MERGERS, ACQUISITIONS, REORGANIZATIONS, SPIN-OFFS, LIQUIDATIONS, AND BANKRUPTCY
Business valuations are frequently performed when one company acquires another company, when a company is targeted for an acquisition, when a company’s capital structure is reorganized, when a company splits up, or when a company enters bankruptcy in liquidation or reorganization. The transactions may include entire or partial acquisitions, divestitures, liquidation, or recapitalization. Mergers will generally require both companies to be valued, while an acquisition may require only a single valuation. The terms of the transaction generally include cash, notes, stock, or a combination of these forms of payment.
In bankruptcy, in addition to the involvement of the different classes for creditors and the Reasons Frequently, the transaction can also provide the seller with a tax-free transaction under Internal Revenue Code (IRC) section 1031. It also provides the seller with the opportunity to take advantage of the tax deferred appreciation of owning the acquirer’s stock. This can be a good or a bad thing. This can also create work for the valuation analyst.
For doing this can include estate tax consideration, family conflict, or sale of only part of the total business. In the liquidation of a corporation, the valuation analyst’s allocation the assets distributed to the shareholders may be required to substantiate subsequent depreciation and other deductions claimed. Many publicly traded companies have acquired closely held businesses by using restricted stock (Rule 144 stock) as the form of payment. The advantage of using stock as a form of payment is that the acquirer does not have to use cash to make the acquisition.
ALLOCATION OF PURCHASE PRICE(2)
An allocation of the purchase price may be performed for either tax or financial reporting purposes. Each of these assignments will be accomplished based on the applicable set of rules for the intended purpose. The tax rules have been around longer, so I am going to start with them.
Years ago, both the purchaser and seller would determine their own values and treat the purchase and sale of the assets differently. The purchaser did not want to buy goodwill because it was not tax deductible, and the seller wanted to sell goodwill because it was subject to lower capital gain tax treatment. This created some very interesting allocation between the buyer and the seller. The all around loser was Uncle Sam. However, the Tax Reform Act of 1986 changed all of that. IRC section 1060 requires that when a business is acquired, a valuation must be performed to support the allocation of the total purchase price to the component parts for income tax purposes. The law requires a uniform allocation of the purchase price based on an appraisal of shareholders, the approval of the bankruptcy, court is usually required. Closely held companies with two or more definable divisions may be split up or spun off into separate corporations. the underlying assets. The IRS now pays more attention to these transactions to ensure that the purchase price allocation is reasonable and is treated consistently by both the purchaser and the seller. An inappropriate or inconsistent allocation of the purchase price can result in an increased tax liability and, in some instances, penalties.
In 1993, the tax law changed, providing for intangible assets to be amortized over 15 years. This change reduced the necessity for valuation analyst to allocate the purchase price between different classes of intangible assets that had different amortization periods, or no amortization period (for example, goodwill) under the old law. Allocation of the purchase price continues to be a required service, although the tax law has made it a little easier.
Not all of allocations of the purchase price are performed for income tax purposes. In some instances, an allocation may be performed when it is necessary to value a certain component (assets or liabilities) of a company and not the entire equity of an enterprise. Example situation, a company was sold, and the value of the transaction was known, However the $17 million sales price was problematic because our client thought that her husband’s business was worth $5 million. After all, he told her this when they settled their divorce action based on this value. To say the least, she was not happy when she found out that the business was sold for $17 million, with the transaction closing about two weeks after the divorce was finalized. The court decided that she was entitled to her equitable share of the excess (due to the husband’s fraud), but, because the divorce was in a state that did not consider personal goodwill or personal covenants not to compete as part of the equitable distribution, she was entitled to the nonpersonal portion.
The valuation analyst representing the husband allocated a large portion of the purchase price to personal goodwill or personal covenant not to compete, or both. We had to allocated the purchase price to support the value of what our client was entitled to receive. This is an example of a non tax allocation of purchase price.
In addition to allocating the purchase price for tax purposes, generally accepted accounting principles (GAAP) also requires these types of valuations. The valuation analyst is frequently being called on to provide valuation services with respect to the pronouncements made by the Financial Accounting Standards Board (FASB). They include, but are not necessarily limited to the FASB Accounting Standard Codification (ASC) 805, Business Combinations (formerly FASB statement No. 141); FASB ASC 350, Goodwill and Other Intangible Assets (formerly FASB statement No. 142); FASB ASC Long Live Assets (formerly FASB statement 144); FASB ASC 820, Fair Value Measurement (formerly FASB No. 157), all of which deal with issues such as the determination of the fair value assets acquired and impairment of goodwill.
ESTATE, GIFT, AND INCOME TAXES
The valuation of a closely held business or business interest is important to estate planners as they consider the effect of the unified estate and gift tax credit on lifetime transfers of property.
IRC section 2036(c), relating to estate freeze techniques, was repealed and superseded by a new, complex set of rules in chapter 14 of the IRC (sections 2701-2704). These rules can be advantageous to the client, but the IRC and IRS regulations include strict provisions for compliance.
In addition to these items, the IRC contains special rules for the redemption of stock in a closely held company when the owner dies and the value of the stock represents more than 35 percent of the gross estate. Valuation analyst need to be aware of the alternatives under the IRC section 303.
Valuations performed for income tax purpose may include S corporation conversions due to the built in gains tax issues that arise if a sale occurs before the required holding period established by the IRC. Although these assignments do not occur as often as they did a few years ago, valuation analyst are still being approached to perform this assignment, especially in circumstances where the client did not listen to its tax accountants when he or she said that the client needed to do the appraisal at the time of the conversion. Clients frequently said, “I have no intention of selling my business during the next few years, so I am not worried about it.” Guess what? The built-in gains tax kicked in when the client received an offer to sell that was too good to pass up. Valuation analyst should consult applicable sections of the tax law to properly understand the unique requirements of S corporation valuation performed for a conversion.
Another practice opportunity that we are seeing show up is the allocation of purchase price for tax purpose. Although I discussed this before, we are starting to see more and more valuations arise when the seller of a business is attempting to allocate part of the sales price of a corporate entity to personal goodwill. We are talking about the difference between income taxes about the 35 percent and capital gains at 15 percent. That 20 percent can be a big number in tax savings.
In a marital dissolution, most of a couple’s assets and liabilities are valued, regardless of whether their state follows equitable distribution or community property rules. Frequently, one of the assets included in the marital estate is an interest in a closely held business. It is typical to have the business valued in its entirety if it is a small business, but sometimes only a portion of the business (for example, a minority interest) is valued in a large business. Usually the business is not divided between the spouses. Instead, one spouse keeps the business, and the other receives different assets of equal value. Because marital dissolution laws vary significantly from state to state, the valuation analyst must be aware of the rules of the state in which the divorce takes place. For example, in some states, goodwill associated with a professional is excludable from distribution, while in other states, it is includable. Another item that the valuation analyst must be aware of is the standard of the valued used in the jurisdiction of the marital dissolution.
Frequently, fair market value is the standard of valued discussed, but the application from state to state varies greatly from the definition found in tax laws. For example, Florida, fair market value has been interpreted to be the value of the business, assuming that the business owner walks away without a covenant not to compete. Logically, what willing buyer would purchase a business if the seller could open up next door and compete with him or her? In Pennsylvania, fair market value excludes personal goodwill. Clearly, the valuation analyst cannot be expected to know every state law, but he or she should ask the clients attorneys before proceeding in a direction that may have his or her report thrown out for failure to comply with the rules of the jurisdiction.
EMPLOYEE STOCK OWNERSHIP PLANS(5)
An employee stock ownership plan (ESOP) is an incentive ownership arrangement founded by the employer. In general, employer stock is contributed instead of cash. ESOP’s provide capital, liquidity, and certain tax advantages for private companies whose owners do not want to go public. An independent valuation analyst must value the employer’s securities, at least annually, and must determine the price per share supporting transactions with participants, plan contributions, and allocations with the ESOP engagement.
A buy-sell agreement allows a partner of shareholder in a closely held business to acquire the interest of a partner or shareholder who withdraws from the business. The agreement may contain a designated price or a formula to determine the price that the remaining owners of the entity will pay to acquire the interest. The price, or the formula, needs to be updated periodically. Payments and terms of the sale or also generally provided. A client may ask a valuation analyst to assist in determining which valuation method is appropriate in such agreement.
Buy-sell agreements are also used frequently to establish a value for a transaction between the partners and shareholders in the event of death, disability, or retirement. It is common to see different formulas for each event. The valuation analyst must be aware of IRC section 2703 and its effect on valuations when there is a buy-sell agreement in effect.
In working with the client, the valuation analyst should caution him or her, and possibly the entity’s legal counsel, about the use of a single formula. Formulas do not always appropriately consider the economic and financial climate of the valuation date, stand the test of time, or achieve the parties’ intention. Therefore, their usage should be limited. Instead, the basis of a buy-sell agreement should be a valuation. If an extensive valuation is required, it should be performed by a qualified valuation analyst.
Stockholders disputes can range from breakup of companies resulting from disagreements between stockholders to stockholder dissent relating to mergers, dissolutions, and similar matters. Because many states allow a corporation to merge, dissolve, or restructure without unanimous stockholder consent, many dispute have arisen over the years because minority stockholders have felt that the action of the minority had a negative impact on them. Dissenting stockholders have filed lawsuits to allow their shares to be valued as if the action never took place. StockHolder Disputes affect not only how the enterprise premise of value is valued. It may also negatively impact how and who has control to authorize necessary operations conducive to the business by appointment of assignment of shareholder Majority Or Minority Interest and the classes of stock issued or tender albeit voting or nonvoting stock along with the class of stOck whether its class A, B, or C.
In such cases, the value of the shareholder’s interest is what it was immediately before the change; it does not reflect the impact of the proposed change on the value of the corporation. In these instances, the value is generally determined according to the standard of fair value, based on either statute or the case law within the state of incorporation. When a valuation analyst accepts an engagement relating to shareholder action, it is advisable for him or her to request the client’s legal counsel to clarify the value definition used in the particular state. The valuation analyst cannot address such issues as control premiums, minority discounts, and discounts for lack of marketability without adequate legal information about the value definition to be used.
Many states also have statutes to protect minority shareholders from being “oppressed” (abused) by the controlling shareholder (s). This is another instance where the valuation analyst much become familiar with the statutes and case law of the jurisdiction in which the legal action is pending.
A valuation of the business may provide lenders or potential investors with information that will help the client obtain additional funds. Financial statements represent information about a business based on the historical amounts. For a new business, the traditional statement may closely reflect the estimate current value. However, this is generally not the case for an established business that has developed intangible value of the years. Assets with intangible value (such a special trademark, patents, customer lists, and goodwill) may not be reflected in the financial statements. Furthermore, other assets and liabilities of the business (such as real estate and equipment) may be worth significantly more of less than the book value as recorded under GAAP.
AD VALOREM TAXES(9)
In some jurisdictions, ad valorem taxes are based on the value of the property used in a trade or business. Various entities are subject to ad valorem taxation, and, therefore the fair market value of such properties must frequently be determined to ascertain the amount of tax. Regulations and case law differ significantly from jurisdiction to jurisdiction. To determine the appropriate standard of value for these properties, the valuation analyst need to consult the client’s lawyer.
