When an independent sponsor identifies a target, there are a number of considerations that come into play before executing the letter of intent. The independent sponsor will need to carefully consider the acquisition vehicle and overall acquisition structure. A key consideration in finalizing an acquisition structure is whether the independent sponsor wants to have the seller roll over equity in the deal and maintain a (direct or indirect) ownership position in the target after the closing, and if so will the seller have an active role post-closing or simply have an economic interest. If incorporating rollover equity into your letter of intent, certain decisions are necessary in order to maximize the benefits to the independent sponsor and the seller.
Structuring of an Independent Sponsor Transaction.
The two most common acquisition structures for an independent sponsor to consider in connection with an acquisition transaction (a “Transaction”) are a limited liability company or a limited partnership (“Holdco”). Holdco is the entity into which the capital providers would receive equity and, regardless of the preferred vehicle, it would typically be treated for tax purposes as a partnership. Holdco would then create either a corporation or a limited liability company as a wholly owned special purpose vehicle to be the acquiror (“Acquisition Co”), and Acquisition Co would take on any debt from a lender to (at least partially) finance the Transaction.
The independent sponsor will often want the seller in the Transaction to accept some portion of the purchase price as rollover equity, typically in Holdco for a variety of reasons, including:
Bridging the Gap on the Purchase Price. If an independent sponsor is having trouble raising the necessary capital to complete the Transaction, either debt or direct investment, or there is otherwise a disconnect in the valuation of the target between the seller and the independent sponsor, the independent sponsor may require the seller to roll over a portion of the purchase price into ownership in Holdco. This allows the independent sponsor to bring less cash to the closing, and also keeps the seller aligned with the independent sponsor giving them “skin in the game”.
Retention of Key Employees or Founders. Independent sponsors will often include rollover equity as part of the consideration for a Transaction to keep value creators of the target involved after the closing of the Transaction, which can be beneficial for the independent sponsor based on the target and the role of those value creators. The same goal can also sometimes be achieved by deferring a portion of the purchase price (especially if some or all of the deferred portion is made contingent on future performance of the acquired business), but as discussed in a prior article, that generates its own additional considerations and complications.
How Rollover Equity Affects a Transaction. Considerations for Structuring a Transaction to Achieve a Tax Deferral for Seller Participating in Rollover
When including an “equity rollover” in an offer, independent sponsors do not always make it clear that the proposed equity rollover is intended to facilitate a tax deferral for the seller. While tax deferral could be reasonably inferred from the word “rollover”, because absent tax deferral, what is being labeled as an “equity rollover” is more accurately described as an “equity reinvestment” or a “reinvestment of part of the post-tax cash proceeds of the sale,” it is best practice to spell out the intended possibility for tax deferral in the letter of intent.
Whether a seller is interested in the potential tax deferral associated with a rollover in a given Transaction, and how much value the seller will attach to that deferral, will vary from seller to seller. For example, a seller that owns stock eligible for the gain exclusion afforded in certain circumstances by the Internal Revenue Code to sellers of “qualified small business stock,” or a seller that upon a cash sale would recognize a loss for tax purposes, generally would assign less (or no) value to a rollover transaction’s tax-deferred nature.
At the time of negotiating the letter of intent, the available information may be insufficient for an independent sponsor to commit to a tax-deferred equity rollover when the letter of intent is signed, even if they have already commenced due diligence. In that event, appropriate wording in the letter of intent may suffice to highlight that partial tax deferral is a point to be resolved early in the ensuing due diligence, and documentation processes.
In practice, this depends partly on the process and dynamics in which the letter of intent is being negotiated and partly on the specifics of the purchaser and target and the extent of information already made available regarding both parties. As a result, deciding how to structure the Transaction in the letter of intent and whether to save that point for after the letter of intent has been signed depends on the specifics of each negotiation, which can be aided by experienced counsel who can help anticipate these concerns and advise on structing of the Transaction. With that said, if it is not included in the letter of intent or otherwise some other approach is not agreed upon by the parties to be addressed in the future, there is a risk that the parties will not be on the same page for what could be a material point in the overall negotiations.
Cost Basis vs. Carryover Basis for Acquired Assets
An independent sponsor (as purchaser) typically wants to structure the Transaction to result in the acquired target assets having a post-Transaction tax basis that reflects the full value of the consideration paid for the acquisition of the target – the cost basis – and therefore a preferred approach is to structure the Transaction as an acquisition of the target’s assets, as distinguished from, say, the acquisition of the stock of a target organized as a corporation. Assets acquired in exchange for cash generally take on an initial post-acquisition tax basis equal to the amount of cash consideration used to acquire those assets.
A corollary to the tax-deferred nature of a properly structured equity rollover is that the assets deemed to be acquired in exchange for rollover equity (with allocation of consideration among the acquired assets generally based on fair market values at the time of the Transaction) will have an initial post-acquisition tax basis equal to the rollover seller’s pre-acquisition basis in those assets – the carryover basis – which typically is lower than those assets’ values. Therefore, Acquisition Co typically would have a lower tax basis in the assets deemed to have been acquired in exchange for rollover equity than for those acquired for cash; a “basis step-up” would be available to the acquirer with respect to the portion of the target’s assets acquired for cash, but not for the portion acquired for rollover equity. A higher tax basis can mean greater cost recovery deductions and therefore lower taxable income for the acquired business post-Transaction, which can translate into real economic savings for the acquirer in the future.
Certain acquisitions of equity interests may be treated for tax purposes as an acquisition of assets, and the structure of the Transaction for state law purposes is not necessarily required to match the structure of the Transaction for tax purposes.
If the target is a limited liability company taxed as a partnership, and Acquisition Co. is acquiring 100% of the target’s stock, then generally it would be treated for tax purposes as having acquired all of the target’s assets, with a basis step-up for the assets acquired in exchange for cash (excluding the rollover equity).
If the target is a corporation, and Acquisition Co. is acquiring 100% of the target’s stock, then with certain exceptions available in specific situations and/or with additional structuring, the post-Transaction assets of the target would retain their same, usually lower, tax basis.
Three factors to consider in determining whether to acquire assets directly or indirectly, or instead to acquire interests in the target, are:
the extent to which an actual direct asset acquisition may initially impact the target’s business operations,
the impact on required counterparty consents with respect to material contracts, which may, at a minimum, delay a closing, and
the risk level of existing or possible claims affecting the business being acquired.
If these factors are not clearly assessable at the letter of intent stage, the parties may assess these factors and make a decision on this structuring point during the commencement (or completion) of the due diligence process.
When an independent sponsor structures its offer in connection with a Transaction, it is important to consider whether it wants to include rollover equity in its offer, as well as the impact that rollover equity specifically, and the acquisition structure generally, has on the desired tax treatment for both purchaser and seller. If you have any questions about structuring rollover equity, please contact Paul Marino (pmarino@sadis.com), Jonathan Bernstein (jbernstein@sadis.com), Robert Cromwell (rcromwell@sadis.com) or Seth Lebowitz (slebowitz@sadis.com).
