STRUCTURING A BuyouT— Wauat Every VC Proressionat Must Know KIRKLAND & ELLIS / PRIVATE EQUITY OR VENTURE CAPITAL PROFESSIONAL (ve") sHouLo Focus IN STRUCTURING THE BUYOUT (“LBRO”) OF AN EXISTING Company (“TARGET”). INCLUDING: A, LBO of Bigco subsidiary B. LBO of private Target owned by individual or group © LBO of publicly traded company B. LBO structured for recap rather than purchase accounting A, Buyout of Bigco Subsidiary In this A. Big ae corporation operating many business ses sell Tager— “originally acquited by Bigco inthe heady days of conglomerization—so that Bigeo can x VC— along with Ta «executives located by VC) and several lenders —is structuring Newco to acquire Target from Bigeo. 1 ©1999 ack, evn of bok Scaring Vente and published annual) and s sack >. Levin is a partner at the law fiem of Kirkland & Ellis where he concentrates on mergers, acquisitions, buyouts, private equity investing, private equity fund formations, oubled companies, and other complex business transactions,Tangs Meme Meus Lend Bank — n-------3 formed to buy 3 Separate Transactions ‘An LBO consists of thre separate mansactions, each, ‘complex and time consuming and all mutually ineerde- pendent in their consummation: 1, Neweo’s purchase of Target ‘The firs transaction —Newco’s purchase of Target from Bigco—presens al the issues inherenc in any complex ‘corporate acquisition: {a) Negotiating the pur business, including (i) whether all of the price is payable in cash or a portion is payable in Newco subordinated note or prefered stock (ie seller pape) i) whether the price is completely fixed ois subject to post-closing for- mula adjustment bared (0) on Target closing dare nee worth or net working capital, and (ii) whether (in addi- tion to fixed price) there is als a formula contingent ‘carn-out based on thelarge business ute performance in Newco's hands. se price (ur the Target (b) Negotiating Bigco’s representations, warranties, and indemnification obligations cgarding Target's bsinese, which Neweo secks for three reasons: © To obtain fom Bigco information Neweo can use in deciding () whether vo buy Target, (i) what price o pay for Target. and (ii) whether to seek specific contractual clauses dealing with specific Target issues. 1 10 perme Newco to call off the deal after signing the contract but before closing if Targer's business fils to conform tothe contractual representations and warranties. on from Bigco after closing ifthe representations low Mewes to sesover money damagee and warranties turn our tobe incorrect. Some of the key representations and warranties Newco _may sek from Bigco inelude: © No undisclosed Target abilities, including cvinosmenlpllion volaions and dean-up obligations, employment discrimination, paten/copyrighd/trademark infingements, tax deficiencies, and athe lawsuits, claims, and contingent liabilities. ‘© Targets inventory good and salable in che cndinary course of business © “Targets receivables good and colecble in the ordinary course of business within a specified peti 9 Tepes angie ase in good condion Tages anil tatemens re and cote. © “Target has goo sd wo is assets and Bigen has 00d tice ro Targets stock, © “Target as not violated any avs or govern ental segulations © No goveinmental or third parey consents neces sary for completion of the LBO, excep as ised ona schedule. Bigeo’ representations and warranties can be unqualified or ‘an be qualified cither by Bigo's knowledge (or the know!- cexlge of specified Bigco executives) or by a materiality tan- dard orby both,Only if Rigen't eppreenrarinns and warranties su the closing can Newco make a contractual claim against Bigoo for damages, in which case the important con- tract negonation issues are () the tlme period during whic Newco can make claims, (i) the stated deductible amount which must be reached before Neweo can claim the excess ofthe threshold amount which must be reached before Newco can claim the entie amount, and Gi) any cap o ceiling on Newoo's claim. Security for any Newco claim against Bigeo (eg. escow, hholdback, serofF agains seller paper, en on Bigco asses} is important where Bigeo is in questionable financial health and may nat be able to satisfy Neweo claims (c) Negotiating Newco's closing conditions. maw gensally asks expansive closing conditions allowing it bow out ofthe uanseton (afer signing the acquisition agreement but before closing) if things do noe 0.35 Newco anticipate fie, Neweo seeks a contact, which isin effect an option to acquire Target), including: £ Success complevon of Newco’ financing ties afnancng ou) £ Suisicory completion of Newco doe diligence examination of Tage (ie ade diligence ou © Compliance with all applicable laws and regulations, including Hart-Scote-Redino CHR" antiteust clearance from FTC. © Necesaythind-parey consents (© No matral averse change (MAC?) to “Targets busines Bigca generally resists both a financing out and a due diligence out or atleast atcempes co limi the time during ‘which Newco can exercise such ous. 5 Neots inst and OID deci are on sehr ad Wii R, Welk article Five New Tax Deve Ud) Structuring the Neweo-Target acquisition as a purchase of assets, a purchase of stock, a forward cash merger, a reverse cash merger, or a reverse subsiutary cas! set which invoives ‘many complex issues, including © Whether the structure selected affords Newco. 