By Cristian Anastasiu and Michael Schwerdtfeger

A while back Cristian Anastasiu, Managing Partner at Excendio Advisors, had the opportunity to co-write a series of M&A articles published by Channel Futures with Michael Schwerdtfeger.   One of the articles in that series discussed a number of deal terms that continue to bewilder newcomers to the M&A process: stock vs asset sales, working capital, and deal documents.   This short read will help clarify the readers understanding of these essential elements of M&A.

Over the past few months, we’ve taken a look at ongoing M&A activities in the IT services sector and the reasons for the current consolidation wave. We’ve also talked about how these companies are transforming to reduce risk and drive value to investors, an investor’s perspective on IT as a service, plus three steps to increase the value of your company, if and when you get ready to participate in the wave.

In the final segments of our series, we’ve shifted to the key transaction elements. Last month we discussed purchase price and terms; this month we will review other key deal terms that you might encounter.

Stock vs. Asset

From a legal and tax perspective, there are two types of M&A transactions: asset sales and stock sales. The key differences between the two are how legal liabilities are treated and how the proceeds and future company are taxed.

In terms of legal liabilities, in a stock transaction, the buyer inherits unknown liabilities, such as potential future lawsuits by former employees or clients. In comparison, in an asset transaction, the buyer usually explicitly declines to purchase any unknown liabilities and leaves those responsibilities with the seller. Consequently, buyers tend to prefer asset sales.

Asset sales are also beneficial to buyers from a tax perspective. In an asset sale, the buyer can usually depreciate the purchase price compared with a stock sale, where the buyer doesn’t get that tax benefit. From a seller’s perspective, in a stock transaction, the proceeds are generally taxed at the capital gains rate, while in an asset deal, the proceeds could be taxed at a rate as high as the income tax. Additionally, if the seller is a corporation that has not made a subchapter S election, it is possible that the proceeds of the sale will be subject to two layers of taxation.

Therefore, it’s no surprise that buyers prefer an asset transaction while sellers prefer a stock structure.

Fortunately, even where an asset sale is chosen, steps can be taken to limit the tax hit. If the seller is organized as a limited liability company (LLC) or has made a subchapter S election, in the case of “asset light” companies such as IT services companies, most if not all of the proceeds can be characterized in a way that will allow primarily capital gains tax treatment for the seller. Even for a C corporation, there are structures that can lead to a significant tax reduction for the seller without being detrimental to the buyer. Having both parties’ tax advisors talk directly can optimize the structure as a win-win for both sides.

So what can a seller do to persuade the buyer to accept a stock transaction?

For one, a buyer will be more open to a stock deal if the perception and expectation of any hidden liabilities is minimized or eliminated. To that end, it is very important for the seller to be transparent and follow a “bad news first” approach from the very beginning, with no surprises throughout the process. Making a great first impression and then consistently confirming it will set the tone for future negotiations and positively impact the terms the seller can negotiate. One buyer shared with us that they have three versions of a purchase agreement, and they decide which one to use in a given deal depending on how the initial due diligence went and their perception of how transparent and forthcoming the seller is: from a “light,” friendly version, with reduced indemnification and reps and warranties requirements, to a very detailed one including significant and broad indemnifications and stronger language.

One other reason a buyer may prefer a stock transaction is that, in a stock deal, most if not all agreements (with clients, vendors, employees) are more easily transferred, making the post-acquisition integration process much smoother. We’ve seen this occur in transactions where there are crucial third-party agreements (or governmental approvals) that would be difficult to renegotiate or otherwise assign.

Working Capital

An offer is not complete if it does not specify the amount of working capital the seller must deliver at closing. This is one of the most misunderstood components — and sources of friction — during the purchase agreement negotiation and due diligence, if it has not been discussed early on, as part of the Letter of Intent.

There is general agreement that an IT services company will “come with” enough working capital — calculated on a cash free, debt free basis — such that the buyer will not have to bring additional money to run the company post-closing. This is sometimes in conflict with an owner’s expectation that he should be able to keep the “equity” in the company at closing, where the seller believes that the working capital is his own.

In most cases, the equity is the same as the working capital a buyer needs to run the company. At the end of the day, this becomes an academic, but sometimes emotional, argument. The bottom line is that an offer needs to specify how the balance sheet, including working capital, will be treated at closing.

However, there are a few exceptions that a seller should consider before agreeing to deliver the full amount of required working capital: If the company is growing and as a result requires more working capital, but the valuation was based on past performance, shouldn’t the working capital be adjusted to those lower revenues? Or if the cash at closing is less than 70 percent or even 50 percent of total consideration, shouldn’t the delivered working capital reflect that percentage?

IT services companies with recurring revenues and multi-year contracts will have a significant deferred revenue account on the balance sheet. Should the full amount be considered a liability when determining the target working capital at closing?

Finally, it is important for the buyer and seller to agree on how working capital will be determined and how the adjustment at closing will be calculated (for example, based on GAAP or on past practices). Lack of clarity can lead to disputes.

Deal Documents

Eventually, there will come a time in the transaction when the attorneys talk directly and work out all the details of the deal documents. But, since many of the items that were discussed during negotiations are business and economic rather than legal, the principals and the intermediaries should be directly and actively involved in this process.

Regardless of whether the transaction is an asset sale or stock sale, the main deal document is the Purchase Agreement, which will include definitions, representations and warranties, schedules, indemnifications, conditions to closing and covenants. The purchase agreement will also most likely be supplemented by other documents such as employment agreements, notes, credit documents, equity agreements and similar forms.

  • Definitions: The definitions section is one of the most important because if done right and comprehensively it can help reduce or even eliminate conflicts post-closing. The definitions, including how EBITDA, gross margin, working capital, and earn-outs will be calculated, are very specific to each deal and require the active involvement of both the buyer and the seller, as well as their counsel.
  • Representations, warranties and indemnities: This section will include representations about virtually every aspect of the business and is intended to be a risk sharing mechanism primarily protecting the buyer. Indemnities address what happens if liabilities occur, and who, how much and for how long should be held accountable.
  • Conditions to closing: This is a list of conditions that must be met by either party before closing the transaction. In the case of IT services companies, the most significant component will be consents from customers and partners, if the respective agreements so require. Also, the letter of intent should disclose what approvals the buyer will need to close (for example, financing).

Covenants: Covenants will include agreements of the parties to do certain things at and after closing. These provisions typically address items such as post-closing employment, non-compete and non-solicitation by the seller and stockholder agreements.