Sale or Merger
A sale or merger of a firm may be in one of several forms, including a taxable sale of assets or shares or a nontaxable sale of assets or shares, sometimes referred to as a tax-deferred transaction. A merger is the technical legal and financial name of many tax-deferred transactions. Each form of transaction dictates the tax impact to the seller, its owners and the buyer and the going forward culture and identity of the seller.
Sale of Assets
A sale of assets ultimately leads to the liquidation and dissolution of the selling firm, with the leadership and employees of the seller becoming part of the culture and staff of the buyer.
Sale of Shares
A sale of shares is a more attractive alternative for the shareholders than a sale of assets since the taxation is at a lower rate and the culture and leadership of the seller may be more likely to continue in place.
Under a merger, the existence and identity of the seller terminates upon the merger.
In each of these transaction scenarios, the issues of the financial and taxation consequences to each party must be addressed and resolved. From the point of view of the seller and its shareholders, the topics of culture, leadership and autonomy should be fully reviewed and agreed upon so as to have an understanding of the impact to leaders, staff and clients.
For purposes of this paper, a sale or merger shall be used as interchangeable terms since the review of the process is similar, notwithstanding the form and consequences of the transaction.
The transaction process of a sale or merger can be set forth in general chronological steps, although often times certain steps are undertaken in simultaneous or parallel steps.
- Transaction Readiness
Any firm contemplating an exit transaction should strongly consider making the firm transaction ready. The purpose of this exercise is to tidy up the business aspects of the firm before a potential buyer reviews such matters in the due diligence of seller. Such steps may include cleaning up the financial statements (for example, independent accountant review, eliminate loans to shareholders, get personal automobiles off the books, resolve any open tax audits, write off very old accounts receivable, terminating underutilized staff at all levels, make sure income has not been recognized prior to being actually earned and accrue paid time off as a liability on the financial statements) and operational issues such as improperly classifying employees as independent contractors, operating profitability and being in compliance with software licenses. The failure to address such matters before discussions with buyers commence has, in my experience, led to difficult discussions with buyers after the due diligence has been completed and may result in a reduction of price, change in deal terms or even a termination of discussions.
- Assemble an Internal Deal Team
Typically, the internal deal team consists of the President/CEO and the Chief Financial Officer. Senior leadership will be involved and it is important to centralize communication, negotiate the transaction with industry experienced advisors and be willing to make the deal a priority in their respective schedules.
- External Deal Team
The external team includes a mergers and acquisitions attorney and a financial advisor/intermediary, in each case with industry specific experience. There are several firms who provide industry specific advisory services, including sourcing and searching for deal partners, valuing your firm and advising during the process. A corporate attorney with transaction experience within the industry, and a tax attorney or accountant, are important to make the transaction tax efficient to the seller. The financial adviser and deal attorney will assist the seller in understanding professional licensure rules and market terms regarding such matters as restrictive covenants, employment agreements and indemnification of buyers. The professional liability insurance agent will provide the seller with advice regarding insurance for the prior acts.
- Financial Intermediary
The seller first interviews and then retains a financial intermediary, who may work on an initial fee and deal success (contingent fee) basis or on an hourly basis. Industry experience, a track record of transactions and an awareness of possible buyers for the practice is critical. Retaining an advisor with no prior experience in the architecture sector is not the proper choice.
- Preparation of Confidential Memorandum
The firm and the financial intermediary will together prepare a Confidential Memorandum describing the firm, services, leaders, operations and locations, financial performance (in a redacted manner) and representative projects. The Confidential Memorandum also makes the case why the firm is for sale and the benefits of acquiring the practice.
- Potential Interested Parties
The firm and the financial intermediary together will prepare and finalize a list of prospective buyers. The seller will be able to pinpoint certain criteria it believes are important in a buyer (size, location, competitor, private or publicly owned, etc.) and cull the list. The intermediary will then contact these firms with a short description of the seller in a manner that preserves anonymity as to the identification of the seller.
- Confidentiality Agreement
A potential buying firm which indicates an interest in exploring a transaction will then sign a Confidentiality Agreement (Nondisclosure Agreement). Thereafter, the buying party will receive the Confidential Memorandum for review.
- Initial Meetings and Discussions
A buying firm which has reviewed the Confidential Memorandum and is interested in pursuing discussions will then have meetings and discussions with the seller deal team in a manner that preserves confidentiality within the seller organization. These meetings may include the financial intermediary and the transaction attorney for seller.
- Memorandum of Understanding/Letter of Intent or Termsheet
At some point when discussions progress, the seller together, with the assistance of the financial intermediary respond to the buyer's draft of a Termsheet/Memorandum of Understanding setting forth the understandings initially reached by the parties. This document then is followed by a Termsheet or Letter of Intent prepared by the transaction attorneys in a more formal form. This document clarifies and memorializes the parties understanding of the material key transaction points, identifies the points of the transaction which must be agreed upon, sets forth a proposed timetable and enumerates binding and nonbinding terms. Typical binding terms include a provision that the seller cannot negotiate with any other party for a specified period, each party bears its own expenses, nondisclosure of discussions, allowing buyer access to seller's records and information, prohibition of any public announcement and how the agreement is terminated. This document is critically important to the seller since it is agreeing to cease further discussions with other suitors and to commit to the expenditure of funds and time going forward with one buyer. The importance of these documents is to give the seller and its senior leadership confidence to go forward and to eventually inform employees, clients and ultimately the public of the impending transaction at the appropriate time.
