Business and Tax Planning Fundamentals
During the 21st century, financial buyers such as private equity sponsors (PE firms) have dramatically increased their participation in the merger and acquisition (M&A) marketplace. PE firms generally acquire "portfolio" companies with the intention of holding them for periods averaging seven years, and then selling them for what they expect to be a substantial profit. Other financial buyers such as family offices (investment arms of wealthy individuals or families) may have longer hold periods. Most PE firms look for companies with strong management teams and routinely encourage some of the target company's equity owners, particularly those members of the management team who are critical to the future success of the business (referred to in this article as "rollover participants"), to "roll over" a portion of their equity. When the acquisition is closed, rollover participants will own a minority equity position in either target company or a buyer holding company.
This article addresses key tax and business issues facing those participating in rollover equity transactions. Although the article is primarily written from the perspective of rollover participants, it can be used by investment bankers and PE firms as an executive summary and issues checklist for navigating through the rollover equity aspects of a typical M&A transaction.
Our experience representing sellers suggests that in the 2019 M&A market, PE firms often have a strong desire to include rollover equity as part of their overall equity piece in putting together the acquisition financing. These PE firms are also looking for ways to differentiate themselves from their 7,000+ peer PE firms when competing for a deal. These factors can result in favorable deal terms for sellers and creativity on the part of PE firms in structuring attractive rollover equity arrangements. For example, a speaker at a recent ACG capital connection mentioned that her PE firm had recently closed a deal which included a feature where the PE firm matched each rollover equity share with an option to acquire an additional share, effectively creating an opportunity for rollover participants to achieve a "2 for 1" return on their equity rollover. The financial stakes can be quite high in a rollover transaction. Rolling over 20% of the enterprise value of a target company often represents a very meaningful share of the overall equity in a leveraged buy-out transaction. Given these stakes, the rollover structuring and negotiating process slants in favor of owners and legal and tax professionals who have expertise structuring and negotiating equity rollovers.
What drives the popularity of rollover equity transactions?
The popularity of rollover transactions can be attributed to a combination of several factors. Foremost, PE firms perceive having the management team roll over a meaningful share of their target company equity is a powerful way to align the rollover participants' interests with their own interests. Rollover equity may also represent a critical part of the overall deal consideration if the transaction is aggressively priced (making the use of "soft" money consideration more useful), or where there is a substantial valuation gap between seller and buyer. Rollover equity functions as a component seller financing, reducing the PE firm's up-front equity investment. Rollover equity is often appealing to the target company's management team because it gives them an opportunity to achieve a substantial additional gain on their investment in the target company. So, it is true to say that participation in the equity rollovers is often both required by the PE firm and desired by the rollover participants.
How are rollover equity transactions typically structured?
The typical rollover transaction involves rollover participants receiving between 8% and 40% of their deal consideration in equity rather than cash. The average is in the 20% range. After the rollover, participants may own target company equity, equity in the target company's holding company or equity in a holding company holding both the target company and one or more other portfolio companies (i.e., where the target company is an add-on transaction) by the PE firm. The rollover transaction itself may be structured as an exchange of target company equity for buyer equity, an exchange of target company assets for buyer equity, a partial target equity sale, a merger, a contribution of target company assets to a newly-formed operating entity, or an equity investment in the buyer. A large majority of equity rollover transactions are structured to allow for the exchange of rollover equity on a tax-deferred basis.
From the economic perspective, the inclusion of rollover equity in a deal is similar to including an earn-out component in the deal's purchase consideration. In both cases, the success of the ownership right rests on the future success of the target company or the buyer's combined portfolio companies. A difference between the earn-outs and rollovers, however, is that an earn-out formula usually pays out over several years if earnings targets are met or exceeded, but the ownership of rollover equity only translates into more dollars in the participant's pocket if and when the target company is resold.
Rollover equity often ranks pari passu with equity purchased by a PE firm's fund, but it can be junior to a class of preferred stock held by the PE firm's investors. Generally, none of the equity owners have a put right or other voluntary exit opportunity until the resale of portfolio company occurs after several years.
Rollover participants are often in a good position to judge whether making a continuing bet on the target company's success makes good investment sense, taking into account whether the purchase price for the target company is attractive, the quality of the going-forward management team, the PE firm's track record for implementing successful business plans and portfolio company sales, the PE firm's plans for add-on acquisitions or other capital infusions to fund growth, and last but certainly not least, the rollover participants up-front cash in the deal.
Some transactions with rollovers will also include the rollover of bonus rights (e.g., phantom equity rights) and unexercised options. Potential rollover participants ask early in the negotiations how these equity rights will be handled (cashed out or rolled over?).
Target company owners should view participating in a rollover transaction as an equity investment.
Members of the target company's management team who agree to rollover equity are making the equivalent of a minority equity investment in the buyer. These potential participants should certainly consider undertaking some level of financial and legal due diligence, focusing on the buyer's track record, the PE firm's proposed business plan for the target company, the PE firm's proposed debt and equity structure for the leveraged buy-out, and other tangible and intangible factors. If the target company is a platform acquisition for the PE firm, a legitimate question is what the PE firm's plans are for expansion through add-on acquisitions or other capital infusions. If the target company is being purchased as an add-on to an existing platform portfolio company, then looking at the financial and business performance and prospects of the portfolio company makes good investment sense. One way of looking how to approach this issue is to ask what level of due diligence the participants would undertake if they were making a cash investment in the buyer equal to the value of their anticipated rollover equity piece. All of this is said with the understanding that the degree of attention to seller due diligence is likely to vary depending on whether the overall purchase price is perceived as being a great or merely acceptable, and the percentage of overall deal consideration being rolled over.
