Mergers and Acquisitions Law

Study highlights from 2010 include the following

•  Corporate reputation is back on top as the highest ranked business issue. In 2009 the highest ranked issue was customer loyalty and retention.
•  Cost of living is still seen as the strongest advantage that Indiana has over neighboring states and has been on the rise as the strongest advantage since 2007.
•  CEOs appear optimistic about 2010. There is a stronger likelihood they will pursue adding jobs, green development, outsourcing, mergers and acquisitions, new alliances, and a variety of other forward looking or growth oriented activities, when compared to 2009.
•  CEOs continue to remain positive about Indiana’s ability to attract business to the state.
•  Perceptions regarding the strength of education programs in the areas of advanced manufacturing and alternative energy have increased since 2009.
•  CEOs report that workers lowest in demand are manufacturing, non-skilled and bio-tech/life science workers.

View the 2010 CEO Survey Full Report.

View the 2010 CEO Survey Excutive Summary.

In the wake of the recent financial crisis, on May 20, 2010, the U.S. Senate voted to adopt sweeping financial reform.  The proposed Restoring American Financial Stability Act of 2010 would:

• create a number of new governmental bodies designed to protect investors;
• severely limit government bail-outs;
• streamline bank regulation;
• regulate trading of derivatives;
• increase regulation of hedge funds and credit rating agencies;
• affect executive compensation;
• undertake some reform of the SEC;
• strengthen the Federal Reserve; and
• increase regulation of securitization and municipal securities transactions. 

But, could it also affect the availability of private equity funds?

The bill aims to end so-called "too big to fail" bail-outs.  The Volcker Rule is part of that effort.  The rule prohibits banks and their affiliates from investing in or sponsoring hedge funds and private equity funds and otherwise requires limited relationships with hedge funds and private equity funds.  Non-bank financial institutions supervised by the Federal Reserve will also have restrictions on their hedge fund and private equity investments. 

Banks and other regulated financial institutions provide a significant portion of the capital for private equity funds.  Without that capital, private equity funds will likely be smaller and less inclined to make investments.  In many instances, private equity dollars are available to companies seeking funding in circumstances under which traditional banks would not lend.  In those cases, the limited availability of private equity dollars could damage companies seeking funding.  Those companies may not be able to obtain funds for operations, strategic acquisitions or expansion if private equity money is not available.

While the financial reform bill has many legitimate purposes, it may have consequences that were not anticipated by the drafters.  Those consequences will affect not only private equity funds themselves but also companies that rely on private equity as a source of funding.

A recent edition of PitchBook News Private Equity: Basic Edition cited a decrease in 2009 in exits from private equity investments through sales to other private equity firms.  The article stated that these secondary sales are down approximately 22 percent from their levels in 2005 through 2007.  In 2008, many private equity exits took the form of sales to strategic buyers.  In 2009, IPOs increased by approximately 19 percent, according to the article. 

So what does this mean?  Late 2007 saw the beginning of the current economic crisis and, in that time, it appears that private equity firms continued to feel confident in investing their money.  In many cases, they did so by buying out other private equity firms. 

In 2008, when it became clear that the economic crisis would not be short-lived or minor, strategic buyers became the most obvious source for private equity liquidity.  Strategic buyers saw opportunities to enhance their businesses through the synergies offered by private equity portfolio companies.  In addition, valuations were very low:  the perfect formula for strategic acquisitions.

In the later parts of 2009, we have seen the public equity markets bounce back significantly.  Instead of shying away from the public markets' previously unequaled volatility and sharp decreases in value, private equity firms looking for an exit option seem to have again turned their focus to the IPO as a possible exit strategy. 

Hopefully, markets will continue to stabilize, valuations will become more reliable and private equity firms will invest some of the money they are currently holding.  If all these things happen, we can hope to see a return of multiple options for private equity exit strategies.
 