- Due Diligence
Upon the signing of the Memorandum of Understanding/Letter of Intent, the buyer will present the seller with a Due Diligence Information Request, which will include qualitative, quantitative and legal matters. The goal here is simple - the buyer wants to find out everything it can about the seller through written documents, discussions and interviews with senior leaders. Most often the written information is scanned and loaded onto an FTP website which is accessible to the buyer, seller and their respective advisors. Face to face meetings with respect to nonwritten materials re also held. The results of the due diligence often lead to further discussions and alterations to the transaction as agreed, based on any concerns or information uncovered or of a concern to buyer.
- Definitive Documents
The definitive documents include the Purchase or Merger Agreement and the Schedules thereto, Employment Agreements and Non-Competition Agreements.
- Purchase or Merger Agreement
This is the transaction document setting forth the transaction structure, the consideration (cash, promissory notes, earnout, buyer's stock), representations and warranties of buyer and seller, indemnification provisions, and the assignments and consents thereto required to complete the transaction. The schedules to the agreement represent the seller's disclosures regarding its business and operations and it is critical that the schedules be complete and accurate, as they are the basis upon which the buyer may bring an indemnity claim against the seller and its shareholders.
- Employment/Non-Competition Agreements
This is typically one document but may be divided into two documents. The employment provisions spell out the position offered for employment, compensation, benefits, term of agreement, termination of employment for cause, not for cause, death, disability or end of term. The restrictive covenants include noncompetition, non solicitation of clients, non solicitation of employees and confidential information. In the case of both the Purchase or Merger Agreement and the Employment/Non-Competition Agreements, the initial drafts are generated by the buyer with the seller and its attorney then negotiating the final versions.
- Purchase or Merger Agreement
- Approval of Transaction
Typically, the transaction must be approved by the Board of Directors of the buyer, the Board of Directors of the seller and the shareholders of the seller.
When the documents are all approved and signed, the closing takes place. Simultaneously or immediately thereafter, a communication plan to employees of both the seller and buyer, clients and the public is implemented. Certain operational matters are integrated, including benefits, payroll, retirement plans, and insurances. Third party consents for assignment of leases and contracts, professional licensure matters and professional liability tail insurance for the seller's prior acts are among the other topics which must be addressed to complete the transaction.
Factors to Consider
In determining a course of action to either sell or merge, there are a multitude of issues and topics to consider. The following are among the most important such matters:
- Compatible Cultures
Are the cultures of the buyer and seller compatible?
Will the name of the selling firm continue, be modified to be used in tandem with the buyer's name or will the name of seller disappear? Is there an agreed upon transition timeline for any name change?
- Prior Acts Professional Liability Insurance
Is the seller required to purchase so-called tail or prior acts professional liability insurance for claims against seller relating to the period prior to the closing but which arise after the completion of the transaction? Is buyer willing to insure such prior acts under buyer's continuing professional liability insurance? Is seller required to pay for the insurance coverage out of the purchase price or is the coverage being borne by the buyer?
- Personal Property of Seller Shareholders
Often the shareholders of seller wish to retain ownership of personal items in their respective offices, sketches of projects and a portfolio of projects (often a duplicate of the portfolios purchased by buyer).
What is the buyer's motivation to buy?
What is the seller's motiviation to sell?
- Deal Structure
What are the tax ramifications of the transaction structure to each of the parties?
- Retention and Future Employment of Seller's Employees
Are there retention agreements in place to motivate the employees of seller to remain with the buyer? Are the restrictive covenants of the buyer understood such that each principal of seller is aware of the limitations in his activities? Are the terms of future employment clear with well-defined roles? After the closing, the only document binding the employees of the seller and the buyer is the Employment Agreement, which addresses future roles, compensation and termination provisions.
Are the post closing indemnities of seller for liabilities relating to the period prior to the closing understood? Typically, the buyer will look to the seller and its shareholders personally for indemnification for a period of 2 to 3 years after the closing for undisclosed or unknown liabilities of seller which were not assumed by buyer.
- Post Closing Operations
Is it clearly understood whether seller will continue to operate as an autonomous unit or will seller's operations be integrated into buyer?
- Future Role of Seller's Management
What are the future employment roles of the senior managers of seller? What are their responsibilities and authority in operations and future strategy?
- Communications Plan
How will the transaction be presented to the various interested parties - employees, clients, professional associations, public at large? What is the branding strategy that keeps the legacy of the seller yet touts the expanded expertise and services of both the buyer and seller?
- Transaction Costs and Expenses
What are the costs and expenses being borne by the seller for legal, accounting, financial and tax advisory services?
- Comparison with Internal Ownership/Management Transition and Succession and Closure
How does the transaction to sell compare overall to an internal ownership transition/management succession program? How does the transaction to sell compare with a closure of the firm? The answers to the comparison of alternatives are firm specific and depend on a number of objectives and priorities of the owners.