1B") or asser carryover asset stepped up bass (°S basis COR") for ene purposes 0 whesher she srr sled resis in single or double xi esl © Whecher che structure selected requires the con- sent of other contracting partes... sale of, assets where seller holds non-transferable tech or lesosholde nology ose (e} Negotiating Bigco transition services agree- iment, Newco fen scks a conerace obligation for Bigco to supply aston services to Newco fora reasonable serid at reasonable pies, including MIS, purchasing ‘employe benef administration, insurance adminisra- cin, space rental accounting services receivables calles sion sndlor payables management. {fi Negotiating Bigco’s covenant not to compete with the Neweo- Target busines (a) Oraanizina Neweo’s due diligence on the “Target business, ‘The second of the three tansactions comprising an LBO—Newoos debe financing —includes negoiating the terms of Newco’ substantial senior bank and subordinated mezzanine ("meza") debt layers (which make Neweo’s buyout of Tarpera leveraged buyout) and struct debe terms so that Neweo satisfies all seven IRS hurdles nnecesary so cha interest and original issue discount OID" on che acquisition debe is deductible” ly dscone in hap 6 the authors Venue Capital book arin de rents Prete Eg Invests Must Know” in i nae Capel Rew ancy asaye 18eo Wines Bveny VE a Neweo's equity financing. Newco’ equity financing isthe third of the ere transac tions comprising an LBO, including such issues as: {0 The common stock split among VC, manage men, and the mers lend. (© Whether management buys cheap common soc to abn ETCC tan ratment or rceo ‘options (ISOs or NQOs). (© Vesting arrangements on managements stock or options, including Code §83(0) tax issues and APB 25-FASB 123 accounrng sus presented by such vesting * (© Whedicr Newou secures ate suusunea that VC is enticed fis vo receive back its investment plus fixed yield (through straight debentures and/or preferred stock) before split- ‘ing the residual (common stock) profits with ‘management and the mez lendet © Board control of Newco and veto powers for certain equity owners and creators. © Right of crs Newco equity oer to man- date or veto Newco sale o PO. 1D Whechee Newco ic formed () a argue corp subject co double exo” i) as a flow-through eatiy (ie. an LLC, partnership, or S comp) subject only o sinele tax in which case ultimate sale of Newco to BuyerCo can be structured t0 deliver asset SUB to BuyerCo with single (not double) ax w Newco and its equity owas Federal income tax aspects Newco would prefer to structure the acquisition so that, for tax purposes, Newco obtains asset SUB for Targets baineas, al othe ten of che purchase price Newen pays Bigo, pls (i) the Targee libiiies assumed by Newco, pls (ii) Neweo’s acquisition expenses Bigco, ‘on the other hand, may prefer ro structure for asset COB, for tax purposes, for reasons discussed below. ‘Where the transaction is structured to achieve asset SUB. for tax putposes,Bigco pays tax as iit had sold Targer’s stees Hlomenet whete die wansacsion nsec for asset COB, Bi tax as fit had sold Targees tock, igco pays ‘Where Target isa Bigco subsidiary (ling or eligible ro file a consolidated tax return with Bigco under the 80-80 test, itis generally feasible to structure the transaction so that Neweo takes assee SUB while Bigco pays only one tax, ice. tax ona sale of Target assets.“ Ths can be achieved eter) by an asset Sale, oF) by a fan ‘of Target into Newco or its subsidiary NewSub, oii) by a stock sale with Code §338{(h)(10) election (under which all parses ro the transaction are weated as if there were an as aa eng asset sale rather than a stock sale)” Various methods ofinceating Newco Tage key ctccuis, including tock options (ISO and NQOs), ales of cheap Newco stock strated obtain LTOG rrestment, vesting Code S83(6) sletons. and APB 2 a sat of me smors Vente Capt! Bok ines at extensively reviewed ASB 123 acon Choice oF ety for Neo is extensively dics in chapter 3 of the authors Venere Capital book “This acces onthe pil sation wher the FV of Target ses exces their as ass The ta seuctaring wou be diferent i Lingts aes ote wort et tan te pre soso Bs BS The 80-80 resis me where Bigco owns 8M of Tages stock dobby wore and by ale ignoring erin rps of non-soing ied and lied prefered oc) uaa. cop ps fea income tax ates ranging up 9 39 on both odinay income OF) and apt gain CCK. Aor $3381 10) eestion speed only whore News ea orporstion (no 2 patterhip or LLC), bath Neweo ad al of Tanger el sr clad sn th sh eines a met A Cane 358810 eco solo eon witha(0 In the SUB transaction discussed in this A, “Target isa Bigco subsidiary before the tansac- rion, By concras, where Tager (before che trans- (ae Band C ssi) is ue a Dig subsiiany below), structuring Newco’ purchase of Target for asset SUB results in double tx on the trans- action (unless Target is 2 seasoned S corporation, a parenersip, oran LLC) © The SUB eansaction described in this A results in only single tax —on Target’ assets gain — because Code $992 exempes Digco tum paying a second level of tax when Bigco receives a liqui- dating distribution (consisting of Target’ aset- sale proceeds) from its 80-80 subsidiary, Target However, where Target isa C corp owned by 2 von of chavohaldor ae dienerd in Band C below) Code $332 does not apply to exempr the shareholders from paying second rax on their hiquidaug dseibution ftom Target. © However, were Bigco (in chs A) co redistribute the sale proceed cits shareholder, there would be a second tax atthe Bigco shareholder level, regardless of whether Rige' sale of Targre was structured for SUB or COB. (One situation where Bigco would resst an asset SUB sruccure is where Bigco’s ousside tax bassin Target stock. substandally exceeds Tages net inside tax basis in its assets, generally because Bigco (i) acquired Targer some time in the pas in a stock purchase structured for asset COP and (i) pa inside nec asset tax basis atthe time of the stock purchase. In this case, Bigeos taxable gain on sale of Target's stock to Newoo (with no Code §338(h)(10) election) is caleue lated on Bigeo’s higher rx bassin Target’ stock, whereas Bisco’ taxable gain ona sale of Targets ases to Newco s cubotansial promium over Tanger (or Bigeo's sale of Targe’s stock to Newco with a Code {§338(5}(10) election) would be calculated on the lower ca basis ia Tanger’ asses." Whether ic is worthwhile for Newco 10 rs its purchase price fr Targe in onder ro induce Bigco co structure for asset SUB (where Bigco’s outside tax bassin Target's stock exceeds is net inside ase rx bass) depends on the dis counted present value ("PV") of Newco’ expected tax sav- {ngs from the additional tax deductions for cost of goods sold, deprecation, and amortization resulting fom asset ‘SUD, wis wae pea wpa 0 The amount of sep-up allocable spectively