Calfee Connections

Calfee Corporate and Finance practice group Co-Chair Brent Pietrafese answers important questions about merger and acquisition transactions, including topics related to F-Reorgs, avoiding post-closing disputes, and handling ESOP-owned targets.

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Video Transcript

Brent Pietrafese:

Hi, my name is Brent Pietrafese. I’m a partner at Calfee Halter & Griswold and the co-chair of the Corporate and Finance practice.

What is an F-Reorg, and when and why should one be used in an M&A context?

An F-Reorganization, often referred to as an F-Reorg, is a specific type of tax-free reorganization under Section 368(a)(1)(F) of the Internal Revenue Code, that can be used to create a step up in the tax basis of the assets of an acquisition target, while also mitigating the risk that the target had made an ineffective S-election or inadvertently invalidated that election at some point in its history. An F-Reorg can also facilitate ongoing ownership in the target by a seller and typically is utilized to preserve a full flow-through structure for a buyer. Confirming that a target has made and maintained a valid S-election is necessary if a buyer wants to acquire the equity of a target, which is more often than not the seller's preferred deal structure, and then make a section 338(h)(10) or 336(e) election. Those tax elections each treat transactions that are legally equity sales or purchases as asset acquisitions for tax purposes only. The reason why the target’s S-corporation election is important in that scenario is that if it is invalid, the buyer will have acquired the stock of a C-corporation, which would not allow for either the 338(h)(10) or 336(e) election. To mitigate that risk, a pre-closing restructuring of S-corporation targets using section 368(a)(1)(F) has become a common technique used by private equity fund buyers. An F-Reorg can also help facilitate post-closing ownership by a seller, typically via rollover, whereas a 338(h)(10) or 336(e) election would not. An F-reorg also leaves a target as a disregarded entity for tax purposes, whereas either a 338(h)(10) or 336(e) election, even if effectively carried out, leaves the target as a C-corp.

By careful evaluating the specific circumstances of the M&A transaction and considering the advantages of an F-Reorg in terms of tax efficiency, operational flexibility and strategic alignment, companies and private equity funds can make informed decisions to optimize the transaction structure and achieve their long-term goals.

What is one of the most common causes of post-closing disputes in M&A transactions, and how can you mitigate the risks associated therewith?

Perhaps the most common cause of post-closing disputes is discrepancies in the target’s historical financial statements. Once a buyer has had a chance to really dig into the financial condition of the target following closing, they can sometimes find issues with the financial statements that were provided by the seller during the course of the transaction. Buyers can reduce or eliminate this risk by engaging experienced legal and financial advisers to scrutinize all legal and financial records during the due diligence period, including performing a quality of earnings report. It is also important to make sure the seller is making thorough representations and warranties about the target’s historical financial performance and condition, and that the buyer has adequate recourse for any breaches of those representations.

What are some of the most common causes of post-closing disputes related to earnouts, and how can you avoid them?

While earnouts can be a great tool to help bridge valuation gaps between buyers and sellers, in mergers and acquisitions, they can often become contentious, primarily due to their complexity and the uncertainties they introduce. Several common causes typically lead to disputes over earnouts. Firstly, ambiguities in performance metrics can be a significant source of conflict. When performance targets are not clearly defined, disagreements over whether these targets have been met are almost inevitable. To prevent this, it is crucial to draft the earnout language meticulously with the help of experienced lawyers to specify performance metrics and ensure they are objective, verifiable, and easy to track. We typically suggest including sample calculations in the definitive agreements to make sure everyone is on the same page with how an earnout is to be calculated and to prevent parties from trying to renegotiate the deal post-closing by exploiting ambiguities in the earnout language. Both parties should have a clear understanding of the contractual language and agree on dispute resolution mechanisms such as arbitration or mediation.

Another common issue arises from disagreements over accounting methods. Different interpretations of accounting principles can lead to disputes about the achievement of earnout targets. This problem can be mitigated by agreeing upfront on consistent accounting standards and practices. A detailed schedule of accounting principles used by the target and agreed to by both buyer and seller should be included in the definitive agreement to determine how financial results will be calculated and reported in order to avoid any misunderstandings.

