Acquisitions
Buying another company is a tried and true growth strategy. Making an acquisition can achieve economies of scale, increase a customer base or product line, expand into a new territory or eliminate a competitor. The cost of acquiring a company with a new product or technology may be less than the cost of creating it internally. In addition, an acquired business may be more profitable as part of a larger organization with greater resources than as a stand-alone business.
Due Diligence.
In the initial stages of an acquisition, it is important, of course, to understand exactly what is being acquired. Every company has its own culture, accounting practices and hidden liabilities. An effective due diligence program can identify the target’s strengths, weaknesses and issues that need to be addressed in the acquisition context. The following checklist of items represent the principal areas of legal due diligence. The acquisition candidate should be asked whether it has any of these items, and if so they should be studied carefully to assess their impact on its business, value and prospects.
- Agreements among stockholders, such as voting trust, buy/sell, stockholder, or right of first refusal agreements.
- Convertible debt and preferred stock instruments; notes and credit agreements.
- Restrictions on doing business in any territory or with any group of customers and any other material business contracts such as supply or distribution, franchise, license or alliance agreements.
- Pleadings in pending and recently settled lawsuits and summaries of disputes with suppliers, competitors or customers.
- Employment, consulting and non-compete agreements and management incentive agreements or bonus plans.
- Audited and unaudited financial statements, financial and operating budgets or projections and business plans, marketing studies and consultant reports.
- Lists of real and material personal property and eases for real or personal property.
- Lists of proprietary technology including issued patents and patent applications.
- Acquisition, partnership or joint venture agreements and any governmental agency inquiries.
Once an acquisition candidate has passed due diligence and a decision has been made to proceed with an acquisition, a new set of issues must be addressed. These issues concern how the transaction will be structured for tax purposes and how other liabilities of the target will be allocated between the buyer and the seller. These questions require input from an experienced tax advisor.
Tax Issues.
The principal tax issues that must be addressed in an acquisition include the following:
- Will the transaction be structured so that the purchaser obtains a new cost basis in the target’s assets or will the purchaser take a carryover basis in the target’s assets (generally, the lower historical asset basis)?
- Will the transaction cause the target to pay a corporate-level tax on all the gain inherent in its assets, including good will and other intangibles? If so, will the economic burden of this fall on the buyer or the seller?
- Will the seller pay tax on the gain inherent in its stock? If so, can that gain be deferred?
Critical Non-Tax Issues.
The principal non-tax acquisition issues include the following:
- Will the purchaser inherit all of the target’s liabilities (disclosed and undisclosed) or will the purchaser assume only specified liabilities of the target?
- If the seller’s representations and warranties turn out to be false, and the purchaser suffers losses from undisclosed liabilities (such as environmental cleanup, unpaid taxes, employment discrimination, anti-trust violations, product liability or patent infringement) or some other shortfall in assets or business operations (such as lack of title to assets, receivables not collectible, inventory not saleable or financial statement inaccurate), will the buyer be able to recover a portion of the purchase price from the seller?
- Will the executive management of the target be retained to operate the business?
Structure of the Transaction.
After these issues have been resolved, the parties must settle on the structure of the transaction and negotiate other contract issues. The following is a partial list of the most common matters that need to be resolved:
- If part of the purchase price is payable in notes, what will be the terms of the notes? What will be their maturity, interest rate, default and other provisions? If part of the purchase price is payable in stock, what preferences, conversion rights, anti-dilution protection, dividend rates, and registration rights will the securities have?
- Will there be any right to adjust the purchase price based on future operations of the business?
- Will any assets of the target be excluded from the acquisition?
- To what extent will the purchaser inherit the target’s liabilities and obligations?
- Will the seller give representations and warranties concerning the target? Will they be qualified with reference to knowledge and materiality? What sort of indemnification will be given in the event of a breach of the representations and warranties?
