Mergers, Acquisitions and Sales of Closely Held Businesses: Advanced Case Analysis

• Chapter 0 - Overview
  • Course Goal
  • Introduction
  • Why CPAs Need to Understand the Transaction Environment
  • Organization
• Chapter 1 - Introduction: Case Study – XYZ Company, Inc.
  • Learning Objectives
  • Introduction
  • XYZ Company, Inc. (the “Company,” or “XYZ”)
  • Background Information – Case Study Method
    • Overview of Operations
    • Ownership and Senior Management
    • Assumed Effective Tax Rates
    • Affiliated Entities – Real Estate Company and Communications Company
    • Products and Services
    • Financial Structure
    • Historical Financial Statements – Income Statements for years 20X1, 20X2 and 20X3
    • Forecasted Financial Statements – Income Statements for Five Years
    • Historical Financial Statement – Balance Sheet for Year 20X3
  • Overall Observations on XYZ Company, Inc.
  • Summary
• Chapter 2 - Transaction Valuation Fundamentals
  • Learning Objectives
  • Introduction
  • Purpose of the Valuation
  • Determining Transaction Price
  • “Price” and “Terms” Briefly Examined
  • Standard of Value for Transactions
    • Fair Market Value (“FMV”)
    • Investment Value
    • Intrinsic or Fundamental Value
    • Fair Value
    • “Emotional Value” – What a Buyer and Seller Perceive
    • Types of Buyers and Sellers
  • Three Broad Approaches to Determining Value
  • Attributes of Ownership – Control Position and Minority Position
    • Control Position (Enterprise Value)
    • Minority Position and Minority Position Valuation
  • Liquidity Issues – Lack of Marketability
    • An Issue with FMV
    • Empirical Data of Lack of Marketability Discount
  • Additional Adjustments to Valuation
  • Three Valuation Approaches: Income, Market, and Asset
    • 1. Income Approach to Valuation
    • 2. Market Approach to Valuation
    • 3. Asset Approach to Valuation
  • Transaction Terms Revisited
  • Application of Computed Values
    • Fair Market Value (FMV)
    • Investment Value
  • Summary
• Chapter 3 - Transaction Structure: “The Art of the Deal”
  • Learning Objectives
  • Introduction
  • A Negotiated Environment
    • Seller and Buyer Perspectives – Overview
    • Family Members
    • Business Partners
    • Third Parties
  • Seller’s Perspective
    • Deciding to Sell – Objectives and Goals
    • Preparing for Transition – “Get the House in Order”
    • Review of Legal Issues
    • Selecting the Seller’s Advisory Team
    • Developing a Marketing Strategy – Likely “Buyers”
    • Preparation of an Offering Memorandum
    • Seller’s Due Diligence
  • Buyer’s Perspective
    • Deciding to Acquire – Objectives and Goals
    • Identify Synergies and Economies of an Acquisition
    • Selecting the Buyer’s Advisory Team
    • Legal Issues and Insights
    • Buyer’s Due Diligence
    • Financing Overview
    • Regulatory Overview
    • Securities and Labor Laws
  • Transaction Terms Revisited
    • Terms Have Substantial Impact on Total Consideration
    • All Cash Deals Unlikely
    • Most Common Types of Terms
  • Summary
• Chapter 4 - Sale or Purchase of Assets
  • Learning Objectives
  • Introduction
  • Deal Structure
    • Goals of Buyer and Seller
    • Strategic Tax and Transaction Considerations
  • Example – Asset-Based Transaction Initial Diagram and Structure of the Deal
    • Illustrated Asset-Based Transaction
    • Standard of Value – Investment Value
    • Major Steps in the Asset Transaction
  • Additional Transaction Considerations
    • Terms Considered
    • Transaction Costs
  • Summary of Strategic Issues
    • Strategies – Buyer’s View
    • Strategies – Seller’s View
  • Summary
• Chapter 5 - Sale or Purchase of Stock
  • Learning Objectives
  • Introduction
  • Deal Structure
    • Goals of the Buyer and Seller
    • Strategic Tax and Transaction Considerations
  • Example – Stock-Based Transaction Structure
    • Illustrated Stock-Based Transaction
    • Standard of Value – Investment Value
    • Major Steps in the Stock Transaction
  • Taxable Stock Purchase Treated as an Asset Purchase (§338)
    • IRC Section 338 Election
    • IRC Section 338(h)(10) Alternative Election
  • Additional Transaction Considerations
  • Terms Considered
  • Transaction Costs
  • Summary of Strategic Issues
    • Strategies – Buyer’s View
    • Strategies – Seller’s View
  • Summary
• Chapter 6 - Specialty Transaction: Employee Stock Ownership Plan and Trust (“ESOP”)
  • Learning Objectives
  • Introduction
  • Traditional Uses of an ESOP