ro inventory, depreciable aes, and amoral ineangibles © The well if ofthe deprecibllamorizable © Whether Newco elects FIFO or LIFO for stepped-up inventory 1 ‘he degre of sk hat IRS succes cha Iengr on adi) Newer SUB alaatan among the ase © The amoune and ciming of fucure eaxable income Newco expects co generate which can be sheltered by the additional deductions © The applicable comport ax rates inthe fare yar when the avon dedwctone ate allowable {0 ‘The appropriate discoune rat lor computing the PV ofthe furure rx savings. side ax bs in Tage stock subantily xceds Tt Targt donot havea sbweanit NOL. Bgco mh linge uct or ance SUB and oni) Newon ier he purchase prise fo Tage 40 8 compensate Bg for Bigs large axon an set SUB transition, Vostansoaes 9“The ul achieved by applying these 12 cons «0 specific transactions changed radially withthe 1993, «enactment of Code $197, under which virally all pur chased intangibles (acquied in an SUB tansaction) are row amortizable for ax purposes over a 15-year period. (Code $197 pro-wxpayer aspect is tax amortization (over 15 years) for goodwill, gong concern vale, and other similar ieangbles which previously were not amortizabe call forex purposes. Code $1975 anti taxpayer aspect is the aucomatic 15-year lf for virally all purchased Jnxangibles, including those which generally hid much shorter tax lives before 61975 enactment. In an asset SUB acquisition, §197% 15 year amortization period applies o vieeuall all purchased incangibles. Even in a COB acquisition, $197 applies to 2 covenant not ro ‘compete purchased from Target sharcholdes ‘Where Newco and Target ate more than 20% related by vote or by vale, calculated by comparing Farge pre- acquisition ownership ro Neweo pre-or post-acquisition ‘ownership, Code $1975 logical and arbiary an churning cules may preven 15yearamonzation of ntan- ables held by od Target before 9/93 char would have been nonamorizable before $197 enactment (goodwill and sing concer value or anyother intangible with no ra: sonably ascertainable wef if)" Ina buyout ofa Bigco subsidiary, cere may be such more-shan-20% overlapping covers beeween Target and Neco where Bigsa buys a potion of Neweo stock Additional LBO issue: 4. the transaction sects both the sizeof person test and the sizeof eransac- tion test and does not quality for an exemption, there is ‘generally a 30-day waiting pesiod after making the -equited HR filing (accompanied by a $45,000 pay- ‘ment), which period is exended if FTC or Department of Justice issues a second reques for information. ‘The sie of pron eis generally me if either Tage {along with is affiliates as described below) or Newco (along with is afiliaes as described below) has annual rer sles or total assets of at least $100 milion and the other has annual net sales or total asets ofa east $10 nillion, Nee sales and total assets are generally measured ar the level of ultimace parent, including any controlled entities (alias). In determining afiliation, a corporation is treated 25 con- trolled by a person who either holds voting securities with 50% or more ofthe corporation’ voting power for direc- ‘ors or has the conteactul Fight ro designate 50% or mote of the corporations directors, whereas aparmerhip or LLCis texted as controlled by person who has the righ seeive 50% oF more of he parenesship/LLC profits or assets upon dissolution, ‘Where Targets controlled by Bigco, Target sales and assets are measured by looking at Bigco and all of Bigeo's controlled entities (including Target). Where VC controls "Newco, Neweo' sles and assets ate measuted by looking at Newco, VC, and all of VCi other contzlled portfolio companies, 1 Phir 61993, many exper enjoyed a degree of sue alosting 8 pron ofthe purchase price nan act SUR rnsston) co ineangles sich as covenants noe wo compet pute casiom compute software customer lists, oer baclog,adeanageos cuore and supplier contac no -how and he ke as opposed ro gong nd going concer ae which were lly notamorisBe) and Smorizing sich amounc over areisonably shot etal useful ik, although there ination was oie que fcespecie whee IRS challenged the deduction. 12 Whee Tage for Newb pacar LLC he acre ae righ iret Inada, ano mee Ae tong sugurents andr the marae and ceeain ror pecdent tat the corpo at-urhing ule shou ot apply unl Target and Neweo sre 50% or more rete by vote ovale IRS proposed regulations (tbe ffecrve om Bian) ke the pion ha the at ‘huring rls general app whore Tage and Newco ae sore than 2096 ele.“The sia ef mimarton rs mes Newco wil (er the ansaction) hold Target voting securities or as, whether acquired in one oa seis oF transactions, (i witha valu exceding $15 milion or (iconstuing 54% oF more of Target’ voting securities where Target and is coneled sobs vocal ass of east 825 milion. ares has annual ner sales oF “The patios ae sonics cape fe ISR ngs where (the acquiring company (Newco) is newly formed, and i)substantially all of Newco’ capital is devoted to acquiting Target, and (i) ao one persan con- trols Newco (generally using the contro test described above), and (iv) no one person holds $15 million of Newco voting securities, ‘generally. Where Newco (or Newco’ subsidiary NewSub) purchases Target took, Target (which becomes a Newco ‘subsidiary remain liable for all oF ts fixed and contin- _gont liabilities. Ifthe parties intend Bigco to retain some ‘of Target’ isi including contingent Hihilies in the context of such a stock acquisition, Bigco can agree to indemnify and hold harmless Newco and is new sub- sidlary Tages against such labiiies. However, should Bigeo fll upon financial hard times, is indemnification say be worthless and Newco’ new subsidiary Target may hence beat such libilts. Wheee Tange mre nen Nino (ar NowSub), sate merger law generally causes che surviving corporation (Newco or ‘NewSub) automatically ro become liable forall of Trger’s hails. tf che parses intend Bigco to retain some of ‘Target’ liabilities in the context of a merges, Bigco can ‘agree to indemnify and hold harmless Newco (or NewSub) against such iabiliies, in which case Newco is protected, subject