the result of certain private equity or venture capital firms picking target industries, hiring management teams to manage the consolidation process, and then financing the deals with their own capital resources. The well-managed roll-up companies have a specific strategic focus and rigid criteria for evaluating deals and are not just haphazardly accumulating companies to build an asset base or a revenue stream through consolidation. These better-managed companies are constantly searching for cross-marketing opportunities and operating efficiencies by and among their operating divisions to their customers as well as ancillary yet related products and services which can be added to the menu. From the seller's perspective, if you are approached by a consolidator who is offering primarily its own securities in order to "join the team," be sure to realize that most of your upside in the deal is tied to the ability of the buyer to successfully execute its business and consolidation plan. Make sure that you understand and agree with the buyer's strategy and vision, and that you are clear as to your role on a post-closing basis.

 

Selling to Your Staff: ESOPs as an Acquisition/Exit Strategy for Sellers

An employee stock ownership plan (ESOP) is an alternative available to sellers for disposing of their business which offers certain tax advantages to both seller and lender. There is a wide range of small- and middle-market companies who can not find a suitable buyer (or who choose to "sell" the company to their employees) and who therefore create an ESOP to buy all or substantially all of the company using deferred compensation. Two general categories of ESOP's are:

1. Leveraged ESOP. Uses borrowed funds (either directly from the company or from a third-party lender based on the guaranty of the company, with the securities of the employer as collateral) to acquire the employer's securities. The loan will be repaid by the ESOP from employer and employee contributions, as well as any dividends which may be paid on the employer's securities.
2. Non-Leveraged ESOP. A stock bonus plan (or contribution stock bonus plan with a money purchase pension plan) which purchases the employer's securities with funds from the employer which would have been paid as some other form of compensation (that were not provided by a third-party lender).

 

General Legal Considerations in Structuring an ESOP

ESOP's, as with all types of deferred compensation plans, must meet certain requirements set forth by the IRS. Failure to meet these requirements will result in the contributions by the sponsoring employer not being tax deductible. To ensure that you're in compliance with IRS regulations, when creating your ESOP you must:

• Establish a trust in order to make contributions. The trust must be for the exclusive benefit of the participants and their beneficiaries.

• Avoid discrimination in favor of officers, major shareholders or highly compensated employees, particularly regarding allocation of assets and income distribution. A good rule of thumb is that at least 70 percent of all non-highly compensated employees must be covered by the plan.

• Benefit no fewer than the lesser of: (1) 50 employees or (2) 40 percent or more of the employees of the plan sponsor.

• Invest primarily in the securities of the sponsoring employer. Although there are no strict guidelines, it is assumed that the ESOP portfolio will include at least 50 to 60 percent of the employer's securities at any given time.

• Vest in compliance with one of the minimum vesting schedules set forth by the IRS. The plan must adopt one of the following: (1) five-year "cliff" vesting (employee is vested after five years of service) or; (2) (7) seven-year "scheduled" vesting (20 percent fully vested after three years, increasing 20 percent per year until 100 percent vesting is reached after seven years).

• Establish voting requirements which conform to those of the IRS. Under the Code, voting rights may be vested in the trust's fiduciary, except under certain circumstances where rights must be passed through to the plan's participants. Generally, passing through becomes an issue when the vote will involve mergers, consolidations, reorganizations, recapitalizations, liquidations, major asset sales and the like. Voting rights in toto may be passed through to employees, however, at the discretion of the employer in structuring the plan. Failure to fully "pass through" these rights may raise personnel and productivity problems (if the employees do not feel like true owners and as a result are cynical about the ESOP) thereby defeating a major incentive for adopting the ESOP.

• Comply with IRS rules regarding the distribution of ESOP benefits/assets. The plan must provide for a prompt (within one year) distribution of benefits to the participant following retirement, disability, or death. The nature and specific timing of the distribution will depend in part on the cause for separation from service with the company as well as whether the sponsoring employer is closely-held as opposed or publicly-traded.