One risk associated with rolling over equity into the buyer's entity is the possibility that the buyer's enterprise value is difficult to verify or inflated. This issue comes up when the target company is an add-on transaction, and the issuer of the rollover equity is the combined business. Rollover participants should review the buyer's financial information and see whether there is support for the valuation of the buyer and its equity, and make sure they understand the company's equity and debt structure.
Typical cultural and governance style issues
Where the target business will operate on a standalone basis post-acquisition, the equity and debt structure of the buyer and the position of the rollover participants in the buyer's governance structure (from the viewpoint of being minority investors) are usual due diligence concerns. If the target company is an add-on acquisition, then due diligence should include a meaningful review of the buyer's other related portfolio companies.
When weighing the relative merits of several PE firm offers, potential rollover participants should look beyond the dollars and carefully consider what their life will be like with the PE firm post-closing. There are many PE firms competing for deals and they have different approaches for dealing with their portfolio companies. Some PE firms take a hands-off approach, relying for the most part on the portfolio company's management team. Other PE firms maintain a substantial presence at the portfolio company and are heavily involved in decision-making. Some PE firm's principals may show up only for monthly or quarterly board meetings so long as there is expected financial performance. Other PE firms place an executive at the offices of the portfolio company for the purpose of observing operations on a day-to-day basis. In some cases, these portfolio executives are involved in day-to-day operations and decision-making.
Regardless of the PE firm's governance style, the target company's management will need to accept that they have traded control of their business for a management role and minority ownership position. A PE firm will usually decide if and when the business will be sold or whether the company will undertake an add-on transaction. The PE firm may involve senior management, but the ultimate decision usually rests with the PE firm. Important succession planning takeaways for rollover participants are to both "know thyself'" (what kind of a partner would the rollover participant make?) and consider the adage that you should choose your partners wisely.
Rollover participants should consider interviewing management (including selling owners) of a PE firm's other portfolio companies to see if the PE firm is the right fit for the rollover participants. Rollover participants should consider whether they personally like the PE firm's owners and ask themselves whether they believe that the PE firm will make a good partner and contribute to the future success of the business. Questions that rollover participants should ask the PE firm up front include:
- What role the PE firm sees itself playing in the target company's operations post-deal?
- Will the PE firm place an executive on the premises?
- What role does the PE firm play in its portfolio company's day-to-day management and decision making?
- How often will the portfolio company executives meet with its PE owners?
- Does the PE have the experience and resources to assist the rollover participants in achieving this exit strategy?
- Does the target business have the management team in place that can support the PE firm's plans for expected growth?
- What is the PE firm's track record?
- What does the PE firm have to say about its business plan and exit strategy for the target company?
- If the strategy is a sale in the "short" term, does this fit with the rollover participants' long-term plans for the business?
- Does the PE firm have the experience and resources to assist the rollover participants in achieving this exit strategy?
- Does the target business have the management team in place that can support the PE firm's plans for expected growth?
In advance of inking a deal, rollover participants should carefully review all management fees, transaction fees, other compensation payments and any affiliate arrangements that might siphon off the target company's profits. A positive aspect of being acquired by a PE firm is that rollover participants who continue in management positions post-acquisition often participate in an equity pool established by the PE firm to incentivize their new portfolio company's management. Rollover participants should also negotiate up-front the terms of their post-closing employment arrangements with the target business. Finally, rollover participants should ask early in the process whether there are additional covenants or material terms that will appear in the LLC agreement draft or a separate equity holders agreement.
The sale thought process outlined above fits best with a situation where a target company is owned by its founders and is undertaking a sale process that includes financial buyers for the first time. It’s increasingly the case that target companies will already be owned by a PE firm and the decision about which financial or strategic buyer will be the next owner is one made at the PE firm owner level, with limited input from the portfolio company's senior executives.
Typical buyer capitalization structures
"What's market" regarding the economic features of rollover equity has been evolving since 2008, as the competition among buyers for companies has heated up. Several years ago, the typical rollover equity currency was common equity subordinated to preferred equity issued to the PE firm's investors. In recent years, common stock has become more typical, although some deals use participating or straight preferred equity. If the equity is issued by an LLC, the same common and preferred equity classes are utilized. The incentive equity issued to management and employees is typically a class of voting or nonvoting common equity. Rollover participants should carefully review the buyer entity's capitalization and debt features in connection with negotiating their deal.
The sale documents typically include provisions that require rollover participants to bear their share of purchase price adjustments and indemnity obligations.
Leverage, leverage and more leverage
Almost all acquisitions by PE firms are leveraged buy-outs that include a senior and subordinated debt piece adding up to 40% to 60% of the overall deal funding. Rollover participants should review the post-acquisition pro forma balance sheet of the issuer of their rollover equity. The good news is that the more leverage in a deal, the bigger the share of the rollover participant's equity. The bad news is that the debt must be repaid before rollover participants participate in the buyer's upside when the second sale occurs. Another way of viewing debt in a leveraged buyout (LBO) with rollover equity is that rollover participants are not only providing a significant equity piece but are also indirectly responsible for their share of the debt used to purchase their target company.
Typical minority ownership issues facing rollover participants
Here are some of the key minority owner issues facing rollover participants:
- Mandatory tax distributions. The inclusion of a mandatory tax distribution is critical to minority owners of a pass-through LLC who don't have any control over whether permissive distributions will be approved by management.
- No involuntary additional capital contributions. A minority owner doesn't want to be forced to make involuntary capital contributions.
- No involuntary loans or personal guarantees. A minority owner doesn't want to be forced to make loans to the company or have an open-ended requirement to guarantee company obligations.
- Understanding the potential for dilution. A minority owner benefits from pre-emptive rights and an understanding of when and how dilution can occur. Typical exceptions to pre-emptive rights include the issuance of equity compensation and the redemption of equity in connection with the reissuance of shares to new investors.