INCENTIVE STOCK OPTION CONSIDERATIONS(10)
Many large companies provide fringe benefits in the form of incentive stock option plans that allow their employees to purchase the company’s stock at a certain point in time and at a state price. Employees pay no taxes when incentive stock option is granted or when the stock option is exercised. Employees do pay taxes, however, when they sell the stock received through the exercise of the option. To qualify as an incentive stock option, a stock’s option price must be equal or exceed its fair market value when the option is granted. Accordingly, the valuation of a closely held company has a significant effect on its incentive stock option plan.
Over the past decade, stock options have become a major component of the employee compensation package. This is especially true for startup companies that may not have the cash flow to pay market rate of compensation to its employees. Instead, the employee works for the company for a lower salary but a very generous stock option plan.
INITIAL PUBLIC OFFERINGS(11)
A substantial amount of legal and accounting services must be rendered to bring a private business to the public marketplace. From a financial standpoint, the corporation’s accounting records and statements are carefully reviewed and amended, if necessary. The capital structure may need enhancement, and executive benefit plans may need revisions. More important, the corporation’s stock is valued for the initial offering.
The underwriter must exercise a great deal of judgement about the price the public may be willing to pay for the stock when it is first offered for sale. Such factors as prior years’ earnings, potential earnings, general earnings, general stock market conditions, and the stock prices of comparable or guideline companies need to be considered to determine the final offering price. The client may ask the valuation analyst to support the offering price by performing a valuation or a fairness opinion.
Many courts cases involve damages. Some cases relate to compensation sought for patent infringements, illegal price fixing, breach of contract, lost profits, or lost business opportunities, while others relate to lender liability, discrimination, and wrongful death actions. The valuation analyst may also be asked to perform hypothetical valuations of a company to determine the amount of damages resulting from the loss of business value (example, diminution of value) to the stockholders. These types of valuations generally require the valuation analyst to value the company twice. The first valuation determines the value of the company at the present time. The second valuation is based on what the company would have been worth had a certain action taken place or not taken place. The difference is generally a measure of damages.
Practitioners are cautioned to be aware of such decisions to ensure that the methodologies employed in these and other types of litigation are generally accepted in the literature. Using methods that are not generally accepted can result in the expert’s disqualification in litigation. This is sure to make for unhappy clients and attorneys. Keep in mind that these cases also apply more than just damages litigation. They are applicable to all types of litigation assignments.
Cases involving risk insurance claims focus on the loss of income because of business interruptions and the value of such separate business assets as inventory and equipment. A valuation may be required to support the owner’s position or the insurer’s position. The loss of income would be determined based on the documentable lost profits. The value of individual assets, such inventory and equipment, would be based on the replacement cost of these assets.
Owners of closely held businesses may wish to give all or part of their interest in a business to a favorite charity. Although shares of stock in a closely held business are donated to charity frequently, this option exists, and the valuation analyst must be aware of the income tax rules concerning the necessary documentation to be included in a valuation report for the deductibility of such gifts. Current tax laws encourage charitable donations by permitting a tax deduction equal to the fair market value of certain appreciated capital gain property. For gifts of property in excess of $500, the IRS requires donors to provide documentation to support the deduction for the year in which the gift was given. If the amount of the deduction warrants the expense, donors can obtain a valuation for the gift. If the value exceeds $5,000, a qualified appraisal is required.
EMINENT DOMAIN ACTIONS(15)
An eminent domain action takes place when the government exercises its right to take over property and must compensate the owner for any resulting reduction in the value of the property. For example, a business may have to forfeit a prime location to accommodate the widening of a street. Although the business can relocate, its value may be adversely affected during the period of the move or as a result of changing locations. An expert opinion on the monetary effect of the condemnation may be necessary to support the business owner’s claim or the government’s offer. As part of the business valuation, the valuation analyst should become familiar with the demographics of the area and should assess the impact of the change in location. In assessing the impact, the business valuation analyst needs to remember that real estate valuation analyst have often said that the key to a business’s success is “location”. Projections may be required to calculate the losses. A valuation of the business, both before the condemnation and after the move, may be required. The expense of the actual move needs to be considered in the valuation.
A service that is very closely related to business valuation is the fairness opinion. A fairness opinion is generally required when a corporation is involved in a merger, acquisition, going private, or other type of transaction where the board of directors wants to have an independent valuation analyst give its blessing to the transaction. This is a high risk type of service, and it should not be performed by a valuation analyst unless he or she really understands the nuances of the fairness opinion.
This service is frequently provided by investment banker (with deep pockets). However, many appraisals firms also offer this service. After the Sarbanes-Oxley Act of 2002, legislation was passed, many smaller publicly traded companies have gone private, requiring the fairness opinion. The purpose of the fairness opinion is for the valuation analyst to opine that the transaction is fair to the stockholders from a financial point of view. The valuation analyst does not determine value because there is already an agreed upon price for the transaction.
THE ROLE OF THE ADVISOR(17)
Frequently, corporations hire an adviser only to write an information memorandum describing the business for sale and to find a buyer. These can be valuable services for a seller and, in themselves, can justify hiring an adviser. Many corporations, including large one, do not have staffs experienced in, and dedicated to, writing information memoranda and do not maintain up-to-date files of potential buyers. However, the real value of an advisor goes far beyond writing memorandum and finding a buyer.
The advisor’s role can include orchestrating the marketing of the business, setting the schedule, contacting buyer, overseeing due diligence visits, and getting lawyers and accountants involved at the right time, among other duties. However, managing process means more than overseeing this kind of external event for the seller. Two of the greatest services an adviser can provide also include helping to manage the process inside the seller and performing “buyer’s due diligence.”
However, more importantly experienced Mergers & Acquisitions Advisor has to have a skillset of transactional knowledge as depicted below in arrears.
The Advisor will be key in transformative transactions involving Acquisitions, Tender Offers, Joint Ventures, Mergers, Spin Offs, Splits, Divestitures, Equity Carve Outs, Asset Sales, Minority Share Sales, Venture Capital, Initial Public Offerings, Leveraged Buy-Outs, Management Buy Outs, Employee Stock Ownership Plans, Stock Repurchase, Hostile Takeovers, Board Seat Amendments, Executive Team Changes,
Since divestitures are not every day event for most companies, they usually involve delegating special authority to that person responsible for carrying out the divestiture. For example, it is common in large corporations to delegate the responsibility of divesting a small unit to a staff person (corporate development officer) and give that person special authority for the transaction. Clearly, that should not include the ability to commit the corporation in matter as significant as setting an acceptable price, which might be the province of the board directors. It should, however, include the authority to ask line managers to attend the meeting on the sale when they would rather be attending to other problem, or to ask the legal department to give priority to reviewing information memorandum.
Because not every issue can be foreseen, the staff person at times has to run back up the chain of command to get authority. What happens, for example, when an important employee, who might even outrank the corporate development officer, attempts to improve his personal prospect with potential buyers? In that case a major decision needs to be made quickly. Perhaps the employee needs to be dismissed. At times the advisor helps manage the process internally by letting the seller know when, for example, its own decision-making process is not working well, or when the internal staff is having a hard time getting the job done.
Another roll of the advisor is to perform “buyer’s due diligence,” or, in other words, review the business through the eyes of the potential buyer. Almost by definition, a buyer will look at the business differently from the seller; indeed, that is what the seller should hope. Frequently, an advisor can highlight and emphasize those elements of a business that might appeal to buyers and discover value in areas where the seller saw little or none.
More importantly, the advisers role in performing “buyers due diligence” is to unearth problems before a buyer can discover them. A good buyer of businesses eventually will understand the business better than the seller, certainly better than management at corporate headquarters, and frequently better then management of the entity being sold. Generally, the less important a business is to the parent company, the sooner the buyer’s knowledge will surpass of the selling management.
In performing “buyer’s due diligence,” the advisor must have not only the experience and the time to do investigative work but the skills, both technically and interpersonal, to help solve any problems that are discovered. For example, it is not uncommon to discover financials that are not prepared in accordance with generally accepted accounting principle (GAAP). Often, both the parent and local management were unaware of that deficiency. In addition to being able to discover the problem, the advisor must have the ability to help solve it. Sometimes this is not an easy task if the solution requires that the parent reorganize past mismanagement.
In rare instances, it becomes apparent during “buyer’s due diligence” that a clandestine management buyout effort is under way. In such a case the advisor needs to proceed very carefully. But there will be more, later on dealing with management.
The role of the advisor can be quite narrow or quite broad, depending on the needs of the specific deal. And it is not always apparent at the outset what the needs will be. Selecting an adviser, the seller must be aware of the importance of having an advisor consultant with a broad range of skills and experience.
No issue is more important than how the parent corporation treats the management of the business to be divested and in no other area can mistakes have more dire consequences. A seller should make the assumption that at some point during the divestiture process management’s loyalty will switch from the seller to the buyer. At a minimum, management will be interviewing with prospective buyers for jobs. At the extreme, the managers will be trying to help the buyer purchase the business on favorable terms, especially if they have become part of the buying group, a situation quite common in the leveraged buy-outs of divested businesses.
One of the most common solutions to the problem of shifting loyalties is to pay a bonus to management if the members stay during the divestiture period and help facilitate the sale. Not only can a “stay bonus” help keep a manager focused on selling the business, but preserving the management team can even add substantial value to the business. One of the most important elements of value to a buyer can be an enthusiastic management team that is willing to work as hard for the new owners as it had for the former employer. The questions are how big the bonus should be and on what conditions should it be paid?
The first recommendation is not to be penny-wise and pound-foolish. The amount of money at risk in a divestiture generally far surpasses the amount required to motivate management. For the manager of a modest subsidiary, stay bonuses typically range from 50 to 150 percent of base salary. The amount needs to be large enough to motivate the manager to help sell the business, but it should not be tantamount to winning the lottery. Obviously, the proper amount depends upon he individual manager’s economic and other circumstances. In some cases, the bonus can be assumed by the new owner and paid out over time, giving the new owner some control over the behavior of the acquired group of managers.
Conditions of bonus payments vary greatly. The simplest condition is only that managers remain employed at the company until the closing of the deal. Such a condition does not, however, assure that the manager will represent the owners diligently in the selling process. To assure that, the bonus should be tied to the results of the divestiture, such as the manager’s level of cooperation throughout the sale process or the price ultimately attained. If management trusts the parent leadership, the bonus can be left to the subjective judgment of the seller. If there is a lack of trust between them, performance may be determined by the selling price, (the higher the price the greater the bonus).
The major difficulty with keying the bonus to purchase price is that to do so requires revealing the price objective of the seller to the managers whose loyalties will shift. Second, keying the bonus to purchase price does not motivate the manager to aid the seller on matters other than price; for example, on improving representations and warranties. One solution to this dilemma is the “Emperor’s Letter,” named after a Chinese emperor who, upon recognition that there would be a succession struggle between his two sons, designated his successor in a document to be opened at his death. Applying this principle, a seller would draw up a contract stipulating the bonus range for a corresponding range of prices, leaving some flexibility for subjectivity. The bonus range would be revealed to the manager but the price level would not. The letter would be opened at the closing. This technique has worked in certain divestitures. Parenthetically, the actual emperor’s letter was blank, but peace prevailed during his reign.
Problems with management also can be avoided by excluding management from any discussions on value. The management of a business being sold should not be party to or have any role in initial valuation discussions, preliminary price discussions, solicitation of bids, review of bids, or final price negotiations. Should potential buyers, employees, competitors, and other unit managers ask about price, the manager of the divested business should be coached to respond truthfully that he or she has not been privy to any discussions of value.