tothe risk Bigeo is unable to full its indemnif- setien obligation, Where Newoo (or NewSuh)prrclivet Target tet, the partes can tailor the asset purchase agreement so that [Newco (or NewSub] expressly assumes only specified labile and leaves all other labiles behund in Larges, which remains a Bigco subsidiary, However, even in such an aset purchase, several legal doctrines (discussed below) may cause buyer involuntarily co inherit a Target liability if Target (which remains a Bigco subsidiary) is unable to py i retain Hablis: Heme ef desirable for Bigeo agree in the asec purchase agreement co indemnify buyer against Target liabilities nor assumed by buyer, in which cae buyer is protected, subject 10 the risk both “Targecand Bigeo are unable to pay the retained liabilities. “The most prevalent involuncary-ibileyinhertance doc- ‘tines applicable ro an asst purchase inchude (i) she bude ade ae nd ih i approninaisly 13 suates ie buyer of Targets asets (including inventory in bulk is generally liable foe Target’ ibilities—up tothe far value FV") ofthe invencory and equipment purchased — unless notice is given to Target's creditors atleast a specified period hefore the sale and il the de fien merer and eucecr lise bility dacerines woder which some courts have held a bulk asset buyer responsible for some Target liabilities —espe- cially wor abilities for deferve products, underfunded pension labilts, and environmental isbilites—under ‘ague common law docttines where Target's busines is transfered to buyer a5 2 going concern and Targe goes cour of existence, especially, but nor exclusively where “Target all eracholder(s) rvs a euheratial eqiey interes in buyer ecause of bulk sles act, de tcto merge, and successor Tail risks, itis often desirable, where Neweo is making orintends to make several acquisitions (or where Newco already has other asset), for NewSub to acquite Targets asses, so hav if buyer is unexpectedly held liable for Target liable nox prey sumed, ouch posure emit NewSub while Neweos other asets at insulted. Aosy samy TROISSH08d JA MEN LH‘Whar Evert VCPRoresstex sme Q Bigeo's unpaid consolidated federal income taxes. Where Bigco files a consolidated federal income ax return with Target before the acquisition, federal tax law (Reg, §1.1502-6) create a surprising isk for Newco: cach entigy (inluding Target) that was a member of Bigeo’ consolidated tax group for any part ofa years liable forall of Bigco group’ federal income tax for such year (even on income generated by other members ofthe soup) if Bigeowhimeely doer not pay IRS: Heme ‘where Newco buys Target’ stock, Target remains lable for the entire Bigco groups federal tax deficiencies for ‘each year in which Target was a Bigeo subsidiary for any pare of the yeas, if Bigco and does not ultimately pay IRS. Relative Rights of Newco's Financing Parties. ‘The essence of an LBO is that no entity above Newco liable on Neweo' aeguiscon deb, dat «ve not any other Newco shareholder guarantees ors other- ‘wise contactualy liable for acquisition debt incurred by Newco in acquiring Target Should Newea defulr on its aequistion debe (eg, hank debt, mez debt) sues would aise as to the relative pri- otty of various creditor groups inter se with respect to the [Neweo-Targer asses, These relative priority issues can be signifcandy affected by structuring (as pat of che LBO) some creditors into a Newco operating subsidiary (so they hhave first claim on such subsidiary assets) and some credi- «os into Newoo holding company (so they are structurally tuboedinated by operation of law so the eubeidiary credi tors with respect to the subsidiary’s assets) in which case lenders atthe subsidiary level can foreclose on and sell subsidiary asets free of Newoo holding company debt. Crdior strata [ol [> subordinated with respect totaidias ats editors with direct, “There are several methods to create oe avoid anc strc subordination with respect to the new acquisition debt: 9 stock purchase. Neweo can purchase Targets stock with money borrowed atthe Neweo holding company level, so Target becomes a [Neweo subsidiary. As lng as Target doesnot liquidate or merge into Newco and Tage does ot guarantee Neves aquison dee, Neve is the onl entity able forthe new acqisiion debt. Hence, Targets rade and other ceizors are not affected by the acquisition andthe acquisition debris actually subordinated to Targets rade and other deb. © Asset purchase. Newco can purchase Targe’s ssc wid money bonowed by Newey al assume Target’ ibis. Ln tis structure (at well a ach ofthe structures discussed below), the new acquisition financing ends wp aliabilsy ofthe same entity that is able co Targets old trade and other creditor. Hence, Newoo' acquisition debe ie not stracurally subordinated xo Target’ pre-acquisiion creditors, andthe old “Targec credivrs are disadvantaged by the 2cqui- sition since che post acquiition eniy (Newco) ‘which is able co them has also become liable for the new acquisition deb. In other words the new acquisition debe becomes pari pasa claim egies the parched Targa sneer —and may even effectively bocome a senior claim if the acquisition lenders receive liens on such assees—thereby diluing the assets available to service Targets pre-acqustion debt. © Stock purchase plus liquidation. Neweo can purchase Target's stock with money borrowed at she Tewue level a liquidate Target by distributing is assets (sub- ject cits liable) upstream into Newco or (ii) smerge"Target upstream into Neweo. Target's imcately dheealir i) pre-acquistion creditors are disadvantaged by the acquisrinn heranse Nevwrn ends np lable for both Target’ pr new acquisition deb. scquisition debts and the© Revers subsiviary merger. Newco can merge a tnansivory Neweo subsidiary inco Target (a reverse subsid rowed a either the Neweo level or the sansitory merger oF RSM), wich money bor. subsidiary level, so thae (i) Target survives the merger (i) Target ald chorale) roxves she stared merger consideration in cancellation of ll Targets old stock, i) Newco receives new Target shares n exchange for its transitory subsidiary