- Board representation. Depending on the percentage of equity represented by the rollover participants' holdings, rollover participants may have board representation (in addition to a seat for a rollover participant continuing as the company's president/CEO) or observer rights.
- Governance issues and management fiduciary duties. The buyer entity's governance documents, particularly when the entity is an LLC, often requires owners to waive the fiduciary duties of care and loyalty otherwise applicable to the financial buyer's board representatives or managers. In many cases, the documentation will go further and provide that the financial buyer and its representatives are permitted to approve decisions that further their interests rather than making decisions based on what is best for the LLC or the rollover participants. Here is where rollover participants need to use whatever leverage they have in early stages of the sale process, with the help of experienced counsel, to make sure that, at the very least, the financial owner doesn't have the right to undertake conflict of interest transactions without obtaining minority owner approval. The reality is that rollover participants need to recognize that there may be situations after the sale where their interests are not comfortably aligned with those of the financial owner, but in most instances, the rollover participants will not have a meaningful say in decisions regarding capital transactions. For example, the financial buyer often drives the decision-making on issues such as whether to add or replace key executives, whether to undertake add-on transactions or restructurings, and whether and when to enter a sale process and the terms of the sale. A further reality is that the rollover participants may have little say in whether there is a required rollover component to the subsequent sale of their company and whether they will be required to participate in the sale. Depending on the business, there can be the additional risk that the PE firm will sell its portfolio company to a strategic buyer that could replace the management team or have goals that don't align with the portfolio company's management team. These risks should be recognized going into the initial sale process.
- Supermajority voting rights. Rollover participants with a substantial ongoing stake in the portfolio company should consider negotiating for supermajority voting rights on key decisions. In many cases, however, buyers will not be willing to grant the rollover participants a meaningful vote on matters other than consent rights associated with a PE firm conflict of interest transaction. Some key issues that might be the subject of a supermajority consent requirement include: (i) amending the buyer's organizational documents; (ii) the making of a non-pro rata distribution to owners not contemplated in the LLC agreement; (iii) the making of non-pro rata redemptions (other than upon termination of employment); (iv) the dissolution or liquidation of the buyer entity; (v) increasing or decreasing the number of directors; (vi) equity redemptions not contemplated in the buyer's LLC agreement; and (vii) consent rights with respect to asset purchases or sales exceeding agreed-upon thresholds. As previously mentioned, PE firms rarely extend consent rights to rollover participants for most of these items.
- Sponsor fees. PE firms typically receive 20% carried interest (profits interest) and pursuant to a support and services or management fee an annual management fee equal to 1.5% to 2% of committed capital. There may be other fees, including directors' fees, acquisition and disposition fees, and monitoring fees. Rollover participants should carefully review a PE firm's fee structure to confirm that the fee structure is market. Obviously, if there are aspects of the fee structure that are not typical or are excessive, this should be addressed during the negotiations.
- Information and inspection rights. Rollover participants usually have a right to periodic financial statements and typical equity holder information rights, but careful attention should be paid to any restrictions on those rights set out in the LLC operating agreement or a separate equity holders agreement.
- PE firm repurchase rights upon termination of employment. Most rollover equity is subject to repurchase rights upon termination of employment. In most deals, the repurchase right is based on some reasonable fair market value calculation, but the terms of the repurchase should be carefully reviewed.
- Put rights upon termination of employment are unusual. Very few deals include rollover participant put rights, and when they are included in a deal, the triggers are usually termination without cause, death or disability. If there is a put right triggered upon termination of employment, the redemption price is usually either set at current fair market value or value of the equity when the target company was first purchased.
- Layers upon layers of restrictive covenants. In addition to any restrictive covenants (noncompetition, non-solicitation, confidentiality) entered into in connection with the purchase of the target company, rollover participants are almost always asked to enter into a second set of restrictive covenants in connection the holding of rollover equity (i.e., often set forth in the LLC agreement or shareholders agreement). If additional restrictive covenants are included in a rollover participant's employment agreement and option agreement, there could be up to four separate sets of restrictive covenants restricting one individual. Rollover participants should consider whether these restrictive covenants make sense. To the extent there are customized exceptions or scope provisions in one set of the covenants, the rollover participants should ask that these exceptions flow through into all the separate restrictive covenants.
- Possible preferential treatment for some other PE fund investors. One place where the interests of rollover participants may not be squarely aligned with those of the PE firm relates to the special treatment of the PE firm's tax-exempt and foreign investors. In many cases, these investors will hold an LLC interest through a blocker corporation to avoid adverse tax effects of being allocated Schedule K-1 profits. When it comes time to sell the target company, the PE firm usually sells the blocker corporation's stock, with the balance of the LLC interests being sold directly to the new buyer. Buyers faced with the loss of a step-up in tax basis with respect to the portion of the equity owned by the blocker corporations may reduce the overall purchase price to reflect the anticipated reduction in tax benefits. In many deals, however, investors owning their interests through blocker corporations won't bear the economic effect of that purchase price reduction. Instead, rollover participants along with other PE firm investors will share of pro rata portion of the purchase price adjustment. This approach may not seem entirely fair but is often a reality when a target company owner agrees to roll over equity into a buyer that has one or more blocker corporation owners. Some large investors may also negotiate lower management fees with respect to their capital.
- Registration rights. Many PE firms include the granting of securities (demand and piggyback) registration rights in their investor documents.
- Additional noteworthy LLC or shareholders agreement clauses. Most rollover equity will be subject through the terms of LLC agreements or shareholder agreements to rights of first refusal or first offer clauses, drag-along (forced sale) clauses in favor of the majority owners, and tag-along (co-sale) clauses for the rollover participant's benefit.
- Rollover déjà vu. Holders of rollover equity should understand they could be "asked" again to roll equity to the owner when the PE firm sells the target company. A likely candidate to purchase a PE firm's portfolio company is always another PE firm. Although this result typically isn't built into the terms of the rollover, from a practical standpoint, it may be difficult for long-tenured executives to avoid rolling over again if they want to maintain their role with the portfolio companies. The same result could apply to some or all their equity compensation if they are participating in an equity plan.