• The employer's contributions should be based on a specific percentage of payroll, such as a money-purchase pension plan, or based on some other formula, such as a percentage of profits, as is the case with some profit sharing plans. This form provides for maximum flexibility in that contributions are in the complete discretion of the employer. Each year the employer simply makes a determination of the appropriate amount of contribution. It should be noted that the plan provides for a minimum contribution sufficient to permit the plan to pay any principal and interest due with respect to a loan used to acquire employer securities. The employers' contribution may be made in cash or other property, including employer's securities. In the event that the employer contributes its own securities, it may obtain a so-called "cashless deduction." The employer is entitled to deduct the fair market value of the securities so contributed, and the contribution involves no cash outlay by the employer.

• Provide "adequate consideration" in connection with the purchase of employer stock in an ESOP. This requires some method for valuation of the shares be available. For publicly-traded companies, this is generally not a problem, since the prevailing market price is a sufficient indication of value. For privately-held companies, however, value must be determined by the fiduciaries of the plan acting in good faith. This will generally require an independent appraisal by a qualified third-party appraisal firm, initially upon the establishment of the ESOP, and at least annually thereafter (the cost and impact of such an appraisal on a closely-held company should be considered before adopting an ESOP plan).

 

Key Legal Documents in the Establishment of an ESOP

There is a wide variety of legal documents which must be prepared in connection with the organization and implementation of an ESOP by a seller. These documents must be prepared by counsel, however, only after input has been received by all key members of the company's ESOP Team (financial and human resources staff, accountants, investment bankers, commercial lenders, the designated trustee, the designated appraisal firm, etc.). The preliminary analysis which should be conducted prior to the preparation of the documents should include:

• Impact on dilution, ownership, control and earnings of the company
• Type of securities to be issued (common vs. preferred)
• Tax deductibility of contributions and related tax issues
• Registration of the securities, where required, under federal and state securities laws
• Employee motivation and productivity improvement analysis
• Current and future capital requirements and growth plans of the company
• Interplay of the ESOP with other current or planned employee benefit plans within the company
• Timetable for planning, organization and implementation of the ESOP

 

ESOP Documentation

Once these and other factors have been considered, and strategic decisions made, counsel may be instructed to prepare the necessary documentation. In a leveraged-ESOP, the documents may include: (a) ESOP Plan; (b) ESOP Trust Agreement (which may be combined with the Plan); (c) ESOP Loan Documentation, such as a loan agreement or note guaranty (the initial set of documents may be from the commercial lender to the sponsoring employer, with a "mirror-image" loan being made by the employer to the ESOP); (d) ESOP Stock Purchase Agreement (where stock is purchased from the employer or its principal shareholders); (e) Corporate Charter Amendments and Related Board Resolutions; and (f) Legal Opinion and Valuation Reports.

The primary issues to be addressed by each of these documents are as follows:

 

The ESOP Plan (Where Trust Agreement is Self-Contained)

1. Designation of a name for the ESOP
2. Definition of key terms (e.g., "participant," "year of service," "trustee")
3. Eligibility to participate (standards and requirements)
4. Contributions by employer (designated amount or formula; discretionary)
5. Investment of trust assets (primarily in employer securities, plans for diversification of the portfolio; purchase price for the stock; rules for borrowing by the ESOP, etc.)
6. Procedures for release of the shares from encumbrances (formula as ESOP obligations are paid down)
7. Voting rights (rights vested in trustee; special matters triggering employee voting rights)
8. Duties of the trustee(s) (accounting, administrative, appraisal, asset management, recordkeeping, voting obligations, preparation of annual reports, allocation and distribution of dividends, etc.)
9. Removal of trustee(s)
10. Effect of retirement, disability, death and severance of employment
11. Terms of the put option (for closely held companies)
12. Rights of first refusal upon transfer
13. Vesting schedules

 

ESOP Stock Purchase Agreement

1. Appropriate recitals
2. Purchase terms for the securities
3. Conditions to closing
4. Representations and warranties of the seller
5. Representations and warranties of the buyer
6. Obligations prior to and following the closing
7. Termination
8. Opinion of counsel
9. Exhibits, attachments, and schedules

 

 

 

© 2006 Andrew J. Sherman.
All rights reserved.
Published by AMACOM Books
http://www.amacombooks.org
A Division of the American Management Association
1601 Broadway, New York, NY 10019
To order call: 1-877-566-9441

Search the full text of this book