    • Provide Liquidity and Diversification for Shareholders
    • Provide a Means of Capital Formation
    • Finance Corporate Acquisitions
    • An Incentive to Increase Employee Productivity and Retain Personnel
    • Provide a Succession Plan
    • Provide Liquidity in Divorce Situations
    • Provide Negotiating Leverage for Any Proposed Transaction
    • Summary of Traditional ESOP Uses
  • Basic Features of ESOPs
    • Operating Considerations of an ESOP
  • Tax Incentives Related to ESOPs
    • Major C Corporation and S Corporation Attributes for ESOP Purposes
    • Major C Corporation Attributes
    • Major S Corporation Attributes
    • ESOP Contributions Tax Deductible within Statutory Limits
    • Contributions to an ESOP Based on Dividends (C Corporation)
    • Contributions to an ESOP Based on Distributions (S Corporation)
    • IRC Section 1042 Tax-Free Rollover (C Corporation)
    • Nontaxable Income Related to ESOP Stock (S Corporation)
    • Assets in ESOP Remain Untaxed until Retirement
  • Examples – Sales of Stock to an ESOP Assuming Either a “C” or an “S” Corporation
    • Illustrated ESOP Transactions Overview
    • Standard of Value – Fair Market Value (FMV)
  • Example – Sale of “C” Corporation Stock to a Leveraged ESOP with IRC Section 1042 Rollover
    • Significant Factors for This Example
    • Illustrated Sale and Major Steps of “C” Corporation Stock to a Leveraged ESOP with IRC Section 1042 Rollover
    • IRC Section 1042 Restrictions
    • Strategic Summary for the Sale of C Corporation Stock to a Leveraged ESOP with IRC Section 1042 Rollover
  • Example – Sale of C Corporation Stock to a Leveraged ESOP with IRC Section 1042 Rollover, Multiple Classes of Stock, and Control
    • Significant Factors for This Example
    • Issue: Receiving a Prorated Control Position Price
    • Issue: Creating a Second Class of Stock
    • Illustrated Sale and Major Steps of C Corporation Stock to a Leveraged ESOP with IRC Section 1042 Rollover, Multiple Classes of Stock, and Control
    • IRC Section 1042 Restrictions
    • Control Position Transaction
    • Likely S Corporation Election
    • Strategic Summary for the Sale of C Corporation Stock to a Leveraged ESOP with IRC Section 1042 Rollover, Multiple Classes of Stock, and Control
  • Example – Sale of S Corporation Stock to Pre-funded ESOP with No Bank Debt
    • Significant Factors for This Example
    • Illustrated Sale and Major Steps of S Corporation Sale to Pre-funded ESOP with No Bank Debt
    • Strategic Summary for Sale of S Corporation Stock to Pre-funded ESOP with No Bank Debt
  • Example – Convert to C Corporation First, Sell Stock to Leveraged ESOP with IRC Section 1042 Rollover and Control
    • Significant Factors
    • Tax Planning Strategy
    • Illustrated Sale and Major Steps Converting to C Corporation First, Sell Stock to Leveraged ESOP with IRC Section 1042 Rollover and Control
    • IRC Section 1042 Restrictions
    • Control Position Transaction
    • S Corporation Election
    • Strategic Summary Converting to C Corporation First, Sell Stock to Leveraged ESOP with IRC Section 1042 Rollover and Control
  • Summary
• Chapter 7 - Specialty Transaction: Tax Preference Reorganizations
  • Learning Objectives
  • Introduction
  • Main Categories of Reorganizations
    • 1. Acquisitive Reorganizations Overview
    • 2. Divisive Reorganizations Overview
    • 3. Restructuring Reorganizations Overview
    • Benefits and Applications of Reorganizations
  • Regulatory and Case Law Requirements for Reorganizations
    • Business Purpose
    • Continuity of Business Enterprise
    • Step Transactions
    • Continuity of Interest
  • Acquisitive Reorganizations Illustrated
    • Standard of Value – Investment Value and Facts for the Example Reorganizations
  • Example – Type “A” Reorganization, Statutory Merger
    • Illustrated Type “A” Reorganization – Statutory Merger
    • Major Steps in the Type “A” Reorganization Merger
    • Strategic Summary – Type “A” Reorganization Merger
  • Example – Type “A” Reorganization, Statutory Consolidation
    • Illustrated Type “A” Reorganization – Statutory Consolidation
    • Major Steps in the Type “A” Reorganization Consolidation
    • Strategic Summary Type “A” Reorganization Consolidation
  • Example – Type “B” Reorganization, Stock for Stock
    • Illustrated Type “B” Reorganization, Stock for Stock
    • Major Steps in Type “B” Reorganization Stock for Stock
    • Strategic Summary – Type “B” Reorganization Stock for Stock