Finally, what is the best way to handle management that wishes to buy the business by executing its own leveraged buy-out, namely a management buy-out (MBO)? From the perspective of senior management of the parent company, an MBO of a subsidiary can seem to be an easy way to repay employees for years of good service by giving them the opportunity to become business owners. An MBO also may appear to be a convenient way to complete a transaction, because the employees do much of the work related to the sale. However, perhaps the most difficult situation for a seller to manage well is an MBO. All too often one sees an MBO that sputters, that drags on and on, often because the managers have trouble arranging the financing. There are some simple rules to help avoid that state.
The selling parent never should indicate to the management of a subsidiary that they will be given the opportunity to put together an MBO until the parent has decided, without help from management, that a leveraged transaction is easily achievable at a price that meets the parent’s objectives. In other words, the parent needs to complete a thorough valuation that incorporates up-to-date terms for debt and equity financing. Frequently, the parent will rely upon outside expertise to handle the calculations.
If an MBO group can, in fact, meet the parent’s price, and the parent wants to management a shot, the management-led team should not be simply told to proceed with a deal. The parent should give the MBO group written instructions on exactly how to proceed. Those instructions should include, among other matters, a schedule specifying the deadlines for obtaining financing and crossing other hurdles; an outline of the information to be used in speaking with investors and lenders; an indication of the terms of confidentiality. The parent ideally should introduce the MBO team to one or more equity sponsors with a reputation for getting transactions done and for simple, straightforward dealing. The parent should keep a record of all outside investors and lenders that review the transaction in case parent must get involved with the transaction. Finally, if the MBO does not work, which should not happen because the parent should give subsidiary management the green light only when there is a very high probability of success, management should be told that they have lost their opportunity forever. It is essential the sputtering.
When the parent does not want to give management the opportunity to buy the business, the best way to handle management’s natural desire to become proprietors is to convince them that their best strategy is to help sell the business. While the potential rewards of sponsoring their own transaction might seem great, they could become aligned with a weak equity partner and, in fact, lose the bid. Then they would have to scramble at the last minute to save their jobs. On the other hand, if they help sell the business and the winner is a buyout firm that lacks operating capabilities, management most likely will receive an equity interest. Moreover, the selling parent should be aware that many buyers simply will not compete if the management is a potential bidder.
In conclusion, many potential problems associated with an MBO can be avoided by following the aforementioned principles. To indicate how bad things can get if these principles are not adhered to, I recall one Fortune 100 company, which, after g to divest a noncore subsidiary, instructed the manager to find a buyer and negotiate the transaction, in essence to do the deal himself. The manager, whose loyalty probably shifted immediately upon receiving the instructions, generated two offers: one was from a buyer who wanted him to stay with the business; the other from a buyer who did not want him. Not surprisingly, the value of the first bid was substantially higher than the second. Also not surprisingly, the manager asked for a substantial portion of the difference to be paid to him personally as a bonus. Blackmail? Perhaps! But the manager had put himself in a position to create substantial value for seller, and he wanted a piece of it to close the higher bid.
The principal techniques for valuing a business are generally well understood and well-practiced by both good advisers and corporations, and their use has become almost routine. Some combination of a discounted cash-flow analysis, a review of the public market values, a review of comparable acquisition transactions, a leveraged acquisition model, and a merger pro forma or dilution analysis, along with a little judgement, can produce a reliable range of value. What varies among sellers, and produces some interesting lessons, is the way in which the range of value is used, once it is derived.
SALE OF MINORITY POSITION(20)
This is an interesting technique that has become a bit of a cottage industry. Warren Buffett is good at buying minority positions at what to him are attractive prices. This is typically a defensive strategy known sometimes as a white-squire or blocking position. We’re going to be seeing this more as a growth strategy. Company X will take a minority position in Company Y for the purpose of eventually exchanging the Y stock for a Y subsidiary that X would like to own for strategic reasons. This is more or less the Mobil-Esmark-Vickers deal. The tax law has changed since then. One can no longer do that kind of transaction back-to-back. In Mobil-Esmark-Vickers, the stock was acquired in the morning and surrendered after lunch for the desired subsidiary. This kind of transaction has to be done today as a tax-free split-off. The shareholder must be established as a historic shareholder, which means owning the stock with more permanence than was the case in Mobil-Esmark-Vickers.Never the less, you will see this minority sale strategy with increasing frequency, both for defensive and growth purposes. Having said that, the first step is having an advisor who has a strong foundation of understanding the valuation of ownership levels as it relates to Majority Interest and Minority Interest and how the two positions affect how a valuation is determined in the first place. Depicted below is a graph that can provide a basic understanding of the relationship of interest in a company within levels of ownership before and after the sale of a position in a company regardless of the subject company’s value.
All of us have read, probably more than we want to, about leveraged ESOPs. The most recent tax bill dealt with two familiar benefits—the tax advantaged loan and the dividends-paid deduction. The tax-advantaged loan essentially is a thing of the past except where the ESOP owns more than 50 percent of the stock of the company, a situation we’re not going to see very often. On the other hand, the more important benefit, the dividends-paid deduction—the ability of the company to deduct dividends paid on stock held by the ESOP—pretty much survived intact. And in response to that survival, Chevron Corp. announced—literally the day after the bill passed—a billion-dollar ESOP for tax reasons and probably for the traditional defensive purposes. The ability to deduct dividends is a powerful incentive to create a leveraged ESOP. They are going to be with us for a while.
These are what in the tax world are called tax-free reorganizations. These are invariably strategic transactions typically done by companies whose stock is relatively fully valued. It is a powerful form of acquisition currency. Taxes are not due at any level on the exchange itself. There can also be accounting benefits if the transaction qualifies as a pooling of interests under APB 16. This is very difficult to do almost impossible, as a matter of fact—although the Bristol-Myers-Squibb transaction qualified as a pooling. A new basis of accounting for the assets cannot be established for the transaction to qualify. The assets are carried over at their historic value. Most importantly, goodwill is not created on the surviving company’s books. There is no periodic amortization of that intangible asset against earnings. So, this is a powerful incentive for companies that are sensitive to the effect of goodwill on earnings. The Section 351 Merger has been used extensively for its tact in taxes.
Section 351 postpones gain or loss on the contribution of appreciated property to a corporation in exchange for stock, assuming certain rules are followed. Section 351 is usually thought of in connection with the organization of unseasoned start ups. However, in fact the issuer can be newly organized or pre-existing when the stock issuance occurs; it can be any size, have an unlimited number of shareholders pre- and post-financing and divide its shares into as many classes of stock as the situation warrants. In contrast to the S Corporation privilege, the principle of avoiding tax is not dependent on the resultant corporation being uncomplicated.
The principal requirement of Section 351 is that, “immediately after” the financing, the investors who contribute property and or cash in exchange for stock are in control; that is, they own at least 80% of the issuer’s combined voting power (all classes of voting stock) and 80% of the total number of all classes of nonvoting stock. If such is the case (and the property is not subject to liabilities in excess of its basis), no gain will be recognized on appreciated property so transferred, either by the transferors or the recipient corporation. And, according to the usual rules governing tax-postponed transactions, the tax basis of that property in the hands of the corporation will be carried over from the basis of the contributor. Hence, it is has a strategic advantage if implemented properly in the merging of corporations.
BEGINNING THE PROCESS(23)
The decision to pursue a sale should be based on an awareness of the general level of interest that prospective buyers are expected to have for the company, a realistic valuation range, and the ability to deliver the goods. Prudent sellers anticipate hurdles to completing a transaction. We urge our seller clients to confirm that good title and all the essential elements of their business can be transferred to a new owner. Thoughtful and thorough advisers work closely with sellers to identify and resolve issues that could prevent the seller from completing a transaction and can provide a realistic and practical framework for what to expect throughout the sale process. Accounting issues are becoming increasingly complicated. Benefit programs and pension liabilities for current and former employees, the adequacy of warranty re-serves and product liability, and the whole area of environmental responsibility usually are handled quite differently by the larger company selling a middle-market business and the privately held company. The buyer will require the seller to conform to its level of disclosure and accounting standards.
Owners usually know their businesses well and have a general awareness of the desirability of the companies. This applies to both the closely held private business the corporate divestiture candidate. The key managers of these companies also the problems and challenges associated with these businesses. Sellers are well to identify, review, and investigate potential sale issues with financial, legal, ting, and tax advisers to avoid surprises. It is best to take a hard look before leaping into the market.
The seller’s financial adviser should absorb information about the company and the acquisition market conditions in order to recommend a marketing plan. Considerations for developing a marketing plan include the complexity of the seller’s business, the number of likely prospects, the degree of screening to qualify interest, timing, the level of confidentiality required, and other items specific to the person abilities and pressures of the situation. The result should be a clear strategy for how the acquisition opportunity should be positioned, who the prospective buyers should be, who should initiate contact, how prospects will be qualified, the anticipated process of exchanging information and ideas, site visits, and the coordination of negotiations with alternative prospective buyers.
Opinions vary about what information prospective buyers “need” or “should have.” An offering document that feels like it’s been widely distributed is not in the best interest of the seller. Each situation is different, but buyers expect owners who genuinely want to sell to be willing to provide the information buyers believe that they need to analyze the business and reach some conclusions on price and deal structure.
The form of the information document should be tailored for its audience. It generally is accepted that a “book” is prepared for corporate divestitures and most closely held businesses which are for sale. We have worked in several situations in which the marketing plan called for variations from the customary presentation materials. These usually were transactions involving buyers that were interested in technology, consolidation within a market segment or region, or other circumstances in which the required information differed from a straightforward overview of a niche company in a mature market for domestic companies that may not know the markets and industry well, or foreign buyers that need even more background and explanation.
Cover Story and Confidentiality Agreements
Sellers must assume that at some point in the sale program, someone inside or outside the organization will ask questions about the owner’s intentions and whether the business is for sale. Disclosure of appropriate information must be made to prospective buyers if serious discussions are to be developed. Some commotion inside the seller’s company is likely to be created by unusual activity and visitors.
We recommend that sellers manage the disclosure inside their companies. In some instances, public announcement of intentions is customary, as when a corporation decides to divest a group of businesses that no longer fit its overall strategic objectives. Usually, the owners are not committed to a particular course of action and they do not want others in their organization to become distracted by the possible implications of a change of control. Our advice to owners of closely held middle-market companies is to prepare a response to the general topic which is consistent with growth and expansion of the business and the strengthening of its competitive position.
The response, however, is not a solution. It is merely a holding action until key members of management are apprised of developments that may lead to the owner’s decision that a sale is the best alternative. By confiding in a small group, which can in turn be sensitive to employee concerns, the seller can be aware of concerns as they arise, and then manage disclosure within the organization.
Counsel to the seller will prepare a confidentiality agreement for the prospective buyer to sign before receiving information about the seller’s company. Most prospective buyers are willing to enter into confidentiality agreements.
GOING TO MARKET(25)
Initial screening should be conducted by the seller’s financial adviser without disclosing the target’s identity. The way in which the contact with prospective buyers is initiated sets a tone for the process and the way the seller manages the sale program.
