4. M&A In the USA for foreign enterprises: Deal Structure and Definitive Acquisition Agreement
Issue 04-2023
This blog post continues our Foreign Direct Investment series for Italian enterprises seeking to enter the US marketplace via an acquisition of or merger with an existing US business. In this post, we review various forms of deal structures and associated transaction documents.
Mergers and Acquisitions in the private sector result from a series of negotiations which have led the Parties thru a series of preliminary agreements, most notably the Nondisclosure Agreement and Term Sheet. In most instances, the Term Sheet will also specify the proposed deal structure which invariably will either take the form of an asset or stock transaction.[1] Although in principle these two forms carry different and distinct legal foundations, yet the documentation underpinning these structures share many of the critical contractual provisions contained in the definitive transaction agreement.
The Asset Purchase. Asset deals simply reflect the Targets assets are being acquired instead of the stock of the Target. Thus, the negotiations in an asset deal focus squarely upon the Target’s balance sheet where both of its assets and liabilities will be allocated between the Parties through negotiation. Certain liabilities on the balance sheet will be assumed by the Client with other liabilities remaining with the Target. For instance, certain shareholder loans made by the Target to its owners may remain with the Target and not assumed by the Client, or certain claims of lawsuits against the Target may also remain with the Target. Similarly, certain assets may also remain with the Target such as any cash on the books or account receivables.
Commensurate with any asset deal, the Client will benefit from the ability to “step-up” the basis in the assets purchased for federal tax purposes which allows for a new depreciation schedule to begin relative to the purchased assets. The economic allocation and valuation of the assets purchased will be appended to a schedule as part of the definitive acquisition agreement. Any purchase price for the assets above the allocation schedule will be treated as goodwill which must be amortized in accordance with applicable accounting and tax principles.
In terms of the mechanics of a definitive asset purchase agreement, it will follow more or less a standard format as follows:
- Assets to be purchased
- Price to be paid for the purchase assets
- Manner of Payment (cash, debt, hybrid of both, stock for assets)
- Earn-Outs – portion of purchase price paid over specified period to time based upon Target meeting defined economic milestones post acquisition
- Assets excluded from the purchase
- Retained Liabilities of the Seller
- Closing and closing obligations
- Buyer and Seller deliverables at Closing
- Working Capital Adjustment Procedure
- Consents needed to transfer assets
- Representation and Warranties of both Seller and Buyer
- Covenants of Buyer Prior to Closing
- Conditions to Close for both Parties
- Termination
- Indemnification and Remedies
- Choice of Law
Each of these provisions carry significant legal meaning and liability and therefore are subject to careful negotiation and adroit drafting. From a legal risk standpoint, the representation and warranty and Indemnification sections are the most subject to engender post purchase claims and disputes between the Parties, Hence they require carefull attention and thorough understanding of their implications post-closing.
With respect to the Representation and Warranty section, the Buyer will demand the Seller represent and warrant all material matters affecting the Purchased Assets. This section is by far the most expansive section in an Asset deal as the Buyer will want virtually all material matters to be pinned down and represented by the Seller in the agreement as factual and warranted as truthful. For example, the Buyer will insist the Seller represent and warrant to the effect “ there are no third-party claims of whatever nature upon the assets purchased” or “the account receivables are in good order and are fully collectible in the normal course of business”. Again, the possible list of R&W’s are too numerous to list here and are driven by the Buyer’s need to be assured of the assets it is purchasing as well as the liability it is assuming versus the Seller’s desire to limit its post-sale exposure. Thus, this section is often the most contentious part of the negotiations and drafting as the Buyer will seek to maximize its post-transaction protections while the Seller will want to limit same.
The tension between these competing forces is resolved within the confines of the asset purchase agreement via the terms of indemnification offered by each Party. This section is also heavily negotiated as the Buyer will want to be indemnified and held harmless after the closing for the breach by the Seller of any post-closing covenant or representation or warranty while the Seller will want to limit its post-sale indemnity obligations and thereby seek to retain as much of the purchase price proceeds as possible. Often the Parties will agree upon a defined monetary limit before any indemnification claims can be made against the Seller for breach as well as a defined limitation upon the time period in which any representations or warranties survive after closing.
The Stock Sale. The Stock of the Seller represents the bona fide ownership in the enterprise and hence, with the purchase of stock, the Buyer accedes to its ownership.[2]
As such, the Seller cannot disclaim ownership of any assets or claims made upon them by third parties as the ownership of stock imbues the Seller with complete sovereignty over the Seller’s balance sheet. Moreover, unlike the asset purchase scenario where assets are individually valued and purchased, the stock sale requires a fair market valuation as to the entire enterprise. The manner in which this valuation is calculated is in the “eyes of the beholder” and can vary greatly and is often subject to differing views and concepts of enterprise valuation between the Seller and Buyer. Often, the Buyer’s accountancy firm or investment banker will assist in this valuation exercise with similar advice sought by the Seller from its professional advisors. Once an enterprise valuation is agreed upon as well as the manner of payment, the mechanics and the legal framework of a stock purchase agreement mimics closely an asset purchase agreement. Specifically, the Buyer will seek the same manner of representations and warranties and indemnities while the Seller will seek to limit its post-acquisition liability.
It should also be noted the different federal tax treatment in a stock sale. Unless the Seller makes a Section 338 election under the Federal Tax code, the Seller will not receive any “step-up” in the assets purchased as it would in an asset purchase deal. If however the Buyer makes a Sec. 338 election, it treats the transaction as a stock purchase for legal purposes. Hence, it continues to acquire the Seller’s liabilities, including outstanding debt, shares of capital stock, and certain contingent obligations. However, under Section 338, the Buyer is deemed not to acquire the seller’s assets; rather it steps up the basis of those assets to the purchase price paid for the stock. Thus, the Buyer reports the transaction as a sale of stock and recognizes ordinary income equal to the difference between the purchase price and the adjusted cost basis of the stock. Any excess of the purchase price over the adjusted cost basis will be treated as goodwill[3].
Next-up in our Foreign Direct Investment Series will focus upon “Post-Sale Integration.
[1] The M&A transaction may also consist of a merger of the Client and Targets enterprises. Merger Agreements may take various forms not addressed here; however, many of the same drafting issues discussed in this Post occur within the realm of a merger agreement as well.
[2] A Buyer may only seek to purchase a portion of the outstanding stock which bestows control such as a 51% stake in the Company. For purposes of this Post, we assume a 100% acquisition of the stock or membership interests in the enterprise.
[3] Goodwill represents the purchased excess over the adjusted cost basis of intangible assets such as customer relationships, brand recognition, and patents