stares, and (i) after the eansaction Newco owns 100% of Target’ stock. Target’ p scquistion credicors are disadvantaged t0 the extent che new aequisiion debt isa che eransi- sry eidiny Lenn sae Tages inerie she acquisition debt in the meiger. However. Targets pre-acquistion creditors are nox disadvantaged to the extent the new acquisition debe is atthe Newco level, © verse merger Newco can merge dvely ico Tage (two-party reverse merger) wth (8 Tage svg she merger, i) Targets ld sharsholde)reciing he sated merge consid raion in canelaon ofl Targets old stock. and li) Newco shareholders recewing new Taxgt share in exchange for thie Newco srs. so that afer the ransction News shareholders om dine 109% of Targets eck. Trgers prescguiion creditors at thus disadvantaged became Target inher the new acuiion debe. © Pert stock purchase, pat redemption, Neweo can purchase a portion of targets stock trom Targets old shareholders) (with money bor- rowed at che Newco level) and Tage can simul- taneously redeem the rmainde ofits tock from Target old sharcholders) wich money howe othe Target lvl tha afer the transaction Newco owns 100% of Target's stock, Targets pre-acquston creditor are dsadvan- raged tothe eten the new acqusition debe is borrowed a the Target eel ro finance che redemption, but are nor disadvantaged co che extent the new acuisiion debs borrowed at the Newco level eo finance che stock purchase eudulent Ce we fsgues, Where the " acquisition is structured so thatthe same entity is lable both forthe new acquisition debe and far Targer’ pre= acquisition lables, o that Targets rade and other creditors are worse off after the transaction chan before Checaner the nee acqsirin lndore have here pi psu with, oF senior ro, Target’ ald creditors, che entity which ends up liable co Targets old creditors must mect ‘three fnanctal rests mmediately ater the acquisition — solvency. adequate capital, and abiley to pay debts in the ordinary course of business a they mature —in order to avoid 2 Faudulent conveyance isk Where any oF these theee reat ic nar mt ca thar the transaction constcures a audulent conveyance, and where the acquisition encry fils to pay its debts, there is risk thar the new acquisition lenders constitute aders and bettors {hence beth losing thet liens and being involun- ‘arly subordinated 0 other creditors) and that Targer’s selling sharcholders (ac least insider shareholders who knew that the transaction added substantial debt o the ee ceeds. There is even some risk a fraudulene conveyance ng entity’ halance chert) mye give back ales peo may cause Newco’ new shareholders to be liable as aders and abetfors, The faudulene conveyance rules. i found ‘0 apply often help nor only Targer’s pre-acquiston cred- stor, bu also subsequent creditors ‘Where the acquisition is structured so that it prejudices “Target pre-acquiction creditors, Newco generally cup plies the acquisition lenders with carefully prepared asset appraisals, contingene liability estimaes, cash low projec- tions, solvency opinions, and other data designed to make he lenders comfortable thac all three of these financial rests are satisfied,B. Buyout of Private Company In thi B, Targets a private company owned by an nd vidual or group (buts nota Bigco subsidiary), Larges principal sharcholders (unable ro locate he fountain of youth) are feaning on estate planning, and hence would Ike to liquefy their estates. In othe respects, che fat are the sameasin A. Co cel _ ce Banks Federal ineama tax acnects Just as in A, Neweo would prefer ro structure the aequisi= tion to obtain, for tax purposes, asset SUB forthe Target business, rowever, depending upon whether Large is 2 C corp, an $ corp, a partnership, oran LLC, Target and its owners may prefer to structure for aset COB, for tax purposes, as discussed below. Targot ie € corp. If Target ie « C orp and the wanene sion is structured for asset SUB—e.., Target’ sale of assets to Newco followed by Target’ liquidation — the sellers owe double tax, i, Target owes corporatelevel tax con its asee-sale gain and Target’ sharcholders owe share- holder-level ax on ther iquidation proceeds less their stock tax bass. Generally, Target’ old shareholders bear the economic impact of both taxes. “The sane dowble tx elt obra where the ranacron is seructured fr asset SUB a a eaxable forward two-party merger ora taxable forward subsidiary merget. However, in these cases the incidence of Target’ corporate-level tax falls on Newoo because inthe merger Neweo (or NewSub) inherits Tage’ eorporat-leel tax ibility” © By contrast, in A above (where Target is Bigco £80.80 subsidiary and Bigoo reins che ale pro. ceeds), structuring the acquisition for asset SUB (ther as an asset sale ora stock sle treated as an asset sale by virtue ofa Code §338(b)(10) lection) doesnot result in double rx because the liquidation (or the $338(h)(10) deemed uidation) of Targe into Bigco is a eicfree Code {9332 liquidation. Where, however, Targets {Cony bu os Bigg 80-80 ssi sta turing for asct SUB results in double tx, “Targetevel eax onthe asec gan and share- holderleve ax on Target’ liquidation. ‘Whee Target ca Cee and daes not havea eran NOL w shel itsaset-sale gain, eis generally not advan- tageous to structure for aset SUB because the PV ofthe seller’ second tax —payable immediately —exceeds the FV of Neweo's tax saving on account of asset SUB—which cocurs over a numberof years (15 yersin the case of Code 197 amortizable intangibles), a described in A above. Where the pantie eruerure for atet COB, i ie generally «ax efficient from Neweo’s standpoint to pay as much of the purchase price as possible directly to Targets share- holders as (i) compensation lor future executive or con- sulting services and/or (i) covenant-not-to-compete pay- ments. Such payments are: 13 Sima, where the amet SUB srocture i Newess purchase of Tages stock fr Newest acquisition of Targets tock na eatable evene subsidiary serge) pus a regular $338 election, chet i alo double tax on the tansacion with Newco beating he corporate 14 One exception: Tage might be wing co uct for