Direct calls from a seller to prospective buyers are inappropriate in most cases. Not only should the preliminary interest of a prospective buyer be screened, but other issues should be addressed before the seller becomes known. Some logical prospective buyers may not be able to conform to the seller’s schedule or preferred form of transaction, or may have priorities that keep them from being in a position to pursue the proffered acquisition.
The most valuable use of the CEO’s time throughout the sale process is to run the business and concentrate on producing attractive results. Management operating efforts will be diluted enough by participating in meetings with prospective buyers and negotiations with the most interested parties. It is important for the seller to remain “above the fray” during the meetings and negotiations. In nearly all sale transactions, the seller has an incentive to preserve the basis for a good working relationship with the buyer. There also are a series of representations and warranties, and indemnification provisions which sellers can delegate to advisers to establish some insulation from the demands of buyers.
LETTER OF INTENT THROUGH CLOSING(26)
A written understanding of what the seller and buyer think that they have preliminarily agreed to becomes the point of reference for due diligence and the preparation of definitive agreements. Many buyers are not interested in letters of intent because they may trigger a requirement for public news releases. Sellers often are more reluctant than buyers to announce a transaction that could be derailed.
We recommend the use of terms sheets and letters of intent, because the parties should be able to reduce to writing the basis on which due diligence can be launched. In some situations, although they are rare in the 1990s, sellers are able to negotiate the definitive agreement in advance of due diligence by the buyer. In most cases, the seller must decide whether to authorize the buyer to conduct due diligence. At that point, the buyer asks the target owner to discontinue discussions with other interested parties.
Our experience has been that owners of middle-market businesses are in a better position if they require letters of intent from the buyers. It doesn’t matter that the letter of intent is usually a nonbinding understanding with sometimes vague language about the terms of the proposed transaction. Those documents are not issued lightly, and they force both parties to clarify their intentions.
The due diligence and preparation of definitive agreements can proceed in tandem. Sellers should focus first on the business terms of the transaction and then focus on the representations, warranties, and indemnification expectations of the buyer. Owners of middle-market companies often are unpleasantly surprised by provisions that even their own counsel might consider reasonable. We have found that corporate divestitures generally involve very limited provisions of this type, because the seller wants no continuing potential liability; or they are relatively loose, because the seller wants to achieve a high price even if offsets occur later because of the indemnification obligations associated with the agreement.
Sellers must take the time to thoroughly understand the intricacies of all material documents associated with the sale. Subtle changes can result in costly consequences. Sellers must issue clear guidelines to counsel on the level of discretion in lawyer-to-lawyer discussions. The devil often does reside in the details.
Momentum must be established and sustained. It is most efficient to have an aggressive timetable for completing due diligence and deal documentation. Unanticipated developments can be disastrous on the downside, and pleasant surprises always can be factored in for upside reward. In general, the amount of work and expense in closing transaction will expand to fill the time available.
FINDING THE RIGHT COMPANY(27)
How does a buyer identify an acquisition candidate that is in a troubled situation? One route is work through the network that has developed around troubled companies. It includes turnaround artists who are very skilled at going in and dealing with a company’s problem. Often they take equity positions. There also are firms that stand behind management teams by putting money into a troubled company. And there are workout bankers that are trying to enhance the positions of their institutions. They can offer indications of what public companies are having problems and what public data are available.
This network is becoming very formal and it can be accessed by talking to the workout bankers, attorneys that specialize in the restructurings and others that may have properties for sale.
In the public company arena, tips come from public disclosures, including the required 10K and 10Q documents as well as the 8Ks when there are bond or debt defaults. Press releases announce troubled situations. And when the audited financials come out, the troubled company may present explanatory language regarding its ability to continue as a going concern that suggests an opportunity to move in on a distressed situation.
There also are troubled industries to explore. Real estate, as an industry, was moving into a distressed situation by the late 1980s. Earlier, it was energy and steel, and the steel industry is still having problems. So a buyer can track the industry with problems and identify the specific companies that are most troubled because of such difficulties as loss of market share or attacks on markets by foreign competitors. The machine tool industry is one such example. And, of course, there are the distressed situations caused by excess leverage. LBO companies as a group may be considered a troubled industry.
What are the early warning signals? Where are the red flags? Extended poor performance is one sign. The number of companies that can sustain continued losses for five, six, or seven years is amazing. They survive by divesting valuable assets such as divisions or product lines in order to meet their obligations as they come due, particularly the institutional debt. This is a way for them to cure loan defaults, although they get a little weaker each time.
These are the most obvious signs of trouble, because they recur year after year. Other signals develop in conjunction—management turnover, director turnover, and a very unstable environment generally. If the company is in a troubled industry, a buyer should look for external factors, such as increased market share for foreign competition, major technological changes, or the onetime glamour industry that is of the product growth cycle into a mature cycle. The companies hurt by require change, particularly management that can assess the changes be made.
Often such as in the case of the troubled LBO, the business is strong. But there hockey stick projections of great growth and improvement in market share that didn’t develop to support the highly leveraged structure. A strong management team may be in place, but the capital structure is out of sync. So a financial fix as opposed to an operational fix. However, there are a lot of companies in mature industries or industries moving declining life cycle that really require an operational fix. Some may be characterized by management ineptitude and management’s inability to deal with environment.
BUYING THE COMPANY IN BANKRUPTCY(29)
Some of the problems involved in acquiring a company that is involved in an out-of-court workout are mitigated if the company is in Chapter 11. However, buying assets of a company in bankruptcy or the entire company itself has still other difficulties that are hard to resolve.
To understand the transaction opportunities presented by a company in bankruptcy, it is helpful to know how the Chapter 11 process works. In very simple terms, a company that files Chapter 11 gets the benefit of the automatic stay which holds up all of its debts and typically stops all litigation. The company has a period of time, called the “exclusive period,” during which the debtor in possession, i.e., the management of the company, is afforded an opportunity to come up with a plan of reorganization. The longer this period is extended, the more information the creditors groups develop, and, generally speaking, the better organized they become.
At some point, a plan is put forth. It may be the debtor’s plan, it may be a consensual plan agreed to by all of the constituents, or it may be a creditors’ plan. A disclosure statement is prepared, circulated just like a proxy, and voted on by all of the constituent groups. The plan is approved if it secures favorable votes from creditors who represent two-thirds of the dollar amount of all the impaired creditor classes, as well as 50 percent of the creditors by number. It then must be confirmed by the bankruptcy court judge before the company emerges from Chapter 11. That process takes between 20 and 24 months on average, although there are ways to shorten it.
CHOICES FOR THE BUYER(30)
An investor can make acquisitions before or after a bankruptcy filing. If there is an all-equity plan, in which stock is exchanged for claims and a massive equity distribution to creditors is made, there is an opportunity to buy the company after consummation of the plan. An acquirer considering companies or assets that are in Chapter 11 has three different ways to do a deal. The first way is simply passive investing. Vulture funds, high yield mutual funds, and individual investors have become quite skilled at this technique, basically buying and trading claims. They see fundamental value in the claims that they will be able to capitalize on when the reorganization plan is completed, or they believe they can profit by just participating in market arbitrage. There are also are proactive investors, including those that will aggressively try to establish a blocking position. These blocking positions often are interesting tactics for acquirers. For example, the buyer of one-third of the dollar amount of an impaired class of claims will be in a blocking position to stop anyone else from completing a plan of reorganization. That, in effect, is what Japonica Partners did in gaining control of Allegheny International in 1991. In essence, the road to a reorganization of Allegheny, which was renamed Sunbeam-Oster, had to go right through the offices of Japonica Partners.
VALUING THE TROUBLED COMPANY(31)
Valuing a troubled company isn’t much different from valuing a nontroubled company, except for the quality of the information the buyer has to deal with. The values still are based on multiples to book, multiples to cash flow, and discounted cash
The key problem is that these numbers may have been produced by the management that got the firm into trouble in the first place. So they must be questioned vigorously as to their accuracy. I had an experience working with a troubled company in the past, and the first question I asked was, “Exactly what does your cost structure look like?” The chief financial officer shot back, “Well if I knew what my costs were, would I be for less than cost?” I then asked for the following year’s projections. I got a simple answer. So part of the problem with the valuation exercise is finding reliable parameters against which to measure.
Therein is both a problem and an opportunity, because there is a premium for really understanding the business. There is a premium for getting inside, and there is a premium for knowing the company better than its management does and then ultimately knowing what price the company can be sold or purchased.
Liquidation Value In a worst-case, meltdown scenario, a company may be worth more dead than alive. In all cases, a distressed company must evaluate its value in liquidation, since this exercise establishes the downside against which all offers must be evaluated. Indeed, Section 1129(a)(7) of the Bankruptcy Code establishes that a Court may confirm a Chapter 11 plan of reorganization without the unanimous consent of all classes of creditors only if holders in impaired classes receive no less than such holders would receive under a liquidation under Chapter 7. In valuing the troubled company an experienced Advisor should be able to conclude this valuation to determine its worth by demonstrating the company’s Risk Premium, Discount For Lack Of Marketability, and Liquidation Value, which is ultimately what the company price will be sold at auction.
There is a two-step process for determining the “enterprise value” of a company in bankruptcy. The first step is an orderly analysis of the company to value the left side of the balance sheet and find out what the assets are worth. The second step comes in valuing the liabilities. Here, the bankruptcy process helps the buyer a great deal ways and hinders the buyer in others.
Through the claims process, presumably everyone with a claim against the company has mailed in a piece of paper. So the due diligence universe has been at least created in advance. At this point, the potential buyer must be careful to with its lawyers to make sure of the bar date, the date beyond which nobody a claim. But even that is not a foolproof guarantee of the exact parameters of the liabilities, because sometimes there is a group of creditors that has escaped notice. They still may have claims. So the potential buyer really needs to do due diligence on the process of how the claims were established. There are two kinds of main claims for financial analysis purposes: liquidated and unliquidated. With a liquidated claim, the creditor seeks a specific amount for services rendered, merchandise sold, a judgment in a lawsuit, and so on. An unliquidated claimant does specify the amount.
The problem is that the so-called total claims that are used in the proceedings often don’t include the unliquidated claims because they are not easily quantifiable. So a potential acquirer needs to be careful to go through all the claims and get a handle on true total, and not just the commonly used aggregate numbers. Another issue in dealing with the claims is reinstatement. Claims can be reinstated after initially being dismissed. It’s difficult for the people on the deal side to understand the process which is designed to protect people against having their legal rights impaired. And it’s a slow process for the typical buyer. People that a buyer may view as unimportant in the deal making sense may have a disproportionate ability to slow down the process. The buyer can try to accelerate the proceedings by agreeing to settle various types of difficult claims. But this represents an economic trade-off, because it can raise the effective purchase price. And any of the options involves a considerable amount of time. Time is not the acquirer’s friend in the bankruptcy process.
To prevent dispositions of valued assets from dragging on until a plan of reorganization is adopted; creditors and other parties increasingly are using a procedure authorized by Section 363 of the Bankruptcy Code, what I would refer to as a bankruptcy auction. This is a quick, cost-effective manner in which to handle the principal assets in a case. Early in the proceedings, the judge allows selected assets, or even an entire company to be sold quickly at auction. The creditors then fight over the proceeds; this prevents the company’s value from deteriorating while the claims are thrashed
STARTING THE AUCTION(33)
The bankruptcy auction can be initiated by three different categories of people. The first is a buyer who approaches the debtor or the trustee and negotiates a purchase agreement. The court then is asked to initiate a Section 363 sale. If it agrees, the business goes out for a public auction.