If the rollover participant is a member of the management team, rollover equity is technically equity compensation subject to the IRC § 83's rules
There appears to be little direct tax authority discussing the tax treatment of rollover equity from the equity compensation standpoint. Nevertheless, if a management team member exchanges target company equity for buyer equity, that issuance of buyer equity appears to technically fall within the potential scope of IRC § 83. In a rollover transaction, the buyer's equity issued to the rollover participants is "purchased" with the exchanged target company equity, and it follows that in the typical rollover arrangement, the rollover participant is paying full value for the buyer equity, so there won't be any taxable compensation at the time of issuance under IRC § 83(a). But if the buyer equity is subject to substantial risk of forfeiture for purposes of IRC § 83, the rollover participant won't be treated as owning the equity for tax purposes until the restrictions lift, unless the rollover participant makes an IRC § 83(b) election.
There is clear authority that employer equity purchased by employees for full value is technically treated as equity issued to a service provider and is subject to IRC § 83. In Alves v. Commissioner, the service provider exercised an option and purchased employer stock at full fair market value. The stock at the time of issuance was subject to substantial risk of forfeiture for IRC § 83 purposes, but the holder failed to make an IRC § 83(b) election. The Tax Court held that when the stock was ultimately sold for a gain, the entire amount of the gain was taxable as ordinary compensation income rather than at capital gains rates.
Some management team members may hold target company stock subject to risk of forfeiture where they previously made an IRC § 83(b) election. If they exchange this target company stock for buyer stock with similar restrictions, they should make a new IRC § 83(b) election within IRC § 83(b)'s 30-day time period after the exchange. If there are no forfeiture risks encumbering the management team's target company stock, they will naturally resist the imposition of new restrictions if they are rollover participants. But the imposition of buy-out rights and transfer restrictions on equity issued in a rollover transaction is common. Whether the terms rise to the level of "substantial risks for forfeiture" for IRC § 83 purposes, is another question that should be considered whenever restrictions are placed on the management team's rollover equity.
IRC § 83 shouldn't be applicable if the rollover participants are retaining their target company equity. If a service provider is treated as owning stock, the subsequent imposition of restrictions that would be treated as "substantial risks of forfeiture" under IRC § 83 doesn't bring the stock back within the scope of IRC § 83 a second time. Likewise, the placing of new restrictions on target company stock retained by the management team shouldn't, in our opinion, result in any change in the stock's status as being a capital asset owned by the rollover participant. Rollover participants should certainly seek their own tax advice with respect to the service provider implications of participating in a rollover transaction.
Tax aspects – structuring rollover transactions
Equity rollovers can usually be structured to allow participants to defer taxes on the rollover piece of their sale compensation. Deferring taxes isn't the same as "tax-free." When the target company is resold by the PE firm, rollover participants will finally be taxed on their rolled over equity, unless they rollover again. Tax deferral isn't always possible or part of the deal, and where it isn't rollover participants are essentially investing after-tax dollars to purchase buyer equity. While most sellers prefer stock sales and transactions structured to maximize tax deferral (unless the equity is being sold at a loss), most buyers would prefer fully taxable asset purchases, which permits a complete step-up in the tax basis of the target company's assets for future depreciation and goodwill amortization write-off purposes. The seller-friendly M&A environment usually translates, however, into buyers who are willing to cooperate in structuring a tax-deferred rollover.
The most common ways for structuring a taxable rollover and tax-free rollovers are outlined below. Obviously, the selected structure varies from deal to deal based on the parties' respective identities from a tax standpoint (i.e., C corporation, S corporation or pass-through LLC), the entity selected through which to operate the acquired business (C corporation or pass-through LLC), and the relative size of the parties.
Tax aspects – structuring taxable rollovers
A fully taxable rollover transaction generally involves the taxable purchase of 100% of a target company's assets or stock, followed by the rollover participants' reinvestment in the buyer's equity on an after-tax basis. A taxable rollover transaction might also involve a stock or asset purchase where the transaction fails to qualify as an IRC §§ 351 or 721 exchange, or merger or other reorganization where a portion of the purchase consideration is paid in the form of buyer equity, but the transaction fails to qualify as an IRC § 368 tax-free reorganization.
The rollover-related tax issues are straightforward in a fully taxable transaction. The key non-tax issues discussed below would remain applicable to rollover participants acquiring their rollover equity on an after-tax basis.
Deals may be structured to include taxable equity rollovers in situations where the sale would trigger tax losses for the rollover participants, the terms of the deal or tax characteristics of the parties make a tax-deferred rollover difficult or impossible, or a taxable rollover is a buyer demand.
It is important to remember that a tax-deferred rollover is usually only a deferral of taxes until the buyer resells the target company.
There are several typical ways to structure tax-deferred rollover transactions:
Tax aspects – structuring tax-deferred rollovers
A tax-free (deferred) rollover involves the deferral of taxes on the portion of the rollover participants' equity rolled over into the buyer's entity. The cash portion of the transaction consideration will be fully taxable. The tax on the rollover portion of the equity is deferred until the second sale of the PE firm's portfolio company.
If "vesting" is imposed on the rollover equity, requiring the rollover participant's continued participation in management, the rollover participant's retained equity piece may be characterized as compensatory equity and therefore not qualify for tax-free rollover treatment. A possible alternative to introducing a "vesting" concept into the transaction structure would be an agreement between the rollover participants and buyer to a purchase price adjustment (which might include equity forfeitures or buy-backs) if certain triggering events occur. The rollover equity would be fully vested at the time of issuance.