sce SUB by an ass where Target shurcholers ar ely and imminently anticipating death SUB fr their sock In ths case double taxon the elles can be avoided where Tage sel asses to Neweo and Target tpene is iquidation by remaining in etence aan investment company unt is aarcholdescbesin SUB for her Target stock bya-taxable co the recipients as Ol, bb. not taxable at che Target level, and «as long as reasonable ia amount. deductible by Nome ore i li of dhe consulting arrange ment (in the case of consulting payments) or deductible over 15 yeats under Code $197 (in the case of covenant payments. However, because Target’ individual shareholders are taxed at substantially higher rates on Ol (including acon: suking or covenant payment) chan on ITCG—a 39.6% top feral incouse as ate fox OF womsperd wo «20% top fedeal income ra rae for LTCG— Target’ share- holders will desite to minimize allocation to consulting oF covenant payments andor may seek a gross-up payment from Newco to compensate them forthe higher rx race Target is $ corp. Where Target isa seasoned S comp rather shan a C corp), Neweo can serceure for aset Ut —entner a sale of Targers assets followed by Tages liquidation ora sale of Target's stock with §338(h)(10) lection without imposing the burden of double tax con the sellers. However in the cate of nS coep which was formerly a corp. Code $1374 imposes a corporate-level ax on any sale the corporation’ assets accurting during its fse 10 eats. as an 9 corp, based om the leser of (a) che bull P. in in an asset a the time the corporation became an S corp or {b) the actual gain recognized on the sale of such asset. This Code §1374 tx also applies 0 assets prev cusly acquired from a C corp by the S corp (even though never nals corp) in an ates COD seancasion (oss aciree merger of a C corp into an $ corp). based on the lesser of a) the buil-in gain in a COB assert che rime acquited by the 9 corp or (BI the actual gain recognized ‘on the sale of such asst. Where Code §1374 applies, ppb an Sump a dnested here ecb pei in ony em rns whore Taps at 1-80 there i double federal income taxation on the portion of S comp gain covered by Code $1374 (the built-in gain). Target io partnerehi Le. Where Tanger ie « parenership of LLC, Newco can structure for asset SUB without double tax to che sellers. In this case. there is no need for a Cade §338(h)(10) election ro achieve aser SUB and there is no Code $1374-like penalty ta, {5197 amortization. in an asec SUB transaction. Code $197 anci-churning rules (as discussed in A) may prover 1 petsons who owned more than 20% of Targer stock before the buyout own more than 208 of Newco’ stock afer the buyout. There may be such more-than-208% overlap where, for example, Newco sells cock co Target’ executives who were Target shareholders before the buvous. Target management tax-free rollover ‘Tanger executive who omits appreciate Tanger ck plans to invest in Newco could exape LTCG recognition ‘on a disposition ofhisherTarger stock by engaging ia 2 tax-free rollover of appreciated Target stock in exchange For Newco stock pursuant ro Code $351 (which deals withthe ravfee formation fa new corporation). In other words, the executive could contribute appreciated “Target stack to Newco (ta fee) in exchange for Neweo srock with an FV equal ro the FV ofthe Targer stock con= tributed, at approximately che same time as Neweo’s ocher shareholders (including VC) form Newco. “This approach is feasible only where che acquisition is structured for stat COB, i, Newoo purchasee Target stock or Newco acquites Target’ stack bya reverse sub- Sidiary merger or Neweo's shareholders acquire Targer’s stock by a everse two-party merger. sunkar’ se Sasso in or whens‘Am executive swapping low basis Target seock tax fee Gin 4 Code §351 eransaction) for high FV Newco stock takes COB forthe Newoo sock (equal ro his or her low bass in she Target stock) and hence defers [TCG until disposi- sion of the Newco stock, bur permanently avoids LTCG recognition if he or she dies while owning the low basis Newco stock.” Shareholder vote ond dissenters’ rights Tina merger or ase sale, vor of Tage’ shareholders by a requisite majority binds ll of Target’ shareholders (ub- ject toa dissenting sharcholde’s right to claim appraisal Fights. i. a cash payment equal ro the cour-determined, FV of the dissenters Target stock). However, where the transaction is structured asa sale of Target stock, any recalcitrant old Targer shareholder has the right co retin his or her Target stock, so that Newco may end up owning, less chan 100% of Tages. ‘This recalcerant-minority-shareholder problem is gener- ally solved —where an acquisition is meant to be taxed as a stock purchase but one oF more old Target stockholders tefuse to sell —by structuring the wansaction asa reverse subsldlary merger (an “RSM") of Newco’ newly-formed transitory subsidiary (NewSub) into Target, wth Targer's old shareholders receiving cash in exchange for tht Target stock and Newco receiving Targer stock in exchange for its NewSub stock. Such an RSM requires the affirmative vote ofa requisite majority of Tage’ old shareholders and generally allows dissenting Target shareholders ro claim appraisal rights. However, afer the RSM Neweo ‘owns 100% of Target’ stock and, for tax purposes, such an RSM is generally taxed as if Newco had purchased “Target's stock, because IRS (i) disregards Neweo tansi- tory subsidiary and hence disregards the RSM and (i views the transaction as if Newco had purchased Targee’s stock fine Targa ld stathalors ‘An akcrnaive method for squscting out 100% of Target’ ld sharchoder is a eves ewo-pary cash merger of newly-formed Newco into Targec in which Targets old shareholders eceive cash while Neweo' shareholders reccive Tage toc in exchange fo their Newco stock and Newco disappears. This eansaction (ike an RSM) requires the affirmative vote of requisite majority of “Tages shareholders and generally allows dissenting “age sacle wo aio appa igh oweres ler the ransacton Neweo' shareholders own 100% of “Tages stock and for tax purposs, this eansaction is