The second group that might initiate a Section 363 sale consists of the debtor company’s creditors. They may recognize one of two things. The company is never going be reorganized, and assets will deteriorate substantially in value during the pendency of the bankruptcy proceeding. Alternatively, if the company eventually is going to be reorganized, the process will be lengthy, and the short-term cash-flow needs of the debtor may be met by selling selected assets quickly to meet its financial requirements. In either case, the creditors will ask the court and the debtor to initiate the sale of assets or operations. The creditors alone cannot initiate a Section 363 sale.
The third route is a prearranged bankruptcy auction. Typically, this starts when the debtor, facing an inevitable bankruptcy filing, will find a purchaser for the company before it actually enters bankruptcy, so that it can move quickly through the process and maximize the value of its assets. The company involved in this process often has some type of special financial problem—such as huge product liability claims or large retiree medical liabilities—and may be effectively worthless because of them. The parties will negotiate an acquisition agreement with full-blown due diligence, and when it is executed, they will file a bankruptcy petition and immediately for a Section 363 sale. With the right company in the right circumstances, this technique enables the purchaser to obtain a financially clean operation and minimizes the deterioration of value that otherwise takes place during a bankruptcy proceeding.
If the court is inclined to allow the sale, regardless of who initiates it, there will be a notice to participants in a bankruptcy and public notice, such as a newspaper advertisement. Once the notice is provided, there is a 30-to-60 day period for other bidders to offer competing bids and for creditors to object. The court will hold a hearing at the end of this period. If the court approves the sale, the closing usually occurs on the tenth day after the approval.
In determining whether to approve the sale, the court looks at five factors. The first is the proportionate value of the assets being sold in relation to the whole estate. If it is a small asset or a small operation, the courts generally will allow the sale if fair value is being paid for the asset. However, if the assets constitute a large part of the operation or the entire company, the process gets a little more difficult. Then the court is going to look at the other four factors very carefully. One is the likelihood that a plan of reorganization will be proposed and confirmed in the near future. Usually this is not the case, but courts like to consider the proceeds received for assets in the context of an entire plan. The courts want to know what will be done with the money from a quick sale; if a plan is likely to be proposed soon, the court will be inclined to sell the assets in the context of the plan. Another factor involves the proceeds of the sale versus the appraised value of the assets. Everyone wants to “steal” an asset in bankruptcy; however, the courts are not in the business of making bargains. There has to be some reasonable relationship between what is being paid and what the asset is worth, even discounting for the fact that the company is “heading south.”
The court also will consider the effect of a proposed sale on future plans of reorganization. Historically, courts have been in the business of rehabilitating debtors, not liquidating them. A court will seek a compelling reason why it should send the company, or assets that the company needs for reorganization, out the door and preclude the debtor’s reorganization. Finally, and perhaps most important, the court will want to know whether the asset is increasing or decreasing in value. If the asset is going to decrease in value over time, the court is more likely to be convinced that the time to sell that asset is now.
THE PURCHASER’S PERSPECTIVE(35)
What kind of factors should the buyer consider in deciding whether to participate in a Section 363 sale? First, the dominant creditors should be in agreement that it is time to sell the asset that the purchaser seeks. That establishes credibility with the court for the offer and increases the probability that the buyer’s efforts will be rewarded. Second, the purchaser must be able to demonstrate that no future improvement in the value of the assets is realizable by the debtor. If the creditors think the value could be increased or held even, they probably will want time to explore alternatives. Third, are there limited financing alternatives for the debtor? That is what very often drives the sale. The debtor cannot get a working capital line and it’s going to strangle in a few weeks without selling some pieces for cash. That happened frequently in the bankruptcy of the Revco DS, Inc. drug store chain. Selected segments of the chain were sold off during the bankruptcy to generate cash for operations while the reorganization plan was worked out. Fourth, fair value must be provable. A professional likely is going to have to testify that full value is being paid. It is possible to reconcile this requirement with the purchaser’s desire to get a bargain, because experts are willing to recognize that assets in bankruptcy should be accorded a substantial discount in value.
BENEFITS OF THE SECTION 363 SALE(36)
One of the benefits of going through this process is the cleansing effect of a bankruptcy order. A purchaser at a bankruptcy auction obtains the same benefits the debtor company would get in discharging claims through a plan of reorganization. Unfunded pension plan liabilities, retiree medical claims, burdensome long-term contracts, and known product liabilities remain with the estate. The accelerated sale also minimizes the deterioration of customer and supplier goodwill that invariably takes place during a long bankruptcy proceeding. Finally, this is a very quick-decision process. It takes only a few months, so the commitment of time and money to an unsuccessful acquisition is very limited. In addition, in most bankruptcy auctions, the initiating bidder will get price and bid protection from the court. For example, the court may declare that the initial bid cannot be topped unless a competing offer exceeds it by some specified factor such as 5 or 10 percent. And if the initiator does lose, the court often will reimburse it for due diligence and financing expenses.
RISKS IN THE BIDDING(37)
Of course, there are risks. If a sale is blocked by creditors, the company’s assets may never leave the bankruptcy estate and the time and effort spent will be lost. There is also the auction risk. The first bid could be topped, although with price and bid protection, that risk can be mitigated. Third, not all liabilities are discharged by a bankruptcy court order. Trade creditors’ claims ostensibly could be left behind. But if the acquirer needs to have an ongoing relationship with trade creditors, such as suppliers, they will have a stranglehold on the purchaser. These creditors need to be repaid or they will never again do business with the buyer.
Environmental liabilities in most cases follow the buyer. However, if the business includes an environmentally contaminated facility that the purchaser does not need, it can be excluded from the sale and the environmental claims left with the debtor in possession. Unknown liabilities also can be a problem. An example is the defective product that has not yet injured anybody but may cause injuries in the future. These claims may follow the purchaser. Unpaid taxes also may be a problem. Several states have statutes that take state tax liability and transfer it to the successor, regardless of the bankruptcy court order. Finally, it is important to remember that these are not pleasant circumstances. In one bankruptcy I know of, hundreds, if not thousands, of former employees with pension plans and retiree medical benefits had all of those obligations canceled by the debtor. Even though the purchaser is not the source of these problems, it will become associated with them. Buyers should consider potential public relations risks before becoming associated with the debtor.
How does a buyer mitigate these risks? The first and most important question to ask the financial and legal advisers is whether the debtor’s business can survive the uncertainty created by the bankruptcy. What is the value going to be in six months or a year? Is it going to be substantially lower at the end of that period? Can it survive at all? Will the purchaser end up with only a shell of the company it thought it was going to acquire? Second, conduct full and customary due diligence. The bankruptcy court order does not discharge every claim, and the purchaser should identify every material risk. In particular, there often is deterioration in risk management activities at the troubled company. For example, when cash flow gets tight, the company may stop managing its environmental problems. It does not pull its underground storage tanks and may not be careful as to who handles its off-site disposal. Finally, there should be a standard acquisition agreement with indemnities. Some claims are not going to be discharged and if they are not disclosed, the buyer should have recourse against the seller. Obviously, it is difficult to sue a bankrupt company. But there are two alternatives that can be written into the agreement:
A hold-back on a portion of the purchase price
Contingent payments beyond the initial price that can be set off against potential liabilities in order to fund indemnity obligations
Bankruptcy auctions offer great opportunities, but a buyer needs to look at all the benefits and risks in each situation. As more and more companies get dragged into bankruptcy, there will be frequent acquisition opportunities through that vehicle. However, by taking the right approach, the buyer does not get involved in the bankruptcy reorganization itself and has the chance to obtain an operation quickly and cleanly.
COMPLETING FINANCING ARRANGEMENTS(39)
If the purchase price is payable entirely or partially in cash, the acquiring company may borrow the money. A loan commitment obtained when the agreement was signed and must blossom into a formal loan agreement by closing. Necessary consents or approvals for the borrowing must be obtained, and preparations must be made for the closing of the loan transaction concurrently with the closing of the acquisition.
If the stock of the target company is selling at a substantial discount from the price, or if the acquiring company wishes to reduce the dilution that will from result from issuing its securities in the merger, it is economically advantageous for the buyer to acquire target company stock in the open market. Care must be taken to give full consideration to the accounting, tax, and securities regulation aspects of such purchases. For example, pooling-of-interests accounting (which avoids the creation of nonamortizable goodwill in the transaction) may be adversely affected by open-market purchases of target company stock. The partially tax-free nature of a combined stock and cash acquisition may be destroyed if too much target company common stock is purchased in the open market. Depending on the timing of the purchases and the formula (if any) in the merger agreement for pricing the transaction, open-market purchases of the target company stock by the acquiring the company may violate the SEC’s Rule 10b-6. (That rule is designed to prevent issuers supporting the price of their stock when a stock issuance is imminent.)
The target company may have outstanding publicly held preferred stock or debt securities. If the merger agreement contemplates that these securities will remain outstanding, no action is required. On the other hand, particularly if the securities are convertible into the target’s common stock, the parties may agree that they be called for redemption. If so, appropriate arrangements must be made for giving the requisite advance notice of the call and paying the redemption price of any unconverted securities. If the conversion provisions in the securities provide that after a merger the convertible securities will be exchanged for acquiring company stock based on the merger ratio, a call may not be required. Financial covenants or of control or other provisions in a loan agreement may require consent of the lenders in the target’s sale. A simple written consent by lenders may suffice, but it may be necessary to make extensive revisions on the loan agreement. The documentation must be in place by the time of the closing.
If the securities of the company being acquired are relatively widely held, it is almost always necessary to prepare a proxy statement describing the proposed acquisition. When the target company’s stock is registered under the Securities Exchange Act, proxy materials must be filed with the SEC or, in the case of a bank, the appropriate banking regulator.
In an acquisition not requiring regulatory approval, the preparation of the proxy statement and the obtaining of shareholder approval are frequently the principal factors responsible for the delay between the signing of the agreement and the closing. If the parties wish to reduce the interim period, preparation of the proxy statement should commence at the earliest possible date.
The proxy statement normally must contain extensive information about the proposed acquisition transaction and about the company being acquired. If securities are being issued by the acquirer, the proxy statement also will contain a description of the securities and of the acquiring company. If both the acquiring and acquired company file annual and other periodic reports with the SEC, much of the proxy statement may consist of material already contained in the most recent annual reports, although it must be updated in some respects to the date of the proxy statement. The principal additional information will be the description of the proposed merger and its background and, in many cases, pro forma financial statements reflecting the acquisition.
Unless the securities being issued in the merger are exempt from registration under the Securities Act of 1933 (for example, because they are being issued by a bank or issued after a hearing on the fairness of the transaction by a regulator), the acquiring company is required to file a registration statement registering the securities under the Securities Act. The proxy statement generally is the major part of any such registration statement.
Because preliminary proxy material for a merger is not publicly available if confidentiality is requested, it is customary to file the documents with the SEC in the form of preliminary proxy material and to obtain the SEC staff’s initial comments. The document then is revised and filed as a publicly available registration under the Securities Act. If the SEC staff comments have been responded to adequately, the registration statement will be declared effective shortly after it as filed. The proxy statement, which comprises the bulk of the registration statement, then is mailed to the shareholders.