The Alliance of Mergers & Acquisitions Advisors and PitchBook Data recently released a study of the private equity industry.  The study showed that there is an overhang of approximately $400 billion in private equity fundraising.  That means private equity firms have raised about $400 billion more than they have invested.  There's a lot of money out there waiting to be invested.  In fact, it's at an all-time high.  Click here to see a copy of the report.

As tough as times have been, people have continued to give their money to private equity funds.  The funds just haven't found companies that they consider good investments.  So what needs to happen?  According to some, it's a matter of companies lowering their expectations.  Companies can no longer expect to get the kind of multiples or the kind of leverage that were used before 2007.  Others say it's all about the stability of the economy and the re-opening of the credit markets.  Still others say that investors need to change the way they do diligence on a company.  The old methods will no longer work in light of the current economic realities.

So which is it?  Probably a combination of all.  Either way, I look forward to the days when we start to use that $400 billion.

The world of mergers and acquisitions looks a lot different than it did just two years ago.  When credit was easily available to a buyer financing an acquisition, things were easier for sellers.  Now, buyers are looking to sellers to take on more of the risk.

• Promissory notes.  Many buyers are asking sellers to accept part (or even all) of the purchase price as a note.  In other words, the seller gets less cash at closing and only receives payments under the note if the company is able to pay.
• Earn-outs.  An earn-out is a mechanism where a seller receives part of the purchase price over time, depending on how well the business is performing.  Usually, the buyer and seller will agree upon financial measurements that the company has to meet in order for the seller to receive any payment.  Earn-outs can be very complicated and difficult to track and measure after the closing.
• Mezzanine financing.  Because senior debt is not as readily available as it once was, buyers are turning to mezzanine lenders.    Mezzanine capital is generally subordinated to any senior debt but has priority over common equity.  Mezzanine financing generally has a higher interest rate than senior debt.  That may cause the buyer to provide less generous financial terms to the seller.
• Equity rollovers.  The buyer may ask the seller to roll over some of its equity into the new company.  That is, rather than receiving the purchase price that would be attributable to all of the seller's interest in the company, it will receive only a portion of the full purchase price plus some equity interest in the new company.  In an equity rollover, the seller continues to own a portion of the business and bears the risks related to that ownership.

Venture capital firms generally demand a number of rights to protect their investments.

Venture capitalists usually receive shares of preferred stock when they invest in a company, while the founders and other initial investors hold common stock.  Of course, if you raise successive rounds from venture capital firms, you will likely end up with several different series of preferred stock with different rights and preferences.  Preferred stock has certain advantages over common stock, particularly dividend and liquidation preferences.  This means that if the company decides to distribute dividends to its stockholders, or sell its assets and distribute the proceeds to its stockholders, the holders of preferred stock will have priority over the common stockholders.  They will be entitled to receive some portion (or even all) of the dividend or sale proceeds before any of the common stockholders receive any money at all.

Preferred stock will probably have better voting rights as compared to common stock.  For example, the company will have to get approval from the holders of a certain percentage of the preferred shares to take major corporate actions, such as approval of the annual budget, amendment of articles or bylaws, liquidation of the company, creation of a new class of securities with rights equal to or better than the preferred stock, sale of the company or acquisition of another company.  This structure lets the venture capital firm have a say in decisions that will have a large impact on the company.

The venture capital firm will also likely demand representation on the company's board of directors.  The number of members will vary depending on the current structure of the company and the amount of capital invested by the venture capitalists, but at least one, and often more than one, spot on the board will probably be reserved for members elected or appointed by the venture capital firm.

Also, venture capital investors will want information and reports about the company so it can track its investment.  For example, the company will likely have to deliver its quarterly and annual unaudited financial statements.  Many venture capital firms will demand audited financial statements, which can be a significant expense for the company.  Plus, venture capital investors will expect some other rights, such as the right to force the company to register its common shares with the Securities and Exchange Commission under some circumstances or to participate in any registration initiated by the company (registration rights), the option to purchase shares of stock of the company that other stockholders want to sell (right of first refusal), the right to purchase any new shares issued by the company (preemptive rights) and an adjustment of the conversion to common stock price in the event the company sells stock at a lower valuation (anti-dilution protection).