Operational decisions made by the buyer post-acquisition can also lead to conflicts. The buyer’s decisions about how the business is run can significantly impact its performance and, consequently, the earnout. To address this, clear guidelines should be established regarding the operation of the business after the acquisition.

This is a topic that is typically heavily negotiated, as a buyer will want to maintain as much freedom as possible when it comes to how it will run the business post-closing, and sellers will want to limit that freedom in a way that will allow it to have a say in decisions that could negatively impact the earnout.

One specific operational decision that is typically dealt with in the definitive agreements is the retention of key seller personnel. If those individuals leave after the acquisition, the company's performance may suffer, leading to disputes about whether the earnout targets were fair and reasonable. To prevent this, the agreement should include clauses that encourage key personnel to stay until the earnout conditions are met, along with clear definitions of their roles and responsibilities.

A lack of transparency and regular updates on performance metrics can often cause mistrust and lead to disputes as well. To prevent such issues, it is essential to maintain open and frequent communication about the company's performance relative to the earnout targets. Agreeing on the frequency and format of these reports in the definitive agreements can help ensure both parties are on the same page.

External factors and market conditions, which are often beyond the control of either party, can also affect the company performance and lead to disputes over earnout calculations. Including provisions in the earnout agreement that address how such external factors will be handled is a good practice. This can include defining certain force majeure events that justify adjustments to earnout terms or targets and even how those adjustments will be made.

While it is generally a good idea to have specific dispute resolution provisions in any acquisition agreement, when drafting an agreement where there will be an earnout, including clauses that specify arbitration or mediation as the first step can reduce the likelihood of prolonged litigation and help reach a mutually acceptable resolution more quickly. Engaging independent auditors to review and verify financials related to the earnout can also help resolve disputes over performance metrics or financial calculations.

By addressing these common causes proactively and incorporating preventive measures into the earnout agreement, many potential disputes can be minimized or even avoided, ensuring a smoother post-acquisition integration and satisfaction for both parties involved.

Should you avoid ESOP-owned acquisition targets?

If a buyer is not familiar with ESOP, or Employee Stock Ownership Plans, they can sometimes discount, or dismiss altogether, ESOP-owned acquisition targets due to a common misconception that those deals are more difficult and can expose a buyer to post-closing risks that are more onerous than what they would typically have with a more traditional seller. While that can be the case, if the ESOP was established correctly and a buyer conducts a thorough due diligence process, including engaging expert legal counsel like Calfee, an ESOP-owned business can be an attractive acquisition target.

First and foremost, the ownership structure of an ESOP-owned business can be complicated. The company is at least partly owned by the employees, which introduces unique governance and decision-making dynamics that you may not encounter in other types of business transactions. This employee ownership can significantly impact how the sale is negotiated and executed. Having legal counsel with expertise in ESOPs can help you navigate these complexities, ensuring that all interests are fairly represented and that the transaction proceeds smoothly.

Regulatory and legal complexities also necessitate careful attention. ESOPs are governed by specific regulations under the Employee Retirement Income Security Act, or ERISA, which imposes fiduciary duties and compliance requirements on the company. Understanding these rules is vital to avoid potential legal pitfalls and to ensure all regulatory obligations are met.

Experienced legal counsel can guide you through the technicalities of ERISA compliance and help mitigate the risk of litigation related to valuations or fiduciary responsibilities. We have done several ESOP transactions here in the past year, and our team does a great job of analyzing the formation of the ESOP from a diligence perspective, and then ensuring that the buyer, seller, and ESOP trustee are all aligned on the regulatory steps that need to be taken as part of the sale.

In conclusion, while buying an ESOP-owned company might come with some complexities, particularly regarding the regulatory and financial considerations, the potential benefits (including a motivated workforce, smoother ownership transition, significant tax advantages, strong community goodwill, and long-term viability) make such acquisitions a compelling option.

Thorough due diligence and expert advice can help navigate these complexities and capitalize on the numerous positives an ESOP-owned business offers. Engaging knowledgeable legal counsel is essential to navigate the intricate ownership structures, financial implications, and regulatory requirements. With the right legal guidance, you can address these challenges effectively and not dismiss the opportunity simply because it is owned by an ESOP.