Approval by the acquirer’s shareholders also may be required if mandated by state law or by the policies of the securities exchange on which the acquiring company’s securities are listed. However, directors of the acquiring company may wish to obtain shareholder approval even though it is not legally necessary. When approval by both shareholder groups is sought, the custom is to prepare a joint proxy statement that will be used by both companies. The proxy statement also must be filed with the SEC as a part of registration statement covering the securities to be issued. Normally the issuance of securities by the acquiring company particularly if it is not listed on a securities exchange will require filings with various regulators under state securities or “blue sky” laws. These filings must be closely coordinated to ensure that the proxy materials can be mailed to all shareholders promptly upon the effectiveness of the SEC registration statement.
Effective Due Diligence(41)
Many acquirers operate under the theory that once the handshake has taken place, the deal is done. On the contrary, the work has just begun. It’s time to determine the deal is as good as it looks on the surface. This requires further investigation, “due diligence” review, and verification of the seller’s representations. A canny buyer should be conducting this “purchase investigation” even before the handshake. Although a thorough investigation sounds like motherhood, its amazing how often this basic principle is violated and buyers risk severe financial losses by proceeding on the basis of inadequate information and half-truths. When they are performed purchase investigations frequently are handled ineffectively and don’t obtain enough of the right information to evaluate the target and make a sound decision. This may stem from poor communication, misunderstandings, lack of careful planning, failure to fix responsibilities and coordinate the inquiry, and, perhaps most important, because the investigation often focuses on the quantity rather than the quality of the information. For example, with respect to marketing information, an acquirer should focus on how the target is different from others in marketplace and whether its competitive strategy is working, not on how it resembles competitors. With respect to financial information, the acquirer should probe major exposure areas, trends, and unusual financial characteristics rather than every item in the financial statements.
NATURE AND SCOPE OF THE INVESTIGATION(42)
A purchase investigation may be performed by company personnel, with or without help of outside consultants (e.g., accountants, investment bankers, lawyers, special industry consultants, actuaries, appraisers). The decision depends on the experience and availability of in-house personnel. We recommend that management play a major role in the investigation, because it will learn first-hand information that is important both to the decision to proceed with the deal and to successful operation of the target after the acquisition. Management, in fact, should be the prime mover setting the scope and taking the lead. By delegating the entire investigation to subordinates or consultants, management frequently overlooks a lot of hard information and misses the opportunity to get a “feel” for the target management and other qualitative concerns that are critical in the purchase decision.
The scope of an investigation may range from a minimum effort (reviewing available financial information, visiting the target’s facilities, and talking to the selling management) to a maximum effort that involves a comprehensive investigation audit. Depth depends on the size and relative significance of the acquisition candidate, price, availability of audited financial information, degree of inherent risk time allowed, and so on. In the case of an unfriendly tender offer, the ability to analyze internal information on the target company may be limited. Consequently the acquirer and its professional advisers may not be able to do much more than gather, compile, and analyze available public information. But if the seller is a private company, the need for a full scale investigation is much greater. Divestitures also require intense buyer scrutiny.
Frequently, it is advisable to perform more than one type of investigation on a candidate. A preliminary investigation may be conducted before the handshake or the signing of a letter of intent or preliminary agreement. A complete or partial purchase audit would follow to verify the candidate’s representation and helps establish a price before final agreement is executed.
The Businessman’s Review(43)
The businessman’s review is a comprehensive review and analysis, usually without independent verification, of a target company’s financial and accounting records and related information. The initial stage comes after preliminary interest is expressed, when the buyer needs to obtain additional information regarding the seller’s operations to reach the handshake stage. It is designed to provide a broad understanding of all aspects of the company’s business, including industry information; marketing, manufacturing, and distribution methods; financial reporting systems and controls; and industrial relations; as well as in-depth comprehension of the target’s financial statements, accounting data, and tax position. At this stage, questions should be raised about research and development programs, regulatory reporting requirements, international factors, and legal matters.
Management is advised to prepare a checklist of questions it wants to raise with the target during a preliminary review so that it gets the information it needs. Because this stage of the review usually does not involve verification procedures or detailed analysis of accounts, it easily can be performed by the buyer itself in cooperation with the target’s personnel.
The second stage of the businessman’s review typically begins after the handshake. It is a more detailed review of tax, financial, and accounting records with or without verification, and often is performed with the help of the acquirer’s independent accountants. Usually, the accounting and tax principles and practices of the targets are reviewed in depth, with special emphasis placed on whether they pose any problems to the specific transaction. It is important that the buyer and its accountants agree on the scope of this review and that the acquirer understands its objectives and limitations.
Purchase Audit and Other cation Procedures(44)
Independent verification or audit of the seller’s financial statements and representations made by its management may be required, depending on the degree of assurance the buyer wants, the seller’s past audit history, and the time permitted for premerger investigation. Verification procedures may involve a full-blown purchase audit or specially designed auditing procedures applied to specific accounts or exposure areas. For example, inventory is such a significant item to manufacturing and distribution enterprises that accountants frequently are asked to observe and test the physical inventories, audit their valuation, and determine any excess and obsolete inventory and valuation practices.
Verification procedures often disclose problems not previously known, and are specially valuable in the current environment when integrity is not always considered a virtue. Although management frequently shuns the cost of an audit, the expense can buy an additional level of assurance that is hard to come by any other way.
When the target has a good audit history (i.e., a reputable accounting firm has examined the historical financial statements and prepared the tax returns), comprehensive verification procedures may not be necessary except in areas not normally covered by the annual audit and not previously verified. Quality of the target’s products, its reputation with customers, and similar nonfinancial areas may be appropriate subjects for verification. However, as a minimum, work papers of the targets auditors should be reviewed in detail to identify exposure areas, problems, and issues not fully disclosed in the financial statements.
Note that the businessman’s review and purchase audit primarily are concerned with financial and accounting matters. Obviously, the buyer should investigate operating matters just as thoroughly. If the buyer does not have the in house capability to do this, outside consultants should be retained to evaluate marketing, manufacturing, technology, competitive position, product capability and so on.
AREAS OF INVESTIGATION(45)
The businessman’s review, with or without verification, should focus on a variety of matters.
Company Background and History
The general nature of the business, principal locations and facilities, history and similar information should be collected in the early phase of this investigation. In addition, information should be obtained on the management directors, and outside advisers. Whenever possible, information on the company’s recent developments plans for the future, and major problems including lawsuits, government restrictions, environmental considerations, and sensitive transactions, should be covered. This information offers initial understanding of the prospective acquisition and identifies areas for further investigation.
When the target operates in an industry that is unfamiliar to the buyer, a detailed industry review, will include: often with help from expert consultants, is prudent. It should precede the investigation of a specific candidate
Financial and Accounting Information
It is useful to compare financial ratios by major business segments for a period of years to determine important trends. These ratios usually returns on assets and stockholders’ investment, gross profits, profit margins, fixed charge coverage, current ratios, net quick ratios, and debt/equity ratios. Information concerning the impact of inflation or recession on operations, the company’s ability to operate in the environment, current value and replacement cost data, and future capital requirements also should be obtained.
The buyer’s sources can be balance sheets of prior fiscal years, statements of income statements of changes in financial position, budgets, and forecasts for the future. In addition, it is important to understand any differences between buyer and the seller in accounting principles and practices. Occasionally, such differences disclose questionable accounting practices
A review of a manufacturer of electronic parts that was up for sale disclosed that it’s returned goods were accounted for differently than the buyer’s returned goods. Further investigation determined that the seller’s inventories were substantially overvalued. The prospective buyer called off the deal.
An investigation of a dealer in fertilizers revealed that, in accordance with industry practice, a dealer’s purchase is binding, but customers can back out because there is no legal requirement that they fulfill their side of the transaction. Because fertilizer prices were declining rapidly at the time of the proposed acquisition, this was important to the buyer because of the likelihood that fertilizer customers would refuse to take delivery. Because these “open” transactions should have been valued at current market values, instead of the higher contract prices, an inherent loss existed, and the deal was aborted.
A review of the target’s tax status serves a dual purpose. It satisfies the buyer that the tax liabilities of the target, as reflected in the purchase price, are properly stated on the target’s books. It also focuses on the ability of the buyer to monetize a portion of the purchase price through proper tax planning strategies and tax attributes of target.
The tax review essentially asks: “Has the target paid all of its tax liabilities on a current basis, and has a reasonable reserve been accrued for known and anticipated adjustments likely to arise on in-progress and future audits by various taxing authorities?” Generally this involves a review and analysis of the tax returns filed for a minimum of three prior years. Special emphasis should be placed on the reconciliation between financial statements and taxable incomes, on the most recent reports of adjustments made by the various taxing authorities, and on adjustments in years still open for examination. The results of this review, when compared with the reserve for taxes, the so-called cushion, determine whether the target has provided adequately for past tax exposures.
Aside from absolute dollar liabilities, the audit should review so-called timing items, such as capitalization of repairs and other costs spread over a span of years. Any changes won’t increase total taxes over time, but the IRS could dispute the capitalization schedule and claim that larger tax payments should have been made in prior years. The key expense here is interest costs, because interest assessments on past taxes have escalated in recent years and have been applied on a compound basis. Sometimes, the ultimate interest cost could exceed the tax deficiency.
State taxes are a very important item for examination. Many states have become extremely aggressive in imposing and collecting taxes from multistate enterprises. And with the federal government adopting an accelerated depreciation schedule in 1980, state taxes are becoming an increasing share of the overall corporate tax bite. In the case of multinational corporations, country-by-country tax reviews may be warranted.
Gaining Tax Attributes
Because potential tax benefits and opportunities to recoup purchase prices through postacquisition assets sales are key elements in setting the price tag on a deal, the audit should determine which of the seller’s tax attributes succeed to the buyer and any limitations that will be imposed under the tax law on the utilization of such attributes after the acquisition. Net operating loss carryforwards, unutilized investment tax credits, and other available credits should be identified and qualified. Quantification goes beyond merely pulling numbers off a tax return. It is necessary to get behind the target’s numbers and adjust the attributes for any potential softness that may result from such things as an aggressive tax policy that is open to successful challenge by taxing authorities or to future limitations.
A buyer purchasing stock from an existing consolidated group guards to protect against loss of tax benefits from post-acquisitior: or from excess credits that can be carried back for tax purposes to the pre-acquisition period. This requires a tax-sharing agreement between the two parties that is tailored to the specific peculiarities of the transaction.
When a substantial premium is being paid over the target’s asset tax basis or the buyer plans to sell off some of the target’s assets after the acquisition, the audit should consider the opportunities for “step-up” or writing up the valued of the acquired assets, and the tax consequences of this procedure. This should focus on the tax incurred to step up the assets and potential taxes due on the sale of the assets; the current tax basis for the assets, which often is lower than the book carrying value, and any other costs associated with the target’s ability to step up asset values. Note, however, that the Tax Reform Act of 1986 significantly reduced the ability of buyers to step up without incurring a prohibitive tax cost. In addition the post-acquisition alternative minimum tax consequences of the transaction should be evaluated.
Essentially, the step-up analysis begins by allocating the purchase price to the targets various assets. Recapture costs associated with the allocation then are quantified and compared with the tax savings derived from stepping up the tax basis the target’s assets. Recapture taxes must be paid within a short period time after the acquisition, but the step-up typically is realized over several years. Thus a true comparison will discount future tax savings by using a reasonable interest rate.