  • Example – Type “C” Reorganization, Stock for Assets
    • Illustrated Type “C” Reorganization, Stock for Assets
    • Major Steps in the Type “C” Reorganization Stock for Assets
    • Strategic Summary – Type “C” Reorganization Stock for Assets
  • Triangular Transactions – Mergers
  • Example – Type “A” Forward Triangular Merger
    • Illustrated Type “A” Forward Triangular Merger
    • Major Steps in the Type “A” Forward Triangular Merger
    • Strategic Summary – Type “A” Forward Triangular Merger
  • Example – Type “A” Reverse Triangular Merger
    • Illustrated Type “A” Reverse Triangular Merger
    • Major Steps in Type “A” Reverse Triangular Merger
    • Strategic Summary Type “A” Reverse Triangular Merger
  • Summary
• Chapter 8 - Specialty Transaction: The Industry “Roll-up”
  • Learning Objectives
  • Introduction
  • Roll-Up Industry Overview
    • Industry Roll-Up with Public Company Acquiring Closely Held Companies
    • Industry Roll-Up Involving Only Closely Held Companies
    • Rationale for Industry Roll-Ups Involving Public Companies
  • Example Roll-Up Structures – Public Companies
    • Standard of Value – Investment Value
  • Example – Roll-Up Involving Type “B” Reorganization Stock for Stock
    • Illustrated Industry Roll-Up Involving Type “B” Reorganization Stock for Stock
    • Major Steps in the Roll-Up Involving Type “B” Reorganization Stock for Stock
    • Strategic Summary for Roll-Up Type “B” Reorganization Stock for Stock
  • Example – Roll-Up Involving Taxable Stock Purchase
    • Illustrated Industry Roll-Up Involving Taxable Stock Purchase
    • Strategic Summary for Roll-Up Taxable Stock Purchase
  • Example Roll-Up Structures – Closely Held Companies
  • Example Roll-Up Involving Type “A” Stock for Stock Consolidation
    • Illustrated Industry Roll-Up Involving Type “A” Reorganization Stock for Stock with Closely Held Corporations
    • Standard of Value – Investment Value
    • Major Steps with Roll-Up Involving Type “A” Reorganization Stock for Stock with Closely Held Corporations
    • Strategic Summary Roll-Up Involving Type “A” Reorganization Stock for Stock with Closely Held Corporations
  • Common Transaction Considerations
    • Practical Considerations – Frequent IPO Failures
    • Concerns Regarding IPO Roll-Up Transactions
    • Roll-Up Transactions with No IPO Orientation
  • Roll-Up Transactions and Consolidations
  • Summary
• Chapter 9 - Specialty Transaction: Between Family Members
  • Learning Objectives
  • Introduction
  • Family Members Considered
    • Active and Inactive Family Members
  • Examples – Sales and Gifts of Stock between Related Parties
    • Standard of Value – Fair Market Value
  • Sale of Business Interests
  • Example – Sale of Stock for Cash
    • Illustrated Sale of Stock for Cash
    • Strategic Summary – Sale of Stock for Cash
  • Example – Sale of Stock Using Stock Bonus Plan
    • Illustrated Sale of Stock Using Stock Bonus Plan
    • Strategic Summary – Sale of Stock Using Stock Bonus Plan
  • Example – Sale of Stock Using Private Annuity
    • Illustrated Sale of Stock Using Private Annuity
    • Strategic Summary – Sale of Stock Using Private Annuity
  • Example Sale of Stock Using Self-Canceling Installment Note
    • Illustrated Sale of Stock with SCIN
    • Strategic Summary – Sale of Stock with SCIN
  • Gifts and Sales of Business Interests
  • Example – Gift of the Stock Using Donee Annual Exclusion
    • Illustrated Gifting Using Donee Annual Exclusion
    • Strategic Summary – Gifting Using Donee Annual Exclusion
  • Example – Combination Sale and Gift Using Annual Exclusion
    • Illustrated Sale and Gift Using Annual Exclusion
    • Strategic Summary – Sale and Gift Using Annual Exclusion
  • Example – Gift Involving Optimal Use of Unified Transfer Rate
    • Illustrated Use of Unified Transfer Credit
    • Illustrated Use of Spouses’ Combined Unified Transfer Credit
    • Minority vs. Control Position Issues
    • Strategic Summary – Using Unified Transfer Credit
  • Example – Gift Involving a Family Limited Partnership (“FLP”)
    • Underlying Theory for Creating FLPs
    • Illustrated Use of Gifting Units in a FLP
    • Strategic Tax Summary – Family Limited Partnerships
  • Summary
• Chapter 10 - Resources
  • Business Valuations
  • Business Valuation Organizations (Alphabetical Order)
  • Employee Stock Ownership Plans (ESOP)
  • ESOP Organizations
  • Business Transactions
  • Closely Held Businesses and Family Businesses
• Chapter 11 - Latest Developments