Looking at all of the ownership and control pieces likely to be obtained by a venture firm, it will probably end up exercising a lot of control over the company.  Such is the price of venture capital.  However a venture capital firm will probably allow the day-to-day operations of the company to continue to be handled by the business people.

Most business owners eventually deal with the issue of their company's worth, whether in establishing a strike price for options or in trying to sell or raise money for their companies. Stating the obvious, the value is what a willing buyer would be willing to pay and a willing seller would accept. That said, business owners are often understandably frustrated when they see the lack of objectivity in determining the value of their business. Unfortunately, like valuing baseball cards, valuing a business is less of a science than an art.

This is not to say that valuations do not have mathematical explanations, nor that there are not industry starting points (as discussed below), but all of that is academic without a willing buyer or investor making a real offer. Using the right advisors, particularly valuations experts, can add to your bargaining leverage, ground negotiations on both sides, offer a variety of creative methods and financing options, and introduce new potential investors.

There are several well-accepted methods of valuing a company in both an investment and a capital raise context. Buyers and investors often use one of the following valuation methodologies: (i) a negotiated multiple of EBITDA (earnings before interest, taxes, depreciation and amortization); (ii) a discounted cash flow analysis (which is often used in the leveraged buy-out setting where acquisition debt payments need to be covered from free cash flows); and (iii) market comparables (where comparable businesses are identified and their stated valuations are used as a basis, and differentiating your business may be the primary point of negotiation). A good valuation expert can help identify other valuation methods that would be most favorable to your company.

The different methodologies rarely have the same outcome. The above methods are all attempts to create some kind of baseline which can be useful to both buyers or investors and sellers.

When you are raising money for your company, a private placement memorandum (PPM) can be used to provide information to potential investors to help them evaluate the merits of an investment in your company.  It is intended to disclose material information to potential investors about the securities you are selling, your company and its business, in particular, the risk factors associated with an investment in your company.  A PPM is not always required for full legal compliance with securities regulations, but it is a useful way to show that you provided all material information to investors.  Generally, each PPM will include a business plan, risk factors, a description of how you intend to use the proceeds of the offering, a capitalization table and a description of the closing process for the investment.

However, there is no "one size fits all" PPM.  They will vary according to the company's size, industry, development stage, offering size and other factors.  Therefore, it is important that a company offering securities retain competent legal counsel to assist with preparing the PPM and conducting the offering.

Business Plan

The business plan section lets you educate potential investors about your company's strengths and weaknesses.  This section should describe the products and services offered by your company, the needs of the market place, the risks which may be posed by actual and potential competitors, your strategic plans with respect to innovation, marketing and financing, and the overall business environment in which your company will operate during the term of the investment.  In most cases, the business plan section is drafted by you and reviewed by legal counsel.  One of the major purposes of legal counsel's review is to ensure that the PPM, taken as a whole, is not misleading to potential investors.

Risk Factors

The risk factors section of the PPM is a specific description of some of the risks that may be associated with your company, the industry and the particular terms of the offering.  If well drafted, the risk factors section can provide useful protection against some potential claims by investors.  Although the actual risk factors for your company will depend on your company's specific business and activities, there are some fairly standard disclosures found in most PPMs.  For example, a "development stage" company will likely include in its PPM the following as risk factors:  lack of revenue, losses and financing requirements, product development risks, technological risks, manufacturing and distribution risks, dependence on key employees, competition, regulatory risks, potential inability to exercise a redemption right, dilution, no market for shares, and difficulty of determining an appropriate offering price.  The company should also include any other risks relevant to its particular business.

Use of Proceeds

The PPM should include a section that describes how you intend to use the proceeds of the offering.  Naturally, you will want to retain some flexibility regarding the use of the funds, but the investors will likely require at least a general breakdown of uses.  The use of proceeds section might list product development, acquisition of new technologies, facilities expansion, hiring of new employees or general working capital requirements as possible applications of the proceeds.  The key to this section is to strike the delicate balance between flexibility for your company and certainty for the investor.

