This article is written by Janhavi Shringarpure who is pursuing a Diploma in M&A, Institution Finance & Investment Laws (PE & VC Transactions) from Lawsikho.

Introduction

The M&A trends in the global scenario are impacted by a host of factors including market conditions, economic conditions, political scenarios etc. Albeit the adverse influence of the COVID outbreak on the economy, the M&A market is still significantly blooming. Owing mainly to the developments in the e-commerce sector, market players are foreseeing a greater potential for cross border mergers, strategic acquisitions and takeovers. Buyers, who are planning an acquisition or takeover, are giving a significant amount of attention to the kind of deal structure they negotiate. Hence they are engaging in proper valuations and scrutinizations of the target company in order to plan a suitable structure for their transaction. The simple reason being, that they are acutely aware of the impact that their choice of deal structure would have on the success or failure of the transaction, hence a very cautious and pragmatic approach in terms of devising a right deal structure would be adopted by the prospective parties.

Understanding deal structures

The primitive step towards M&A transactions is to devise a suitable deal structure for the acquisition. A wrong choice of deal structure might make the entire transaction an uphill battle.

Deal structure, in simple words, is a binding agreement between the parties which articulates the rights and obligations and mutually accepted terms between the parties in carrying out the proposed transaction.  The goal of a deal structure is to carve out the transaction in a manner which aligns the interests of the parties and would ultimately result into a seamless transfer of business from the seller to the acquirer.

In a generic sense, there are certain points to be borne in mind by the parties, before devising a deal structure :

1. Scope of negotiation and the bargaining power of the party.
2. How maximum returns can be generated by keeping the risks to a bare minimum.
3. What would be the tax, legal, accounting, financial implications of the transaction and how they can be competently managed.
4. Conditions which can cause the deals to be unsuccessful.

Devising an optimal deal structure would give your company the best opportunity of maximizing the value generated by the acquisition.

Types of deal structures

An acquisition can be structured either as an asset purchase deal or an equity deal/ stock purchase deal. Both the structures have its own perks & setbacks and for arriving at a suitable structure, the parties should weigh the pros and cons of both the structures for carrying out the transaction in the most sustainable way.

Asset purchase deal

In an asset sale, the acquirer would purchase the individual assets of a company such as plants, property, machinery, equipment, goodwill, intellectual property, licenses etc, while the seller retains the ownership of the enterprise. It can include any type of property whether tangible or intangible, which the acquirer desires to purchase. Thus in an asset purchase, the buyer has the option to cherry pick the most attractive assets which would maximize his returns from the acquisition. 

The acquirer will purchase limited assets but the name and brand equity will be transferred to him. A valuation of individual assets and liabilities is done before entering into the legal arrangement of an asset sale and depending on it, the acquirer and the seller negotiate the price for the same.

Generally, an asset acquisition strategy is used when the acquirer has clear goals of picking up certain attractive assets but not interested in the entire business operations of the target company. For instance, Tata Motors acquired Jaguar and Land Rover from Ford in 2008 for $2.3 billion to bolster its image as a global company. Tata’s top-down strategy was to acquire manufacturing facilities of high quality and the brand assets (including the Embedded NSC Assets, the Halewood Plant, the Halewood Assets and the Halewood Properties), without acquiring an iota of liabilities.

In such cases, the buyer does not take over the liabilities of the target company and can avoid the risks associated with those unknown liabilities. It is a part of the game plan for market players to use this approach instead of buying the business, as the assets would cost less upfront, while still provide ample of rewards and accolades on the back end.

As per the Deloitte’s survey report for 2019, corporate respondents preferred acquiring technology assets as the No. 1 strategic driver for their M&A deals in the year ahead. This especially the case where corporates wish to leverage the talent and technology of the target company to both deploy and grow these capabilities at scale in a way that is secure and efficient.

Another strategy is where corporations acquire assets in exchange of their existing assets, instead of cash. DuPont said it would sell part of its crop protection unit to FMC and buy nearly all of FMC’s health and nutrition business in a deal that will fetch DuPont about $1.6 billion because of the difference in the value of the assets.

