Although the value and volume of merger and acquisition
(M&A) transactions varies from year to year, deal activity
throughout the pandemic trended largely in one direction: up. For
seven consecutive quarters between Q2 2020 and Q1 2022, global
M&A activityexceeded $1
trillion.
The dizzy ascent, however, has begun to falter. Since the second
half of 2022, deal-making has been sluggish due to a range of
economic headwinds, such as the rising cost of debt, mounting
inflation and the still looming threat of recession.
Unfortunately, not all sellers have gotten the message.
Bolstered by years of rich purchase prices and public market
valuations that continue to defy gravity, many private market
sellers are holding out for the higher value offers no longer on
the table. As the expectation gap between buyers and sellers
widens, deals are stalling. This, despite the fact that private
equity buyers have money to spend and many business owners remain
incented to sell following the harrowing years of the pandemic and
as they reach retirement age.
Fortunately, strategies exist that can help bridge the value gap
between buyers and sellers interested in transacting. Some are
tried-and-true solutions resurging in popularity in response to the
current deal environment. Others can be combined within a single
transaction to reach the desired results. All, however, rely on
careful coordination between commercial and tax advisors.
1. Spin-offs or split ups
Sometimes, buyers and sellers find themselves agreeing on the
value of most of the target entity’s assets or
business—but not all of it. In these scenarios, it may be
possible to bridge the gap between the buyer and seller by spinning
off the segment of the business whose value is in dispute, assuming
those assets are not integral to the buyer’s desire to acquire
the target business.
In this situation, the target entity will typically spin the
disputed assets or business unit into a new company that either can
be retained by its shareholders (i.e., the sellers) and
operated independently or sold to a third party (either by the
buyer, target entity or sellers) who may value it differently than
the buyer. With these disputed-value assets dealt with, the target
entity holding the remaining assets can be sold to the buyer at a
mutually agreed upon price.
While this approach can serve to bring buyers and sellers into
alignment, it typically requires significant tax planning to
execute, depending on who is acquiring the disputed-value assets,
whether the target entity has material accrued but unrealized gains
on those assets and what that entity’s other tax attributes are
(e.g., loss carry forwards). If those assets are being
distributed to the shareholders of the target entity, tax planning
is also necessary to determine the optimal form of distribution
(e.g., as dividends, a return of capital or something else
entirely). To minimize taxes, it is essential to consider the tax
attributes of both the target entity and its shareholders before
locking in a structure.
2. Share exchanges
If sellers are feeling shortchanged but believe the buyer’s
business will continue to rise in value, they may be willing to
reduce their cash purchase price in exchange for shares of the
buyer. From a commercial perspective—if the buyer’s
shareholder is willing to be diluted—this allows the selling
shareholders to participate in any upside the buyer realizes,
including upside from the business they are selling. From a tax
perspective, the exchange of seller’s shares of the target
entity for shares of the buyer can be accomplished in some cases
without the gain being realized for tax purposes. For example, it
is typically possible to exchange shares of one Canadian
corporation for shares of another Canadian corporation without
realizing accrued gains. Where the buyer is foreign,
“exchangeable share” structures may be the answer. Again,
understanding all the available options requires close
collaboration between your trusted business and tax advisors.
3. Earnouts
Sellers who truly believe in the future value of their business
may be willing to make a portion of the sale price contingent on
achieving certain metrics over time. For instance, let’s say
the buyer is willing to pay $60 million for a business the seller
believes is worth $100 million. In this case, the buyer may agree
to pay $50 million on closing, plus 10 per cent of earnings or
profits for the first three post-closing years, to a maximum of an
additional $50 million. In this manner, the buyer’s risk of
over-paying is mitigated by making part of the sale price
contingent on post-closing performance of the business.
This structure allows a buyer to defer part of the payment over
time, while making it contingent on the achievement of carefully
predefined results. At the same time, it allows sellers to attract
a higher value for the business if it meets specific pre-agreed
milestones within a pre-set time.
Although earnouts have been around for a long time, their
structure has shifted recently. Rather than buyers paying 80 per
cent to 90 per cent of the anticipated value of the deal up front,
as they did in the past, today many are offering only 40 per cent
to 70 per cent of the value up front—putting sellers in a
position of potentially earning out more than half the value of the
sale. Proving that each contingency has been met has also become
highly disputed, leading to a growing incidence of litigation
related to earnouts, which makes careful structuring and
documentation more important than ever.
Earn-outs are especially tax-intensive, and unless structured
properly, they can result in the sellers being taxed at higher
rates (i.e., above the normal rates applicable to capital
gains) on the variable portion of the sale price (or possibly the
entire amount). There are certain techniques accepted by tax
authorities for mitigating this potentially adverse tax result,
again making early-stage tax planning very important.