Tax aspects – purchasing less than 100% of the target company's equity (C corporation, S corporation or LLC target)
The most straightforward way of effecting a tax-deferred rollover transaction, but one that isn't frequently used because of the buyer's concern over contingent liabilities of the target business, is for the buyer to purchase less than 100% of the target company's equity. Generally, buyers prefer structuring transactions that allow for a basis step-up. An asset purchase not only accomplishes the desired basis step up and usually allows the buyer to avoid the target entity's unknown liabilities and unwanted obligations. A buyer's concern about target company liabilities and obligations can often be mitigated (but not eliminated) through relying on due diligence and the rollover participants' indemnification obligations. In some deals, however, regulatory issues or concerns over third party approvals may override these issues and point toward selecting a stock acquisition.
If the target company is a corporation, a stock purchase will not automatically trigger an inside basis step-up to reflect the consideration paid for the rollover participants' stock. This reduces the post-acquisition value of the company to the extent of the lost tax write-offs. If the target company is an S corporation that has been taking advantage of its pass-through tax treatment, the purchase of stock by an ineligible shareholder (e.g., a PE firm's fund taxed as a partnership) would trigger the termination of the S election. An 80% to 100% purchase of an S corporation's stock can be treated as an asset purchase if the parties make an IRC §§ 338(h)(10) or 336(e) election. But the portion of stock rolled over by the rollover participants is not tax-deferred, as 100% of the target company's assets are treated as having been sold, including the percentage representing the rollover participants' rollover equity piece.
If the target company is an LLC taxed as a partnership, the sale of LLC equity by the rollover participants will generally be entitled to tax-free sale treatment under IRC § 741, but a portion of the sales proceeds may trigger ordinary income if the target company holds IRC § 751 "hot assets" such as appreciated inventory, receivables and depreciated equipment. If a selling rollover participant has a long-term holding period for his LLC equity, he will be entitled to long-term capital gains treatment even if the LLC holds capital assets with a short-term holding period. But if the rollover participants have contributed cash to the LLC or leveraged the LLC during the 12 months preceding the sale, a portion of the sales proceeds may be short-term under the IRC § 1223 rules. A step-up can be achieved by making an IRC § 754 election to step up the basis of a pro rata share of the target LLC's assets under IRC § 743.
In some cases, the first step will be a recapitalization of an LLC's outstanding equity interests into several classes of preferred and common equity, with an eye towards the classes of equity to be purchased by the buyer and retained by the target company's rollover participants. Buyers may use blocker corporations to hold some of its target company equity if the buyer's fund includes tax-exempt or foreign investors.
Tax aspects – utilizing a corporate holding company formation structure (C or S corporation target)
The holding company formation structure works in a transaction where the target company is a C or S corporation, the buyer is acquiring target company stock, and the rollover equity is intended to be an interest both in the holding company (which may hold both the target company and one or more other PE firm portfolio companies).
The transaction involves the formation of a newco C corporation (holdco). The target company shareholders contribute target company stock in exchange for holdco stock and the buyer contributes stock or assets to holdco in exchange for holdco stock. The cash contributed by the PE firm is distributed to the target company shareholders. The transaction fits within a tax-free exchange under IRC § 351, except for the cash "boot" distributed to the target company shareholders.
In a variation of the holding company formation structure that addresses the issue of non-pro rata participation in the rollover, the buyer first purchases target company equity from those shareholders not participating in the rollover and contributes the purchased stock to holdco. The rollover participants contribute the remaining target company equity to holdco or their "contribution" is effected through a merger of the target company into a holdco acquisition subsidiary.
One tax issue associated with this holding company formation structure is that the transaction triggers no basis step-up in the target company's assets.
Tax aspects – utilizing an LLC holding company formation structure (C or S corporation target)
Here the buyer forms an LLC holding company and contributes cash to the holding company in exchange for the agreed-upon post-closing equity interest. The rollover participants among the target shareholders then contribute a portion of their target stock to the holdco LLC in exchange for LLC units. Using the capital contributed by the PE fund and outside financing Holdco LLC then merges a transitory merger subsidiary with target and cashes out the remaining target shareholders.
The portion of the cash consideration that is funded by third-party debt will likely be treated as a redemption of target company stock. If any of the selling shareholders who receive cash are also rollover participants, the distribution could be treated as a dividend to the extent of the target company's earnings and profits, if the distribution fails to qualify for sale and exchange treatment under IRC § 302.
Having an LLC holding company post-acquisition should provide some welcome flexibility in structuring add-on transactions and equity compensation arrangements.
Tax aspects – utilizing an LLC "drop-down" structure to effect asset acquisitions (C or S corporation target)
In some cases, a buyer may be operating a business in corporate form, but the holding company formation structure won't work for various reasons (e.g., the deal doesn't merit forming a holding company size-wise) or the buyer wants to operate the business as a pass-through LLC. In those cases, the parties may utilize a "drop-down" LLC structure. First, the target company forms an LLC subsidiary. Second, the target company contributes assets wanted by the buyer into its wholly-owned (and disregarded for tax purposes) subsidiary LLC. Finally, the buyer either purchases a majority interest in newco LLC's equity from the target company, or alternatively, the buyer contributes cash to newco LLC in exchange for newco LLC equity. The cash is immediately distributed to the target company.
The purchase or issuance of newco LLC equity will be treated as a formation of a partnership under IRC § 721 coupled with a sale by the target company of the equity interest held post-transaction by the buyer. The rules discussed above regarding the possible impact of "hot assets" in a sale of a partnership interest will be applicable here, as the transaction includes the sale of those "hot assets" generating ordinary income. Also, if the target company has a short-term holding period for any of its capital assets, the transaction will include short-term capital gain on the deemed sale of those assets. Newco LLC will receive a tax basis step up in portion of assets deemed to be purchased and a new holding period will commence in the purchased assets. Newco LLC will have a carryover basis and holding period in the portion of assets deemed purchased. It is possible to structure the transaction as an installment sale under IRC § 453 if the payments are spread over more than one year, but the contributing rollover participant will be taxed on all the gain associated with the IRC § 751 hot assets at the time of contribution, regardless of whether payments for those assets are deferred into subsequent years.