Capitalization

The capitalization section describes the capital structure of your company.  The capitalization section should include a capitalization table which will allow a potential investor to determine how much of the company he will own (or how much of the company's debt he will own).  The capitalization table should reflect both the actual debt and shareholders' equity of the company prior to the offering, as well as the adjusted figures reflecting the completion of the offering on the terms contemplated in the PPM.

Closing Process

The closing process or subscription procedure (as some refer to it) can be foreign and confusing for investors.  Therefore, it is helpful to provide investors some guidance in the PPM regarding how the closing will proceed.  You can require that a minimum amount of money be raised before you will proceed with the offering.  If that is the case, the PPM should disclose the minimum aggregate capital commitments. After any applicable minimum is met, qualified investors generally have to complete and return a subscription agreement which obligates them to buy the securities, along with a check for the amount of the purchase price (payment may also be made by wire transfer), by a date specified in the subscription agreement.  Sometimes the subscription agreement is included with the PPM.

The investor may also be required to complete and return an "accredited investor" questionnaire to allow the company to comply with certain exemptions from the securities laws.  If required, the questionnaire is typically attached to the subscription agreement. 

After the company has received all signed documentation and funds, it should provide the investor signed counterparts of the documentation.  The company may also provide the investor share or unit certificates or promissory notes, if applicable, and signed copies of the company's governing documents.  If the company is making the private offering pursuant to certain registration exemptions, after the closing it may need to file various documents, including Form Ds and U-2 Uniform Consents to Service of Process, with the state and federal authorities where the investors are located.

President Obama has made education a key component of the stimulus package.  More than $43 billion has been allocated to the Department of Education and an additional $9.9 billion in tax credit bonds for the land acquisition for, or construction, rehabilitation or repair of public school facilities.

Read more about the impact on education.
 

“Retention and reuse of older buildings is an effective tool for the responsible, sustainable stewardship of environmental resources,” stated Richard Moe, President, National Trust for Historic Preservation: at a dinner last December where Moe was honored by the National Building Museum with the Vincent Scully Prize for his work on historic preservation.  Moe went on to state that “[N]o matter how much green technology is employed in its design and construction, any new building represents a new impact on the environment.  The bottom line is that the greenest building is one that already exists.”

Moe is not alone in seeing the critical interplay between historic preservation and sustainable development.  I’m with him, which is why when I was recently asked by the Indiana Chapter of the United States Green  Building Council to speak to its members and guests about tax incentives for sustainable development I could not resist the opportunity to talk a little bit about federal historic rehabilitation tax credits.  Federal income tax law has allowed for many years two credits , a 10% credit for pre-1936, non-certified historic structures, and a 20% credit for “certified historic structures”.  The credit amount equals credit rate (10% or 20%) multiplied by amount of “qualified rehabilitation expenditures”. 

The 20% credit provides the historic developer a source of funds with which to fund gaps in financing.  The source is tax credit equity provided by an investor or investors willing to become an owner of the project for 5 years in return for tax credits generated by the project expenditures.  For example, assuming the project has $10M of qualified rehab expenditures (defined below), the project owner (a partnership for federal tax purposes) has $2M in federal tax credits to pass through to its owners.  The project owners can typically raise 85-95% of the $2M in the form of tax credit investor equity. 

There are four basic requirements to consider, though other requirements and limitations(such as those related to tax-exempt use of the property) may apply

Must involve a “certified historic structure” 

Must result in “qualified rehabilitated building” 

Must have “qualified rehabilitation expenditures” 

Must be a “certified rehabilitation” 

• Rehabilitation of a certified historic structure must be certified by the Secretary of the Dept. of Interior in order to qualify for the credit
• Three part application process involving the State Historic Preservation Officer (SHPO) and the Dept. of Interior

As mentioned above, other limitations and special rules apply, but historic rehabilitation tax credits can serve as one of the many incentives potentially available to finance sustainable development.