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Chapter 0 - Overview

Course Goal

This course is intended to provide an overview of a range of many of the most common business transactions. The goal will be facilitated by using a case study approach to illustrate transaction mechanics.

Introduction

All closely held businesses will transition at some point; it is only a matter of time. Indeed, one could argue that closely held businesses are in the perpetual process of transitioning and evolving. This dynamic process compels the business to adapt to the changing nuances of the market. Eventually, the process of transitioning will result in a transaction of some type. For our purposes, a “transaction” is generally defined as a change in the controlling ownership of the business.

There are a wide range of transaction options available to business owners. Progressive and enlightened business owners will embrace the transition process and elect a transaction structure of their choosing. Unfortunately, others will elect to resist (perhaps, ignore) the inevitable and fail to plan adequately for the transition process. In such cases, those business owners will almost certainly be very disappointed with the transaction results.

Clearly, this course is largely aimed at business owners and their professional advisors that embrace the transition process. Anticipating the process and mastering its demands will result in the attainment of goals. When the transitioning process is headed for an actual transaction, the territory often becomes very technical and detailed. It is typically not enough to simply complete the transaction; there are other paramount concerns. Business owners want to complete transactions in the most efficient manner possible. This largely entails achieving stated goals, managing transaction-related costs, and minimizing taxes.