Structuring an asset deal

An asset sale is customarily undertaken through a business transfer agreement or an asset purchase agreement, where all the individual assets which the acquirer wishes to cherry-pick are stated in the agreement. It is prudent to clearly specify in the agreement, the assumed and excluded assets, as well as assumed and excluded liabilities, to be transferred to the buyer.  

An asset sale is preferred due to the following reasons:

1. The buyer has flexibility and discretion while choosing the assets that it wishes to purchase. Since he will have a detailed eye on every asset he wishes to bag, he knows which obligations he has and is prepared to take care of meeting them.  The buyer would conduct a proper valuation of the assets and then make a shrewd and informed decision of which assets to purchase, depending upon how much they are prepared to take over.
2. The risks associated with unknown liabilities are eliminated in an asset acquisition as the buyer’s ownership is confined only to the specified assets. On the other hand, if the buyer goes for a stock purchase, a myriad of risks will stem from the known and unknown liabilities of the target company.
3. Tax advantages – The assets are valued at its market value at the time of purchase.  For additional tax benefits, the buyer can negotiate for a higher value for assets which depreciate quickly (like equipment) and by allocating lower values on assets that amortize slowly (like goodwill). This would not only reduce the taxes but also improve the cash flows of the company in its initial years. Tax benefits will be subject to and in accordance with the domestic tax laws of the acquirer and seller.
4. The purchaser is not obliged to absorb all the employees. This is another added advantage for an asset purchase, that all the employee contracts can be modified, however they have to be renegotiated post the acquisition
5. This approach is viable when chances of gaining shareholders approval are somewhere between slim and none.

There are however a few disadvantages pertaining to an asset purchase deal:

1. The seller will be left with the unwanted liabilities of the business. This can crop as a substantial issue that would affect the seller’s price negotiation as he would demand higher prices for the assets.
2. Tax implications – In an asset sale, capital gains tax will be attracted on the seller corporation and further distributions of the proceeds to the shareholders would be taxed in their hands. Hence, double taxation is attributed to an asset sale transaction.
3. The seller might face a difficulty in disposing off the remaining unsold assets
4. Employee contracts and licenses in some cases will have to be re-negotiated
5. Creditors, suppliers, and even key customer consent may be required to approve the transfer of certain assets to a new owner. The process can become cumbersome, if there are many assets to be included in the sale. The title to every single asset must be transferred and a new title assigned to the new owner. The seller may be required to pay the transfer fees This adds complexity and time to the process.

While an asset sale sounds like a lucrative option for the buyer, it would not be a convenient option for a seller.

Equity deal/stock purchase deal

An equity deal is when the vendor transfers all the shares to the acquirer and eventually the acquirer becomes the new owner of the business. Thus the buyer acquires the stock of the target company directly from the selling shareholders, along with the entire package of its liabilities and assets of the seller. 

When Microsoft acquired LinkedIn in June 2016, what Microsoft was acquiring with its cash was LinkedIn stock. Each shareholder gets $196, there are approximately 133 million shareholders, for a total value of $27.2 billion. LinkedIn shares are cancelled and cease to exist.  As a result, Microsoft would effectively step into the shoes of LinkedIn and own the entire thing.

Many market players prefer a stock acquisition strategy when they foresee an organic growth in the value of stock of the company, and feel that the current and future liabilities of a company are minimal to be taken over. Further, if the seller stipulates extravagant costs for individual asset sale, a stock purchase deal turns out to be a feasible option for the acquirer. 

Businesses where a substantial asset value is attributed to Intellectual property or goodwill, generally are procured by the way of equity deal. For example: In 2011, the most notable transaction was Google acquisition of Motorola, which provided Google with a strategic patent portfolio of around 17,000 patents. According to Google’s CEO Larry Page, “the strong patent portfolio was a crucial element in considering the acquisition”.