The drop-down structure is particularly useful where the rollover participant's entity is operated through an S corporation and the buyer is an ineligible shareholder (typical for a PE firm buyer with investments through funds operated in partnership form). The rollover participants' S corporation will continue post-transaction as an equity owner holding rollover equity. The LLC drop-down transaction structure allows the parties to take advantage post-transaction of the often-favorable pass-through tax treatment afforded LLC owners. In some cases, financial buyers may employ a "blocker" corporation if the ultimate owners are foreign investors or tax-exempt investors trying to avoid a pass-through of active trade or business income (which generates UBIT for tax-exempt shareholders).
Tax aspects – utilizing an LLC "drop-down" structure to effect asset acquisitions (LLC target)
Where the target company is an LLC, a transaction may be structured with the first step being the target's formation of a new LLC subsidiary. Newco is capitalized with several classes of common and preferred equity, asset, liabilities and contracts included in the deal are dropped down into newco LLC, and the buyer acquires equity in newco. The transaction is treated as an asset purchase for tax purposes, followed by the formation of a new partnership for tax purposes. The buyer may use a blocker corporation if some of its fund investors are tax-exempt or foreign investors.
Debt financing at the LLC level may cause part of the acquisition to be taxed as a redemption or other distribution, which would generate a tax basis adjustment inside the partnership which would likely be shared by the LLC's owners (rather than a tax basis adjustment generated by the equity purchase, which belongs to the purchaser).
It isn't unusual for the target company's owners to be divided into those who will and those who won't participate in the rollover transaction, and whether owners will either rollover all or only a portion of their equity. How this affects the ability to structure a tax-free rollover depends on the tax identities of the target and buyer and the structure of the sale transaction. If the target company is an LLC taxed as a partnership and the transaction is an asset sale, it may be possible to specially allocate gain on the sale among the target's owners to account for who is rolling over and who is being cashed out in the transaction. If the LLC interests are being sold, the exchange versus sale can be accomplished at the individual target owner level. If the target is an S corporation and the transaction an asset sale, the S corporation will need to continue as an equity owner in the rollover transaction. Depending on the goals of the S corporation shareholders, it may be possible to take some of the target shareholders out through pre-transaction redemptions. If S or C corporation stock is being exchanged for acquiror equity, then the sorting out of continuing and existing target shareholders can be accomplished as part of the IRC § 351 transaction. Rollover participants and their counsel must drive this planning and structuring process as the buyer's tax goals are not aligned with those of the rollover participants.
Tax aspects – utilizing an F reorganization (S corporation target)
An example of where the F reorganization (mere change in identity or form) comes in handy is where the target is an S corporation, the parties want the target company to continue in existence for state law purposes, the buyer wants a basis step-up for the portion of the target's assets that it is purchasing for cash, the parties want tax-deferred treatment for the rollover equity portion of the deal, and most importantly for making the transaction work, each target shareholder will rollover a pro rata portion of target equity into the buyer. A typical but not universal part of these rollover deals is an agreement by the buyer to make the target shareholders whole for any tax differential between the asset sale and a stock sale.
The typical F reorganization is accomplished by forming a new corporation (that becomes the historic S corporation for tax purposes in the F reorganization), having the target shareholders contribute their target company stock to newco, and making a Qsub election for the target corporation (now a subsidiary of newco). The target Qsub then converts into an LLC under state conversion or merger statutes. The buyer then purchases the desired percentage of the target company's assets for cash and newco distributes the sales proceeds to newco's (formerly the target company's) shareholders. Tax issues that need to be addressed include ordinary income recapture and the possible impact of the disguised sale provisions in a leveraged acquisition.
The F reorganization structure permits the parties to avoid transferring the target company's assets and contract to a new LLC prior to the sale transaction, which is often desirable from a business standpoint. If the asset transfer isn't an issue in a deal, the parties can just avoid the F reorganization steps by having the target S corporation transfer assets into a newco LLC.
Tax aspects – utilizing tax-free reorganizations (C or S corporation target)
If structured properly, tax-free reorganizations allow selling shareholders to defer taxes on all or a substantial portion of the sales proceeds. Rollover participants must take a substantial portion of their consideration in the form of buyer entity equity. In most cases, the percentage of equity being rolled over won't qualify the transaction for tax-free reorganization treatment. In a merger transaction, the transaction often involves at least 40% of the consideration being in the form of buyer stock. Other reorganization provisions such as assets for stock reorganizations ("C" reorganizations), stock for stock reorganizations ("B" reorganizations) and triangular mergers require a greater percentage be in the form of voting stock.
Buyers considering using tax-fee reorganizations must weigh the benefits associated with using their stock as purchase consideration against the loss of the tax basis step-up for the portion of the transaction involving buyer equity. With respect to the target company's unknown liabilities, the availability of the assets for stock "C" reorganization is helpful, but the requirement that the target assets be exchanged solely for voting stock of the acquiror or parent usually disqualifies the C reorganization. Tax-free reorganizations are much more common where the transaction involves a publicly-traded strategic buyer.
Tax aspects – avoiding tax traps
The drafting details of LLC agreements are beyond the scope of this article but as outlined throughout this article, can have a significant impact on rollover participants.
Advisors structuring rollover transactions must be familiar with the technical tax rules for achieving tax-free treatment under IRC §§ 351, 368 and 721. There are also various potential tax traps to be avoided.