In this course a range of the more common transactions will be explored. To facilitate learning and comprehension, the case study approach is used. Most commonly a hypothetical company, XYZ Company, Inc., (“XYZ” or the “Company”) will be used to demonstrate transaction principles and applied taxes. As appropriate, additional hypothetical companies will be introduced to demonstrate key principles. The impact of planning will often be illustrated when the proceeds relating to the transaction are analyzed.

Why CPAs Need to Understand the Transaction Environment

If a CPA aspires to be a strategic advisor to the business owner of a closely held company, a wide range of business knowledge is required. One important practical area of expertise is transition planning. All businesses are in transition, and over time the process of transitioning will result in a business transaction. We have defined the business transaction as a change in control of the company. The following list includes a number of the important reasons for a CPA in either industry or in public practice to understand transactions.

• Transactions are inevitable – Being prepared for this eventuality is an important aspect of your professional development.

• Optimize the business owner’s negotiating strength – For CPAs in public practice, knowledge of the transition process that eventually results in a transaction is a very high value-added service that you provide to clients. In business you do not get what you deserve, you get what you negotiate. This axiom especially holds true in the transaction environment. You are typically in the strongest position to negotiate when you have viable options. When considering transactions, knowing the range of alternatives for structuring potential deals is paramount in developing viable strategies.

• Transactions often involve succession planning – Transactions often involve succession planning, where the control of the business is passing to a new generation of leaders. With proactive involvement by the public practice CPA, you may have a significant impact on being able to articulate succession alternatives that result in preserving the client relationship.

Transactions involving family members, company management, or an Employee Stock Ownership Plan and Trust (“ESOP”) are common examples of situations where the client relationship is retained. Knowing the attributes of successful transactions involving these principles is often a key aspect of retaining the client relationship. If no succession guidance is provided, business owners may opt to sell the company to a third party with catastrophic results for maintaining an ongoing relationship.

• Transactions that do not relate to succession planning – Other transactions will focus on acquiring or divesting a business for operational reasons not typically related to succession planning. If you bring to the client relationship table a strategic understanding of deal structure, this high level of service is a candidate for appropriate compensation and cementing a long-term client relationship.

• Knowledge of structuring business transactions helps mark the CPA as a valued strategic advisor – All CPAs in public practice and industry will be regarded as a valued strategic advisor with knowledge of this complex area of application. Transactions are typically very complex situations with a host of behavioral considerations along with the myriad complexities of regulatory and tax constraints.

• Business transactions may be related to operations – For the CPA in industry, business transactions often represent one of the most fascinating and rewarding activities of the CFO function. Clearly, involvement at this level marks the industry CPA as an invaluable member of the senior management.

Organization

Chapter 1 – Introduction: Case Study – XYZ Company, Inc. Primarily, the purpose here is to introduce the hypothetical company that will be frequently referenced in the following chapters. This is the heart of the case study approach, and it is important to briefly study the fundamentals of XYZ Company, Inc. (the “Company” or “XYZ”).

Chapter 2 – Transaction Valuation Fundamentals. This chapter presents an overview of business valuations for purposes of this course. By means of its summary of valuation principles, one important end result of the material is to illustrate the fact that, depending on the purpose of the valuation, the quantified amount of the value will differ even for the same company. We will illustrate varying valuations based on fair market value and investment value. It is emphasized that these materials are intended to illustrate broad business valuation principles with a reasonable degree of believability. The subject of business valuations is so vast that we have deliberately defined very narrow purposes for this chapter.

Chapter 3 – Transaction Structure: “The Art of the Deal.” We now begin to lay the groundwork for thinking about the transaction environment. All transactions are typically negotiated down to small details between the interested parties. The various parties to the “deal” carry agendas into the transaction arena. These agenda items range from behavioral issues to tax efficiency concerns. We quickly realize that the transaction environment is very complex and that many intended deals never materialize due to the often crushing weight of competing interests.