generally ated as if New shareholders had purchased “atget’ stock from Tage’ ol shareholders, because IRS (i) disregards Newco as tansitory and hence disregards che merger and (views the wasaction as if Neweo's sharcholders had putchased Targets stock fom Targets ld sete.” LTCG tax on sale of Newco ‘When Newco i ultimately sol, its shareholders who are individuals generally pay tax on their shareholder-level sain at a 20% LTCG rate, However. where the tansse- tion meets certain requitements, an individual who owas Neweo stock directly (or chrough a partnership, LLC, or S comp including a vere capt fund formed as a low through entity) i ented co reduced 14% LTOG rate under Code $1202. Some of the many arbitrary require- sments for this §1202 TCG rate reduction are (i) the individual (or flow-through entity) must have purchased the Newco stock directly from Newco and held ie foe more than 5 years and (ji) Neweo must have eld $50 rillion o less of assets immediately after the individual's Anvesement in Neweo. Where Newco meets the requirements necessary for a (Code §1202 rate reduction, Code $1045 allows an indi- vidual who holds Neweo stock directly (or through 2 Aounsheongh omtiny) spay tw Cte da the gui 1 An execu escnng any Newco “Non-uined erred general debe redeemable prcered sock —in such an otherwise save rllover would rcopie gain up othe Noo Qualified Preleneds FV wales one of he eceptions dina in 403.1) through (15) of he authors Venare Capiz ook tis than normally rqsited by satel ph foe ae ng 19 this case mo $3380) 20) esos perme fenen where Tages aS corp) besa single compra ci did or puis leas an 80-80 smoune of Tage tok unk Neco isl an 80-80 subi of anercopoaton.‘on asale of Newco stock where the shareholder has held the Neweo stock more than 6 months and reinvests an samoune equal vo che proceeds in other $1202 qualified stock within 60 days afer the Newco stack sale. Such deferred gain is then recognized when the individual sells the eplacement stock, unless the individual des holding the replacement stock and thus qualified for death SUB.” ‘The LBO of private Target owned by a group, ae dis- ‘cussed in this B, also presents all the issues discussed in A above where Target was a Bigco subsi C. Buyout of Public Company In this Tages api waded C cop Targets bard of ics concluded tha () although Tre bsines issoan, he rock markt does no propel vale acom- pany of Target’ size in Target’ industry and (ii) Target's Sharcholder valu canbe maxed by sling Tag. cxher respec the fas ar the same a in A above > formed to buy One-step vs. two-step LBO ‘There are to principal methods for structuring Newco's LBO of public Taye: aa one-step merger sracsure, Newco (or Newco’ subsidiary NewSub) merges into “Target with Targets sharcholders receiving cash for theit “Target stock in a two-party cash reverse merger (or an RSM), With such a one-step approach, Newco docs not Vensure Capita book, 21 Under Code $7 gain control of Target uneil the merger is completed, ‘which can take as long as four months, principally because oF SHI pron ruler which apply eon public ‘Target’ sharcholders must vore on the merger. In a ewostep approach, Newco fist makes a cash tender offer for Target’ stock followed by a squeeze out reverse cash merger of Neweo (or NewSub) into Targee, with “Targe’ remaining shareholders (who did noc sll in the cash tender offet) receiving cash for their Trger stock in the clean-up merger. With such a two-step approach, SECS tender offer rules allow Newco to complete the frst step tender flr quickly (approsienatly one month) and hence gain contol over Target Federal income tax aspects ‘The federal income ex issues in acquiring publily eaded ‘Tange are generally the same as those discused in B ahowe regarding the LBO of free-standing private C corp (ie. a ‘company which is neither a Bigco subsidiary nor an $ corp, partnership, or LLC). Whether Newco acquires Target in ‘one step or in two steps, che transaction is generally stuc- tured for asset COB so cha only one taxis imposed on the sellers ie, 8 LTOG tax on Targets shareholders, By contrat the transaction were structured for asset ‘SUB —with Newco purchasing Targets assets or Neweo acquing Targee in a forward cash merger —double ax would be imposed (i.e, corporatelevel tax on Target's inherent asec appreciation and shareholder-level eax on the Target shareholder stock gain) In an actual asset sale, the double tax would be wholly borne by sellers, while ina forward cash merger the corporae-evel tax would be borne by Newco, As discussed in B, itis gener- ally nor tax advantageous to structure the acquisition of (Coep for aser SUB (because the PV of the second seller «ax exceeds the PV of Neweo's tax saving), unless public Target has a substantial NOL co shelter es corporate-level asser-sae gui, ery pully made company—even if formed a. parteship o LLC— sree a cop for x pusposes,Pract ‘VC may prefer to approach public Targets CEO with a firm offer a stated premium price, fully backed by financing commitments, in order to induce Target © accept the VC-Newco offer as quickly as possible However. 0 delay Tarets public dislosure obligation. VC may instead decide co approach Targer’ CEO with merely an expression of interest. TEVC' approach to Target management is nor produc. tive, VC may decide vo approach Targets board members, cicher drecly through general contacts or by delivering a “bear hug” letter proposing afiendly combination on terms to he negotiated. ‘During this proces, VC may begin accumulating Target stock in the open marker, Moweves, VE must Ale with SEC a schedule 13D once VC acquires more than 5% of class of Target’ voting stock registered under 1934 Act {912 and muse generally make an HSR fling with FTC once VC acquires $15 million of Targer voting securities. In advan, UC mer fle rhea 120) oven before acquiring more than 59% of a class of Target's voting stock when (i) VC is acting in concert with other Target share- holders ho, in the aggregare cogether with VC, own suf- ficient Targer shares to exceed the 5% reporting threshold ot (i) VC obtains