Management, Organization, and Relations
The buyer must appraise the capabilities of the seller’s management, particularly when buying in an unrelated industry. The buyer should interview the senior officers and managers, review their prior business experience, investigate their backgrounds and compare compensation benefit levels and plans, because changes will often result from the transaction.
Union contracts, strike history, and related factors should be reviewed to determine any existing problems. Many planned personnel savings may not be possible because of labor agreements. Pension, profit-sharing, and other employee benefit plans must be studied to determine their effect on the future operations of the combined business. One target company had many valued, long-term employees, all in their late fifties, who would have caused a drain on the buyer’s cash flow when the unfunded pension benefits had to be paid at their retirement. Consequently, the terms of the transaction were substantially lowered. On the other side of the equation, many pension funds have surpluses that serve to make the acquisition less expensive although recent changes in the tax law have made it difficult to use these surpluses.
Product and marketing factors to be analyzed include:
The targets trends should be compared to industry averages to determine the company’s relative performance. An example of how product obsolescence affects the transaction concerns the target company that manufactured a leading, long term establishment angina medication and demanded a high premium for its reputation. The acquirer discovered that, although the target’s trend had been good, a new product, encompassing new technology and application, had just come on the market and ultimately would make the target’s product obsolete. The buyer substantially reduced its offer. The marketing intelligence also should be compared to an analysis (aging and usage by item) of inventory to detect slow-moving, excess, and obsolete inventory. Some buyers who don’t perform this inventory analysis frequently are forced into the costly scrapping of inventory after acquisition because they later find items that are components of discontinued or declining line.
Manufacturing and Distribution(47)
A review should include:
Research and Development(48)
The buyer should analyze costs and benefits of the past, current, and planned R&D programs, personnel and facilities used in them, and methods of accounting for R&D.
Understanding a seller’s internal reporting and control systems is particularly important when the target is in a different industry than the buyer or has weak controls that can affect the business. Often, it is not possible to install identical systems in both companies because of operating or philosophical differences such as the degree of autonomy for subsidiaries. When such differences arise, any required changes should be made at reasonable cost after the acquisition.
Regulatory Reporting Requirements(49)
Reporting requirements promulgated by regulatory authorities should be given special attention. They can have a profound effect on the future of the combined business and lead to substantial fines and embarrassment if ignored. The buyer should satisfy itself that the target company’s facilities are in compliance with requirements of the Environmental Protection Agency and the Occupational Safety and Health Administration.
Foreign operations of a target should be studied as to how they affect overall operation. Questions concerning the foreign country’s investment climate, trade and investment restrictions, exchange controls, inflation rates, and reporting requirements should be addressed.
Certain expenses, such as research and development costs and repair and maintenance costs, can be deferred for the short term by the seller with adverse long-term consequences to a potential buyer. A careful review will help avoid unanticipated future outlays of capital that effectively increase the cost of the acquisition.
COMMON PROBLEMS OR EXPOSURE AREAS
It is helpful to know some of the more common financial and accounting problems uncovered in purchase investigations.
Undervaluation of inventory by private companies minimized taxes but can lead to distorted earnings trends and potential.
Overvaluation of Inventory(50)
A key source of overvalued inventory is unrecorded inventory obsolescence caused by product overruns, changing technology, new product development, and maturing or discontinued products. The undervaluation usually results from excessive obsolescence, write-downs, or failure to count inventory on hand accurately.
Few firms are free of litigation, the most common resulting from product liability. This type of liability often surfaces well after the acquisition.
“Dressing up” of Financial Statements before Sale
“Dressing up” tactics can include deferral of R&D expenses and repairs and maintenance, “release” of inventory reserves, unduly low reserves or estimates for such things as bad debts, pension accounting, sales returns and allowances, warranties, slow-moving and excess inventories, and undisclosed changes in accounting principles or methods.
Receivables Not Collectible at Recorded Amounts
Doubtful accounts, cash and trade discounts, dated receivables, and sales returns and allowances may not be adequately reserved for.
Unrealizability of Certain Investments
Investments accounted for by the equity method and non-marketable investments are required to be written down only for “permanent impairments” of value, not for temporary declines. Liberal judgments may have been applied to eliminate recognition of permanent impairment.
Credibility and Integrity of Management
A private investigation may be needed to obtain sufficient information and background on target management to determine if it is right for the job and trustworthy.
Personal Expenses in the Financial Statements of a Private Company
Personal expenses usually reduce reported net income. But such costs also can be used to affect trends and produce a favorable appearance that is misleading. Pro forma adjustments by the seller to eliminate such expenses often are overstated.
Tax contingencies represent one of the biggest problems areas in an acquisition, because most companies tend to be very aggressive when paring their tax returns.
Unrecorded liabilities may include vacations pay, sales returns, allowances and discounts (volume and cash). Pension and postretirement health and insurance liabilities, claims items resulting from poor cutoffs, loss contracts, and warranties, among others.
Most often found in private companies, related party deals can have a material effect on the company under new ownership, or on the historical trends presented during negotiations.
Poor Financial Controls
Included in poor financial controls are poor pricing and costing policies, and deficient budgeting systems and controls.
Lack of compliance with environmental laws has become a significant problem. Outside experts should be retained in most cases to evaluate compliance. Other regulatory problems may exist in the areas of safety, taxes (including state, local, sales, and customs duties), labor, and so on.
Reliance on a Few Major Customers or Contracts
Loss of a major customer can have a material effect on operations.
Need for Significant Future Expenditures
Significant future expenditures needed might include plant relocation or expansion, replacement of aging property, plant, and equipment, or new product development requirements.
Overseas units not only pose labor, management, and operating difficulties, but also may have poor quality accounting information and differences in accounting principles and practices.
Extraordinary actions such as sales of assets prove the trend presented by the target.
THE SELLER’S ACTIONS
The seller, of course, must respond to the many requests for information made by the buyer. If proper planning has gone into the sale process, the effort involved should be routine, thereby allowing the seller to concentrate on fine tuning the sale agreement and working out final details. Unfortunately, sale planning is frequently inadequate, making this period traumatic.
The seller also should consider making an investigation of the buyer to determine if that buyer is best able to capitalize on the seller’s strengths, is compatible with the seller, and has no skeletons of its own. This is particularly important if the seller is continuing in management. The seller’s investigation should focus on basically same elements as the buyer’s investigation. However, it need not be as comprehensive, unless the paper being accepted is subject to considerable risk.
The two major types of business dispositions are spin-offs and divestitures. A spin-off creates a separate new legal entity. Its shares are distributed on a pro-rata basis to existing shareholders of the parent company. Thus, existing stockholders have the same proportion of ownership in the new entity as in the original firm. There is, however, a separation of control. In some sense, a spin-off represents of a dividend to existing shareholders.
In a divestiture cash comes into the firm. A divestiture involves the sale of a portion of the firm, i.e., a subsidiary, division, product line, etc., to a buyer that presumably finds it more valuable. An equity carve-out, a variation on the divestitures involves the sale of a part interest in a subsidiary via a public stock offering to create a new stand-alone company that nonetheless remains under the parent’s control.
Schipper and Smith’ found a positive 2.84 percent abnormal return to the parent (statistically significant) on the spin-off announcement date. The size of the announcement effect is positively related to the size of the spin-off relative to the size of the parent. The average size of the spin-off is about 20 percent of the original parent. Spin-offs motivated by avoidance of regulation experience an abnormal return of 5.07 percent as compared to 2.29 percent for the remainder of the sample. Examples of regulation avoidance include separating a regulated utility subsidiary from non-utility businesses and spinning off a foreign subsidiary to avoid restrictions by U.S. laws.
Hite and Owers found abnormal returns of 3.8 percent, somewhat higher than for the full sample of Schipper and Smith. They also found a positive relationship between the relative size of the spin-off and the announcement effect. Neither study found an adverse effect on bondholders.
The Copeland, Lemgruber, and Mayers study extends the earlier studies in a number of dimensions. Particularly, they test for post-selection bias. In their first sample, they did this by including announced spin-offs that were not completed (11 percent of the sample). This enabled them to study the effects of such successive announcements. A second expanded sample, subject to post-selection bias, confirmed the impact of successive announcements. Additionally, they studied ex-date effect which they found to have positive abnormal performance. Further, they found that taxable spin-offs do not have positive abnormal returns, while nontaxable spinoffs do. However, when they controlled for the size of the spin-off, the difference between the two tax categories disappeared.
For their sample with no post-selection bias, the two-day abnormal return from the first announcement was 2.49 percent; for the larger sample it was 3.03 percent. Both results are significant from a statistical standpoint. Thus, avoiding the post selection bias makes a difference; the return is lower for the sample which includes firms with announced spin-offs that never were consummated. For the eight firms with announced spin-offs that never were made, the two-day average return was a negative (but insignificant) 0.15 percent.
Event studies of divestitures have found significant positive abnormal two-day announcement-period returns of between 1 and 2 percent for selling firm shareholders. The announcement effects on returns to buyers did not appear to be statistically significant. A study by Klein looked at divestitures in depth. When firms initially announced the price, the size of effects depended upon the percentage of the firm sold, as measured by the price of the sell-off divided by the market value of the equity on the last day of the month prior to the announcement period. There was no significant price effect when the percentage of the equity sold was less than 10 percent. When the percentage of equity sold was between 10 and 50 percent, abnormal returns to the seller averaged a positive 2.53 percent. When the percentage of the equity sold was greater than 50 percent, the abnormal return was 8.09 percent. The results appear to reflect the potential impact on sellers.
When the abnormal gains to sellers from divestitures are aggregated, the totals represent substantial dollar amounts. Black and Grundfest estimate that for the 1981-1986 period, the abnormal value increases to sellers in corporate divestitures could be placed conservatively at $27.6 billion.
Equity carve-outs on average are associated with positive abnormal returns of almost 2 percent over a five-day announcement period. This is in contrast to findings of significant negative returns of about 2 to 3 percent when parent companies publicly offer additional shares of their own (as opposed to their subsidiary’s) stock.
The main explanations for the positive returns in spin-offs and in equity carve-outs relate to management incentives. Managers may receive incentives and rewards more closely related to actual performance than when the quality of performance might have been obscured in consolidated financial statements or monitored by superiors unfamiliar with the unique problems of a disparate subsidiary. In spin-offs, the creation of a free-standing stock price, reflecting the market’s assessment of management’s performance on a continual basis, may help assure that management compensation plans based on stock options will more directly measure and reward performance. In addition, more homogeneous organization units may be managed more effectively.
For divestitures, the main explanation appears to be that the resources are shifted to higher-valued uses. The buying company is motivated by the expectation that it can generate greater value from the assets than the selling firm.
Changes in Ownership Structure(55)
Share repurchases represent an alternative means of making payouts to shareholders. Cash tender offers to repurchase shares result in significant positive abnormal returns to shareholders of about 13 to 15 percent; returns are even higher when they are financed by debt than by cash. Both tendering and non-tendering share-holders benefit. Through an exchange offer, a company can change its capital structure while holding its investment policy unchanged. Debt-for-common-stock offers have the effect of increasing leverage, and vice versa. The theory and wealth effects of exchange offers are similar to those for share repurchases. Among the characteristics that typically result in positive returns to shareholders are:
Leverage-increasing exchange offers, like share repurchases, often are used as an alternative means of making payouts to shareholders. When share repurchases or exchange offers are used as takeover defenses, returns to shareholders are likely to be negative.