For example, if a target business was in existence on or before August 10, 1993, and the rollover participants will own more than 20% of the equity post-transaction, the target's goodwill and going concern value may not be amortizable under IRC § 197 due to the "anti-churning rules." If the buyer is an LLC, the anti-churning rules can be an issue even where the rollover participants hold less than 20% of the buyer entity's equity after the transaction. If the target company has been operating as an LLC taxed as a partnership, the business cannot be converted into a corporation for the purpose of engaging in a tax-free reorganization. The likely result of a conversion in anticipation of a merger transaction would be the IRS' invocation of the "step transaction" doctrine, which would transform the hoped-for tax-free reorganization into a taxable sale transaction, regardless of how much of the consideration was in the form of acquirer stock.
If the rollover is structured as a deemed sale of assets, whether due to an IRC § 338(h)(10) election or sale of interests in a disregarded entity, success-based fees (e.g., investment banker fees) may need to be capitalized and treated as a reduction of the amount realized on the sale, as opposed to generating an ordinary deduction.
The provisions in an LLC agreement dealing with the partnership audit rules can be another source of concern for rollover participants. Under the new audit rules, tax audits and litigation are generally conducted at the partnership level under the auspices of a "partnership representative." There are several issues that need to be addressed in the LLC agreement, including what information and consent rights the owners have versus management and the partnership representative, and whether any resulting tax liabilities will be "pushed out" to the owners or paid at the partnership level. Any with respect to payment at the partnership level, how such payments are to be funded and by whom.
Tax aspects – the terms of an LLC agreement can impact the allocation of net income to rollover participants during the target company's post-sale operating years
An important issue where the buying entity is an LLC is the LLC agreement's terms governing post-sale tax allocations. Unfavorably drafted tax allocation provisions can act to accelerate the allocation of taxable income to rollover participants, which blunts the benefits associated with the deferral of taxes on the built-in gain (i.e., the gain associated with the equity or assets rolled over in the sale transaction).
The tax allocation provisions in an LLC agreement can be structured in several different ways to accommodate both the business goals of the owners and the requirements of IRC § 704(c) that tax allocations have "substantial economic effect." One drafting method commonly seen in today's agreements is to provide that the annual general tax allocations are made among the owners based on a deemed sale of the LLC's assets, followed by a liquidation of the LLC. Once this calculation is made, taxable income and tax losses are allocated to the extent possible to bring the owners' capital accounts in line with their anticipated share of the LLC's liquidation proceeds. Further, these LLC agreements often include allocation provisions addressing the working of IRC § 704(c) in conjunction with the allocation rules found at the IRC § 704(b) Treasury Regulations, that permit the controlling owners to make tax allocations that accelerate the narrowing of the book and tax difference associated with rollover participants' built-in gains in the years immediately following the sale.
The goal of the rollover participants should be to defer as much as possible the imposition of taxes on the built-in rollover gain until the second sale occurs. One step the rollover participants should take is to demand that allocations be made using the "traditional" method rather than other methods such as the "remedial" method. Another step would be to provide for a general allocation on a per-unit basis rather than any method involving deemed asset sales. The selection of the allocation method is often dependent both on the tax sophistication of the parties and the market for businesses.
The PE firm owners generally would want provisions in the LLC agreement that basically narrow the tax and book gap associated with the rollover as soon as possible, as this would have the effect of incrementally reducing the non-rollover participants' taxable income. But in a seller-friendly M&A market, PE firms may be willing to give rollover participants the benefit of the most favorable tax treatment with respect to preserving their tax deferral.
Tax aspects –rollover of restricted stock, compensatory options, profits interests and other equity-like bonus rights
A rollover transaction may involve the rollover by the management team of outstanding restricted stock, compensatory options, profits interests and various types of bonus arrangements and stock rights. In some cases, such as where rollover participants are holding restricted stock or profits interests, they may be asked to roll over this equity into buyer equity. With option arrangements, the management team may be asked to either exercise their rights or roll them over into comparable buyer-entity rights. Bonus arrangements, rights to issuance of equity in the future and certain other stock rights and compensation programs are subject to IRC § 409A and there may be restrictions on the ability to roll over these compensation arrangements. A full discussion of the issues involved with the tax and business issues associated with this aspect of a rollover transaction is beyond the scope of this article. But there are a couple of observations that should be taken into consideration.
If a profits interest with a distribution threshold in place is rolled over into a partnership or corporation, in each case the capitalization of the buyer and/or the equity issued to the rollover participant would need to address the existence of the distribution threshold or the rollover would likely constitute a taxable event. Further, if the transaction occurs within two years after the issuance of the profits interest, there is the question of whether the initial issuance of the profits interest would continue to qualify for profits interest treatment under Revenue Procedure 93-27. If restricted stock for which no IRC § 83(b) election was made is exchanged for unrestricted stock, the rollover exchange is likely to be a taxable event for the rollover participant. Finally, most rollovers involving exchanging options or bonus plan rights for comparable rights in the buyer entity should not trigger any taxable event for the rollover participant.
Tax aspects – using "contribution agreements" instead of "purchase agreements" in rollover transactions
Best practices dictate the use of a transaction agreement titled "contribution agreement" rather than titled "purchase agreement," if the parties intend for the rollover equity to be tax-deferred for the rollover participants. Characterizing the transaction form as a stock or asset purchase invites an IRS agent's argument that the form of the transaction dictates tax treatment. Using a contribution agreement makes sure that the form of the transaction is one where the default is tax-free treatment (subject to dealing with cash boot). It also makes sense in the contribution agreement to describe in some detail the tax aspects of the transaction, including an acknowledgement by buyer and rollover participants that the transaction involves, at least in part, a tax-free rollover. At the very least, a purchase agreement should clearly state that the rollover equity piece of the transaction is governed by IRC §§ 351 or 721 and intended by the parties to constitute a tax-free exchange, rather than a purchase of equity.