Chapter 4 – Sale or Purchase of Assets. Closely held companies will typically transact an assetbased deal. There are compelling tax and legal issues that favor this type of transaction structure. We begin with consideration of important tax planning issues. This chapter examines XYZ as both a “C” and an “S” corporation with significantly different end results to the selling shareholder.

Chapter 5 – Sale or Purchase of Stock. Sales of stock are far less common for closely held businesses. When they do occur, they are typically less complicated than asset-based transactions. There are tax incentives for business sellers to prefer stock sales, but those reasons are often outweighed by negative aspects to the buyer. This chapter examines XYZ as both a “C” and an “S” corporation in a stock transaction.

Chapter 6 – Specialty Transaction: Employee Stock Ownership Plan and Trust (“ESOP”). ESOPs have been an option for business owners to consider since 1974, but inherent limitations in the tax code often made them impractical for many potential applications. During the past several years, however, tax regulations have been greatly expanded to encourage ESOP formation, particularly with regard to “S” corporations. Today, the option of employee ownership is far more favorable than at any time in history due to recent tax legislation. This chapter explores the many aspects of ESOP transactions for XYZ as both a “C” and an “S” corporation.

Chapter 7 – Specialty Transaction: Tax Preference Reorganizations. This complex world of business transactions largely is focused only on “C” corporations. Often tax preference reorganizations are used in restructuring publicly held corporations. With proper attention to transaction details, tax preference reorganizations will accomplish worthwhile corporate goals with favorable tax consequences to the shareholders. This is a very complex topic, and this chapter serves as only an introduction of major concepts into this fascinating world of transactions.

Chapter 8 – Specialty Transaction: The Industry “Roll-Up.” An industry “roll-up” is really just a consolidation of companies with the stated hope of attaining greater economies and building shareholder value. During the early to mid-1990s the “roll-up” was often combined with an initial public offering (“IPO”) to create a lot of investor interest in these transactions. This chapter examines the potential of roll-ups in both the public company venue and with closely held businesses. Often the industry roll-up is an extension of tax preference reorganizations. The focus is largely on “C” corporations.

Chapter 9 – Specialty Transaction: Between Family Members. Most closely held businesses are owned largely by family members. All companies will eventually have to transition. This chapter examines many of the most common techniques to transfer ownership among family members. We will again focus on XYZ in a variety of planning settings.

Chapter 10 – Resources. This seminar is intended to provide an overview of the most common transactions typically involving closely held companies. This chapter identifies a number of resources for further reading and research.

Chapter 1 - Introduction: Case Study – XYZ Company, Inc.

Learning Objectives

• Establish a realistic company for the case study approach throughout the balance of this course.

• Provide sufficient detail about the case study, XYZ Company, Inc., (the “Company” or “XYZ”), to illustrate key transaction principles and strategies.

Note. The case study approach assumes a financially successful business. Such entities optimize planning opportunities. While the principles of transactions apply to a broad range of situations, it is generally beyond the scope of this course to explore such things as net operating losses (“NOL”), and other highly complicating factors.

Introduction

A hypothetical company is used to illustrate transaction principles and strategies throughout this text. As each chapter evolves, we will come back to reference the hypothetical company as a case study. By illustrating key concepts with one company, the nuances of the transaction world are highlighted. This chapter introduces the hypothetical company, along with sufficient information about the business to serve as a good baseline for analysis. To illustrate key concepts in succeeding chapters, some of the details and assumptions may be adjusted. Generally, the basic facts presented in this chapter will hold throughout our analysis.

XYZ Company, Inc. (the “Company,” or “XYZ”)

The Company is a hypothetical business that is deliberately configured to be a financially successful entity. The many concepts and strategies illustrated in the materials have the broadest application with financially successful businesses. We are not emphasizing the world of transactions generally with financially challenged businesses. That transaction world is typically dominated by parties with significantly varying negotiating positions. Rather, we have assumed financially successful parties to the transaction, as such examples typically allow for greater negotiations and more interesting solutions.

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