Stock purchase deals are also used as a strategy to establish a brand as a market leader. Since equity ownership gives a controlling right to the acquirers, they are in a position to establish dominance in the target market segments. To quote a reference, in 2005 Adidas took over one of its top 3 rivals in the footwear industry, Reebok and completed the deal valued at $3.8 billion. Incentivized mainly by the developed distribution channels of Reebok in the USA, Adidas sought for strengthening its position as a number two on the world footwear market through this acquisition.

Structuring a stock purchase deal

Typically, a stock purchase deal is carried out by executing a share purchase agreement, where the specific number of shares are listed along with their purchase price on the terms and conditions which are mutually agreed by the parties. While executing a share purchase agreement, it is prudent to keep in mind the fundamentals of the transaction and accordingly prioritize the business aspects.

Below is a quick primer on some advantages of a stock purchase deal 

1. The buyer is not required to carry out expensive valuations and retitles of individual assets, thus it turns out to be a simple cost effective method. Hence in most cases stock purchase is preferred over asset purchase as the legal work involved and the expenses thereof are very low.
2. Non-assignable licenses would be transferred to the buyer without obtaining specific consents. This is exactly why companies acquiring an entity which has a strong patent portfolio prefer stock purchase over acquiring individual assets.
3. Tax implications – There are certain transfer tax benefits available in case of a stock acquisition. Further, stock acquisitions avoid double taxation.
4. The acquirer enjoys complete ownership of the business along with its voting rights. Thus he holds a controlling stake in the business, rest assured.  
5. The seller can get rid of all his current and future liabilities, which would otherwise have been tedious and costly while disposing them off.

Disadvantages associated with equity deal

1. The biggest set back in a stock purchase deal, is that the buyer has to assume ownership to all the assets and liabilities and bear the risks associated with it. If the risk of unwanted liabilities is marginally high, it might cause a sticky and costly situation for the buyer. In comparison, in an asset purchase, the buyer is at an advantage as he can pick up the attractive and profitable assets and the remaining liabilities would vest with the seller.
2. In some cases, the minority shareholders or dissenting shareholders may pose a hindrance while carrying out the deal if they adamantly refuse to sell or refuse to accept the terms of the acquirer.
3. Certain tax deductions pertaining to depreciation and amortization cannot be claimed by the buyer in a stock purchase structure.

Usually stock purchase is an easier pitch to sellers as they do not want to be left with the downside any more.

However, the buyer–seller preferences as averred above, are just broad generalizations and ultimately the choice of a deal structure would be based on which party has better negotiated the terms in its favor.

Points to be considered while devising an optimal deal structure 

1)  Check the liability profile of the target business. If the present and future liabilities are few in comparison to the value and returns derived from the assets and ownership, an equity deal would be a feasible option.

2)  Check the third party consents and approvals required and other regulatory requirements. If approvals and consents can be obtained expeditiously and on easy terms, and the regulatory regime is not very stringent, then an asset purchase deal would be a convenient option.

3)  Check the shareholding pattern. If there are too many stockholders who are varied and split, it might be difficult to pursue the negotiation. In such a scenario, an asset purchase deal should be preferred

4)  Tax considerations. Check if the tax laws of the specific country provide for any benefits and whether double taxation can be avoided.

Conclusion

The decision regarding deal structure is generally based on multiple negotiation rounds and deliberations, depending the size and value of the entities.

Whether to go for an equity deal or an asset acquisition depends on the negotiation of the parties. A buyer willing to go for an asset acquisition may be persuaded to go for a stock purchase if the seller is ready to offer incentives and large concessions on the price. Similarly, a seller who desires a stock sale might be convinced to opt for an asset sale if the buyer is purchasing the assets for a high price and at favorable terms.

Every potential acquirer or target company might face its own set of challenges and hence upfront planning is crucial, especially when the deal structure is to be decided. The deal teams should always endeavor to procure the best attorneys or advisors and tax and legal experts for negotiating the deal suitably in the interest of its company.