4. Vendor financing
Like earnouts, Vendor Take Backs (VTBs) allow buyers to defer a
portion of the purchase price to a later date. Rather than making
the future payout contingent on achieving specific milestones,
however, a portion of the purchase price is structured as a debt
owing by the buyer to the seller pursuant to a vendor take back
financing agreement. In essence, the buyer pays the seller-financed
portion of the purchase price plus interest over a pre-agreed
period (e.g., the next one to three years) subject to
certain acceleration clauses. The VTB’s applicable interest
rate is typically materially lower than what the buyer could obtain
from a third party.
As VTBs come back into vogue, their tax implications must be
considered. In some cases, sellers may be able to defer tax
recognition of the unpaid portion of the purchase price over the
period between closing and when the debt is fully paid (up to a
maximum of 5 years) by claiming a reserve. For instance, if the
buyer agrees to pay $50 million at closing plus an additional $50
million over the next five years via balance of sale proceeds
(e.g., $10 million per year for five years), the seller may be able
to claim a reserve for tax purposes on the portion of the sale
proceeds received after the year in which the sale closes, thereby
deferring tax on some of the gain otherwise realized on the sale.
Moreover, if the debt owing is structured at low or no interest,
the seller may also be able to get a better total purchase price
while minimizing taxes that would otherwise be owed on interest
income.
5. Partial purchases
Like earnouts, partial purchases allow buyers to pay a lower
price than sellers want in exchange for less than 100 per cent of
the target entity. Generally, the buyer will purchase a majority
stake while the seller retains a minority and both parties enter a
shareholder agreement that allows the buyer to call the shares of
the target entity held by the seller—or the seller to put its
shares to the buyer—at a pre-set price, depending on the
achievement of specific performance metrics or using a pre-set
valuation formula after an agreed period of time has passed.
If target entity performs well post-acquisition, the sellers may
receive the full purchase price for which they were looking.
However, if performance falls short, the call may allow the buyer
to purchase the seller’s remaining shares at a discount
(sometimes as low as $0.01 per share).
While this structure can be complicated from a commercial
perspective due to the restrictions contained in the shareholder
agreement, it is somewhat less tax intensive than other solutions,
particularly if the buyer puts money into the target entity without
requiring existing shareholders to sell their remaining shares.
Instead, their ownership stake would simply be diluted. That said,
if the sellers would like to take money out as part of the
transaction, there are several tax issues that should be resolved
in advance of the transaction.
6.Alternative consideration
Yet another way for a seller to earn a higher total return is by
agreeing to work for or advise the target entity or buyer
post-closing as an employee or consultant in exchange for a
compensation package. This could include not only a salary and/or
consulting fees, but also above-average bonuses, participation in
any equity compensation or pension plan the buyer operates and even
the right to earn warrants at a later date contingent on achieving
certain milestones.
From a tax perspective, so long as the amounts being paid
represent reasonable fair value for the services received, these
expenses would normally be deductible to the target entity or
buyer. While the recipient may earn amounts as fully taxable
income, in some cases certain forms of compensation can be
tax-advantaged to the recipient and constitute a way of putting
funds directly into the hands of specific individuals providing the
relevant services to the target entity or the buyer.
7. Tax relief via existing tax attributes
In some cases, a seller’s over-all after-tax receipt can be
significantly improved without increasing the purchase price by
optimizing the use of all the available tax attributes of the
target entity and the seller. For example, frequently significant
taxes can be saved by using the lifetime capital gains exemption
for Canadian-resident individuals, by using loss carry forwards or
other available tax shelter, by having the target entity pay (or be
deemed to have paid for tax purposes) dividends to a holding
company owned by the seller rather than to the seller individually,
by using the target entity’s capital dividend account prior to
closing or various other tax planning techniques. Not surprisingly,
expert tax advice (preferably obtained from counsel on a
confidential basis protected from disclosure to tax authorities by
solicitor-client privilege) is necessary to achieve these
results.
8. Dealing with liabilities
While less obvious to some sellers, liability relief may make
sense where the dispute in value relates to a latent liability that
could impact the long-term value of the deal. In many cases, buyers
can claw back a portion of the purchase price as part of an
indemnity claim if they find themselves faced with unanticipated
material liabilities post-closing (e.g., unpaid bills, tax
obligations, pending lawsuits, environmental remediation, etc.). In
exchange for having these indemnity claims waived, sellers may be
willing to accept a lower purchase price. Using representation and
warranty insurance, which the buyer typically pays for, the sellers
could walk away from the deal with zero risk (e.g.,
selling a house without any closing conditions). Conversely, where
the buyer is concerned that the target entity has a particular
liability that the seller thinks is not a problem (viz.,
the parties disagree), changing the form of the transaction
(i.e., from a sale of the target entity’s shares to a
sale by the target entity of its assets) serves as a structural
solution by relieving the buyer from bearing that risk and
eliminating the discount to the purchase price it would otherwise
insist on.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