Going Private and Leveraged Buyouts(56)
“Going private” refers to the transformation of a public corporation into a privately held firm. A leveraged buyout (LBO), financed largely by borrowing, is the acquisition of the stock or assets of a public company by a small group of investors. The buying group may be sponsored by buyout specialists (for example, Kohlberg, Kravis, Roberts & Co.) or by investment bankers. A variant of the LBO going-private transaction is the management buyout (MBO) in which a segment of the company is sold to its managers. Since 1981, unit MBOs have represented more than 10 percent of total divestitures.
Increased leverage does not seem to have been a dominating motive in LBOs. While leverage is increased at the formation of the LBO, it is sharply reduced in successive years. Muscarella and Vetsuypens present data showing the pattern of leverage for a sample of 72 firms that were taken private in LBOs and returned to public ownership through stock offerings about three years later. The debt-to-equity ratio before the LBO was 78 percent, rose to 1,415 percent at the time of the LBO (on a market basis), dropped to 376 percent before the offering, and declined to 150 percent after selling shares to the public. Since equity values are increased, the ending leverage ratios at market could be below 100 percent. Thus, super-leverage does not appear to be a lasting consequence of LBOs. The initial financing is de-signed to facilitate higher management participation in the equity, which is associated with subsequent operating improvements, value increases, and leverage reductions.
There is an important economic perspective to bring to LBOs. They were a unique and valuable economic innovation in combining four important elements. First, was the use of high leverage so that the equity segment was reduced in size. Key management personnel could be provided with a significant equity ownership either through their own investments or the improvements they achieve in operating performance. The gains to managers would have significant impact on their wealth positions. Second, there was always a turnaround element involved in the LBO, based on highly qualified management either already on board or available for recruitment. Third, the management possessed the power of unrestricted decision making; they could utilize their knowledge, could be flexible, and could make prompt decisions without several layers of hierarchical review. Fourth, the rewards of successful operations were large and significant; they provided strong motivation to key managers and employees in the new firm.
This innovative concept was sound. Returns to the original shareholders on the initiation of an LBO or MBO were at least on the order of magnitude of 40 to 50 percent. Successful LBOs could go public again. In the so-called reverse LBOs, returns to the shareholders (who now included the key personnel) were in the 50 to 60 percent range.
To understand the subsequent history of LBOs, we must view it in an economic perspective. Significantly high returns attract additional investment. LBOs began to total $20 billion annually by the early 1980s and had reached $61 billion per year in 1988. The data clearly illustrate the operation of the fundamental economic principle that high returns attract the flow of additional economic resources for investment. But LBO activity fell off greatly in 1989 and 1990.
By 1988 there was enough LBO money to finance an additional $250 to $300 billion of LBO transactions. But by 1989 some LBO funds were reporting that they hadn’t done a deal for two years because many proposals made no business sense or were overpriced. When they did bid on attractive deals, the winning bid was often 50 to 75 percent higher than the second highest bid.
Leveraged cash-outs (or defensive recapitalizations) are a relatively new technique of financial restructuring first developed by Goldman, Sachs & Co. for Multi-media, Inc. in 1985. It is considered to be a defensive tactic, because in most cases leveraged cash-outs (LCOs) have been responses to takeover bids. In a typical LCO, outside shareholders receive a large one-time cash dividend, and insiders (managers) and employee benefit plans receive new shares instead of cash. The cash dividend is financed mostly by newly borrowed funds, both senior bank debt and mezzanine debt, i.e., subordinated debentures. As a result, the firm’s leverage is increased to an abnormally high level and the proportional equity ownership of management significantly rises through the recapitalization. LCOs are associated with a positive 20 to 30 percent abnormal return at the announcement time. But financial difficulties often were encountered after the recaps when cash flows were not large enough to pay down debt.
An employee stock ownership plan (ESOP) is a type of stock bonus plan that invests primarily in the securities of the sponsoring employer firm. A dramatic increase in the use of ESOPs as a takeover defense occurred in 1989. For example, in response to a tender offer by Shamrock Holdings, the investment vehicle for the family of Roy E. Disney, Polaroid established an ESOP that held 14 percent of Polaroid’s common stock. Like most large corporations, Polaroid is chartered in Delaware. The Delaware antitakeover statute forbids hostile acquirers from merging with a target for at least three years unless 85 percent of the company’s voting shares are acquired in a tender offer.
ESOPs have been used in a wide variety of corporate restructuring activities. Fifty-nine percent of leveraged ESOPs were the vehicles used to buy private companies from their owners. This enabled the owners to reap tax-free gains by investing the funds they received in a portfolio of securities. ESOPs also have been used in buyouts of large private companies as well.
Thirty-seven percent of leveraged ESOPs were employed in divestitures. In one of biggest ESOP transactions, Hospital Corp. of America sold more than 100 of its hospitals to HealthTrust Inc.—The Hospital Co., a corporation created and owned a leveraged ESOP.
Leveraged ESOPs have been used as rescue operations. An ESOP was formed in 1983 to avoid the liquidation of Weirton Steel Co., and it subsequently became a profitable, publicly owned company. However, ESOPs used in attempts to prevent failures the of Rath Packing, McLean Trucking, and Hyatt Clark Industries did not succeed and were followed by bankruptcies.
A number of leveraged ESOPs were formed as takeover defenses to hostile tender offers. ESOPs were established as takeover defenses by Dan River Corp. in 1983, Phillips Petroleum Co. in 1985, and Harcourt Brace Jovanovich, Inc. in 1987.
The Tax Reform Act of 1986 also permits excess pension assets to be shifted into ESOP tax-free. Ashland Oil reverted $200 million and Transco Energy Co. $120 into new ESOPs to take advantage of that shield.
ESOP transactions may represent economic dilution. Potentially, they transfer shareholders’ wealth to employees. ESOPs represent a form of an employee pension program. If the ESOP contribution is not offset by a reduction in other benefit plans or in the direct wages of workers, employees gain at the expense of shareholders. The argument has been made that any borrowing by the ESOP uses some of the t capacity of the firm. It also could be argued that such borrowing substitutes for other forms of debt that the firm otherwise would use. To the extent that there is a valid belief that ESOP transactions represent economic dilution to the original shareholders, the price charged the ESOP for the company stock transferred to the plan may contain a premium to compensate for economic dilution. Since the U.S. Department of Labor reviews such transactions, this may be a source of its disagreements about the fairness of the price charged the ESOP by management. The impact of moving equity shares to the ownership of the employees is a disadvantage of ESOPs.
The broader economic consequences of ESOPs have been analyzed. If management also controls the ESOPs that are created, there is no increase in employee influence on the company. While employees may receive stock that can be sold, the additions to their wealth may be relatively small, and may not be sufficient to foster motivation for increased efforts by workers or harmonious relations between workers and management.
On the other hand, if workers do receive substantial increases in control over the company through ESOPs, other harmful results might follow. Workers might use their increased ownership powers to redistribute wealth away from the original shareholders and other shareholders in the firm. The view has been expressed that market forces can be relied on to produce employee ownership where it is appropriate, without the necessity of tax subsidies, and that the subsidies may cause a misallocation of resources.
ESOPs have provided some participation to workers. However, the motivational influences do not appear to have been sufficient to truly affect company performance. In addition, the ESOPs appear often to be controlled by managements and used by them as instruments of policy. It has been estimated that the federal revenue losses from ESOPs for the 1977-1983 period were about $13 billion, an average of $1.9 billion per year. Questions have been raised about whether these tax subsidies really serve a useful purpose.
Corporate Control Issues(58)
The fourth set of restructuring formats deals with corporate control issues. We first consider unequal voting rights such as a Class A and a Class B stock. Typically the Class A stock has superior rights to dividends but inferior rights to vote. The Class B stock has superior voting rights but limited dividends. One study shows that in dual class companies, management’s voting rights ownership was almost 60 percent, but their claims to cash flow were only 24 percent. Often two classes of stock appear in corporations where the family founders seek to maintain or increase their control positions.
A strong motive for superior voting rights is that they enable the management control group to achieve continuity of future plans and operating programs. Some argue that the superior voting rights are likely to receive higher benefits in a merger or takeover. Empirical studies indicate that securities with superior voting rights sell at a premium of 5 to 6 percent.
One way to establish two classes of stock is by dual-class recapitalizations. Years ago, firms that established dual classes of stock were delisted from the New York Stock Exchange for violating its rule of one-share-one-vote. But in June 1984, the Big Board put a moratorium on the delisting of dual-class equity firms. Studies both before and after the moratorium date indicate a small but insignificant effect on stocks with resulting inferior voting privileges.
Lehn, Netter, and Poulsen compared dual-class recaps with LBOs. Firms with greater growth opportunities, lower agency costs, and lower tax liability, appeared more likely to consolidate control through dual-class recaps. Their study also found significant increases in industry-adjusted operating income for dual-class firms, but less than the increases found in a sample of LBOs. Dual-class firms allocated a higher percentage of subsequent cash flows to capital expenditures than LBO firms. A high proportion of dual-class firms subsequently issued equity securities. The evidence suggests that dual-class firms possessed more growth opportunities than the LBO firms.
A proxy contest represents another form of control struggle. Proxy contests are attempts by dissident groups of shareholders to obtain board representation or enough seats to control the board and the company. Various interpretations of the success of proxy contests have been offered. One is that the dissident group usually wins a majority of the board. Another view is that a proxy contest succeeds if at least two persons are elected directors, one to propose motions, and the other to second them, so they can get discussions into the minutes of the board meetings. Still a third view holds that the mere staging of a proxy contest is sufficient to indicate that changes will have to be made in the firm’s management.
Studies of proxy contests indicate that they are associated with positive abnormal returns ranging on the order of magnitude of 6 to 10 percent. Even if there is conflict within the board as a result of a proxy contest, the results seem to indicate that the benefits of adversarial mutual monitoring between the two groups outweigh the coats. The positive shareholder gains indicate that there had been agency problems or potential for improved management performance prior to the proxy battle.
Proxy contests over the right to control the firm increase the likelihood that corporate assets will be transferred to higher-valued uses. They perform an important and effective disciplinary role in the managerial labor market. Finally, they provide met another approach to takeover activity. Changes in laws and regulations to effect a reduction in the costs of a proxy fight would increase the use of proxy-contest mechanisms in the market for corporate control.
In a defensive context, the premium stock buy-back is actually a euphemism for “greenmail.” The company repurchases the shares that have been acquired by outsiders as the opening wedge to mounting a hostile takeover, and the “raider” group drops its bid. The proceeds usually include a premium over the market price of the stock and the deals often are replete with standstill agreements that bar the raider from launching a new bid for a specified period of time, such as 5 to 10 years.
Some authorities believe that greenmail and standstill agreements are harmful to shareholders because the raider may have been able to provide more short-term value for them. The counter argument is that existing management may see greater value potential in the future, which justifies paying greenmail. Additionally, management may feel that given sufficient time it can develop multiple offers, initiate a bidding contest for the firm, and obtain higher value for shareholders than if the raider’s efforts succeeded. In many cases, targeted companies indeed have generated large increases in shareholder values after raiders had been bought out. However, the initial impact of greenmail and standstill agreements may be small negative changes in the value of the firm’s shares