Earn-out arrangements in sales to financial buyers
It isn't uncommon for PE firms to structure an acquisition to include both rollover equity and an earn-out provision. Earn-out arrangements make a portion of the overall purchase consideration contingent on the target company meeting negotiated post-closing financial goals. Including an earn-out in a deal may be attractive to a PE firm because it defers payment of a portion of the purchase price, it shifts some of the risk of disappointing performance by a business in its portfolio to the rollover participants and may assist in bridging gaps between the rollover participants' and PE firm's estimation of a target's value. From the rollover participants' standpoint, an earn-out can increase the overall purchase consideration and defer taxes, but most earn-out formulas require good to excellent performance, which as rollover participants more than anyone can attest, is anything but a sure thing.
Rollover participants who are inclined to agree to an earn-out arrangement should consider whether they would be satisfied with the up-front consideration if the earn-out piece is never earned. They should view the operation of the earn-out formula realistically and work to build in whatever protections they can negotiate for to ensure that the new owners will operate the business in a way that favors satisfying the earn-out targets. For example, rollover participants may negotiate for specific covenants that the rollover participants will remain employed and operating the business during the earn-out period and that the earn-out vests in full if the business is sold during the earn-out period. Rollover participants should negotiate for a covenant from the PE firm that it will not take actions that would adversely affect achieving the maximum earn-out amount. PE firms will try to avoid provisions that are seen to tie their hands in how they manage or operate the target business, but rollover participants may be successful in obtaining favorable covenants if they demand them as a prerequisite for considering an earn-out.
Incentive equity pools established by financial buyers
Many PE firms and other financial buyers establish incentive equity pools for the target company's key management team. The plan usually includes senior executives and sometimes covers a broader range of employees. Like rollover equity, these arrangements are seen to incentivize employees by giving them tangible "skin in the game", which aligns their interests with those of their employer. In some industries, making the benefits of an incentive equity pool available to key employees is both customary and required to be competitive in a labor market. PE firms use incentive equity pools both as a retention tool for the target company's employees and as bait for attracting new management blood to their new portfolio companies.
Incentive equity pools generally average about 12.5% of the company's outstanding equity but can range from 5% to 20% of a portfolio company's common equity. Incentive equity includes grants of restricted equity, options or profits interests (used with LLCs). A typical equity plan provides for equity that vests based on a combination of time vesting and performance-based vesting (typically return on investment capital or IRR). Rollover participants and management who leave employment generally forfeit unvested equity and are required to sell their vested equity back to the company. Incentive equity is almost always common equity that is subordinated to a class of preferred equity (usually held by the PE firm's fund and the rollover participants). In many cases, holders of incentive equity do not expect to receive profit distributions from day-to-day operations but are looking to participate in a liquidity event such as a sale of the company or IPO.
Addressing the tax consequences of an equity incentive plan is always a critical aspect of the planning process. Deferral of compensation income is always a primary goal of participants, but this desire must be weighed against the benefits of incentive equity that allows for favorable capital gains treatment for the proceeds of a liquidity event. Although the detailed business and tax consequences of incentive equity pools are outside of the scope of materials focusing on the rollover participants' rollover equity, those consequences should be studied and fully understood by rollover participants, who should take into consideration the terms of the incentive equity plan and whether they will be included in the scope of the plan's participants.
In some deals, participants receiving incentive equity or options will be asked to roll some or all their equity or options when the PE firm resells the target company. This may occur whether the governing plans and agreements provide that the sale should be a liquidity event. From the participants' standpoint, it is difficult to plan for these circumstances, particularly when their primary interest when the portfolio company is sold may be staying on with the company (i.e., keeping its new owners happy). The PE firm will want to build flexibility at its discretion into the compensation documents or plan with respect to whether incentive equity and options are cashed out or rolled over in their portfolio company's sale.
Legal representation and disclosure issues in sales to financial buyers
If a target company's ownership includes both management personnel and investors, there may be circumstances where it makes sense for the management team, the investors, or both, to have legal counsel separate from the attorneys representing the target company in the sale transaction. The reason for separate counsel is that in a sale transaction, the interests of these various constituencies may materially differ. It is not unusual, however, for target company counsel, in the interest of moving the deal forward, to handle the review and negotiation of not only the purchase documents, but also the management team's post-sale contracts, with the proviso that management and target company equity owners should consult with their own legal and tax advisors.
If there are minority investors on the sell side of the deal, best practices would include disclosing to them all the material terms of the management team's deal with the target company and/or the buyer post-sale. Focus on full disclosure and addressing concerns of self-dealing or conflict of interest transactions can become a significant concern and sometimes an issue where the management team and/or rollover participants, unlike minority owners, are expected to roll over equity their equity into the acquirer, enter into new employment arrangements and/or participate in post-sale incentive compensation plans. Full disclosure of the deal terms, the approval by at least majority of the minority investors of the deal terms, and/or structuring the transaction to make available statutory appraisal rights are tools used to address these potential conflict of interest situations.
Pre-sale process succession planning for business owners
For many rollover participants, the sale to a PE firm is a culmination of a multi-year succession planning process. Meaningful succession planning encompasses tax, business and estate planning and focuses both on the target company's owners and the business itself. Ideally, the target company's owners should begin considering succession planning issues when they start a new business, and the process should then include periodically revisiting aspects of the plan throughout the lifecycle of the business. Along the way, careful consideration should be given to whether the target company's owners want to maintain a significant management role in their company post-sale. If the target company's owners would rather move on entirely or play a limited role, then they should pay attention early in the lifecycle to the job of developing a management team that can step in to run the business post-sale. Obviously, a strong management team capable of taking the business to the next level not only adds value to the business but almost always makes it a more attractive acquisition target. Other options include selling to a strategic buyer who can bring in its own management team or transferring the business to family, management or employees (e.g., through an ESOP).