an option to acquite Target stock, whether from Target or from Target shareholders, which causes VC to be created as owning sufficient Targe shares to exceed the 59% reporting threshold, When Target’ management is investing in Newco there is a contice berween (i) Target management’ duty to obtain the highest posible price for Targets public shareholders and (i) Target management's natural desire for Neweo (which wil be parly owned by Targets management) 10 purchase Target at the lowest possible price. Thus, Targe’s board may urine some oral of she fllowing prosesive devices co avoid labilisy t Targer’s public shareholders for breach of fiduciary duty: (i) appoint an independent “Target board commiete (which in turn selects indepen ent legal counsel and an independent investment banker 2 om piblicLBO ius, for che commirre), i) ebrain an investment banker fit- ress opinion, ( cexted directors, and (iv) seek a majority vore of Target’ disinterested shareholder. seek a majority vote of Target's disintr- Once Neweo and Tarmet have reached a least tentative deal and during che render offer one-month delay or the merger four-month delay, Newco may deste some or all of ie Fa peting bidders and/or to compensate Newco should another bidder ukimately triumphs (i) a.n0-shop clause, (i) an exclusiiey clause, i a break-up fe, lv) 2 oping fee payment to Newco if Target is sold to another buyer at a higher price, () an option to buy unissued Targec shares sca fixed pri shares a a fixed price fiom one or more large Target share- holders, and (it) a eovet-Jewel option ww buy a Tange, division or other key Target asset at fixed price ing, promt evi ow ison (i) an option co buy outstanding Target D, Buyout Structured For Recap Arraunting Sever yer air VC has acquired Target ina buyout VC often turns tothe publi equity makes to slits Tage stock Because the price of Tage’ shares in 2 publi ofering ion base on a mulple of Tages took earnings auld in aecordance with geerly accepted counting principles (GAAP"), VC may wane wo srctre is inal buyou of Tagen ode wo aban the benefia of recapitalization oe “esp” acounting increasing Tare’ post-soqision GAAP eamings nd, topefily is ukimate1PO ae ‘Where VC simply forms Neweo 0 acquite Target in a buyout (as described in A dhrough C), GAAP purchae counting rae generally require Targets assets to tke a new aggregate book value equal othe amount paid by Monee to acquire Tages pls Tange liailis amu plus expenses ofthe acquisition. This new aggregate book values then allocated first vo Target’ curtene asses at FV, second to Target’ fined asets and identified intangibles a FV, and the residue to Target’ goodwill GAAP purchase cluding federal margin elation, SEC’ ging pve aes. SEC tender fer and poy ules are dicusedssccuing ules seyuise sls yuna ee be amortised thus reducing Newco! Target's pos-LBO GAAP earm- Ings —over not mote than 40 years (depending on the industry often much less than 40 years) and FASB has proposed reducing this amortization period to a max imum of 20 veas “These GAAP purchase accounting rules apply regardless of clair the LBO is structured av am ance purchase, stole purchase, or merger, Hence, eren where the acquisition has lbcen structured eo achieve asset COB for ax purposes (eg. a stock purchase with no Cade $338(h)(10) election), so that Newco has no rx saving from asset SUB, the GAAP. purchase accounting rules require increased book deprecia- sion/amortzation. If Neweo/Targe were subsequently (0 _ public (or be acquired by a public company focused on “Targets GAAP decreaze Newco/ Target’ valuation, tp, porlne aucun would Pooling accounting —under which Target’ old asset book value simply caries over with no increase in post-acquisi- on GAAD deprecation amarrizatian— applies onl if 909% ot mote ofthe consideration for the acquisition of ‘Target common stock and common stock equivalents consists of Newco voting common stock and numerous ‘other arbitrary pooling eequtements are satisfied. Because the predominant consideration paid ro Target's share- holders in 2 buyout is almost invariably cash, the 90%- Neweo-voting-common-stock requirement cannot be mot. Marana, FASR hae raped thar prealing accounting be repealed, However where VUs buyout of largets structured for recap accounting, a poolinglke result is obtained —i.e ther is no change in Target’ asset book value, no addtional goodwill is created, and hence Targets post-acquisition book cextnings ae not reduced for goodwill amorzation. 2 Paths and ep ascouning. Recap Accmunting” in The on fcxtenively dacs inde authors and Willam R. Wels’ atiche“S Capital Rese Spine 1599, and in #54 he ators Ventre Cail hol Been wh tro, recap accounting —and not purchase accounting — generally applies to Target so long as (i) Targer survives, (i) Targets old shareholders as a group continue to own 4 bbuyour multe ina change of Targers come “signiicane” (generally somewhae more chan 58) stake in recapitalined Target's common equity and (i of other arbitrary recap requirements are met a number Recap accounting may ako apply in vvo circumstances where old shareholders do not ean a significant (or indeed say) continuing interest in tecapitalized T's ‘common equity. Fins recap accouncing genealy applies where T has publicly held debe or publicly held prefered sock oustanding prior to and independent ofthe recap tlizaion and such public debe or prefered stock remains outstanding afer che recapitalization. Second, SEC has syprore say sn investors purchasing significant stake in T's recapitlized common equity as part of the LBO is independent ofthe investor sponsoring the recapitalization transition, rg wea as ant ve uf ‘Where che rransactian satisfies ane ofthese coures 0 recap accounting, recap accounting generally applies (i whether pre-ecap Target i privately owned (as in B), publicly traded (asin C), or Bigeo subsidiary (asin A) and (i) whether Target is aC corp, § corp, LLC, or part netship. Even where Target is a Bigco division (nota separate entiy owned by Bigeo), recap accounting can generally be achieved.”® ceaturing Buyouts far nary