Cash versus “Paper”
The seller’s willingness to accept notes or stock of the buyer is determined partially by the personal need for current cash and more importantly by the quality and liquidity of the buyer’s “paper.” The seller who is not in need of immediate liquidity may, therefore, be somewhat flexible in this respect. The principal advantages of accepting the buyer’s “paper” versus accepting cash are:
• It may increase the number of potential purchasers and the selling price. • It may make it possible to structure the deal as a nontaxable transaction.
• If the interest and/or dividend rate is set at an attractively high level, it may present the seller with a better-yielding investment than he could otherwise obtain. The seller may be in a better position to follow and understand this investment as well.
• If attractively yielding preferred stock is taken back, the seller will hold a preferential position over common equity holders and the risk of a decline in value may, therefore, be lessened. Conversion, participation or other equity features may permit the seller to benefit from future appreciation of the underlying common stock.
freedom in deciding when to “cash in” on his “realized” but unrecognized gain. Future tax planning may be easier, and the shareholder may avoid bunching and alternative minimum tax problems.
• Installment sales reporting (matching the tax liability with collection of the principal on notes received) may allow for the deferral of tax payment to when the cash is received. • Elderly stockholders may permanently escape the payment of tax by allowing the “paper”
to be stepped-up to current fair value in their estate upon death. Advantages of cash are:
• The risk of nonpayment does not exist.
• “Paper,” particularly common stock, usually has considerable downside investment risk. • The ability of successor management is not as important.
Installment Sales
Changes in the installment sales provisions have expanded their application to sales of businesses. The general purpose of these rules is to achieve a matching of the tax liability with the collection of cash. Thus, when one-tenth of the purchase price has been collected, one-tenth of the gain will be taxed. The principal changes are as follows:
• There is no longer a 30% limit on the amount that can be received in the year of the sale. Thus, the installment method can be utilized even when 90% of the sales price is collected in the year of the sale.
• Special rules have been added to make the installment method available when the purchase price is contingent in amount.
• Tax is no longer triggered when installment notes received during the course of a 12- month liquidation are distributed in the liquidation.
Contingent Earnout Arrangements
In both taxable and nontaxable transactions, the seller and the buyer may disagree on the growth potential for the business and, therefore, on its value. Such disagreements can be remedied by structuring an earnout contingency whereby the amount of stock issued or cash paid is increased if earnings exceed agreed levels. In nontaxable transactions, care must be exercised when incorporating such features. The IRS has published guidelines that can be followed to produce the desired results. In taxable transactions in which an allocation of the purchase price must be made, the rules regarding the allocation of contingent payments are unsettled. The IRS may assert that contingencies based upon future earnings should be treated as nondeductible goodwill. Leveraged Buyouts (LBO)
The term “leveraged buyout” refers to a very popular form of taxable transaction in which the purchase price is funded primarily by lenders rather than by the buyer. From the seller’s
perspective, it is a cash sale, but from the perspective of the purchaser, it is largely a “paper” transaction. In a management leveraged buyout, key members of the management join or
organize the buyer’s equity group and must contribute their own funds or shares held in the seller’s name to the transaction. These transactions are more complex than most because they involve additional participants (lenders, management and the equity investors), each of which
must be satisfied with the transaction.
The tax consequences of the transaction are generally no different than those of any taxable transaction. Thus, the buyer must decide whether to take advantage of the step-up opportunities. Similarly, the sale of assets versus stock must also be analyzed by the participants.
Expanding Concept
The LBO is an evolving and expanding concept. The lenders are increasingly basing financing on cash flow rather than on the collateral value of assets, thereby making this a viable option for businesses with high cash flow but nominal physical assets. Because of the large profits that can be reaped by the equity participants, numerous leveraged buyout firms have been established, some of which specialize in smaller transactions. These firms have established relationships with interested lenders.
The LBO technique also permits the seller the choice of retaining a portion of his equity interest, thereby providing considerable flexibility to the seller in “cashing-out” versus sharing the future appreciation in the business’ value.
What Makes a Good LBO Candidate?
The principal qualifications for a good LBO candidate are:
• Stable cash flow.
• Moderate growth prospects. • Sound management.
• Ability to cover pro forma debt service and repay all debt in 10-20 years.
Regulated Investment Company Technique
If the selling shareholder(s) in a taxable transaction is not in need of cash but does have an interest in developing a diversified investment portfolio, an asset sale may be used advantageously. Instead of distributing the sales proceeds to the shareholder(s) and liquidating the corporation, which may result in substantial capital gains tax, the sale’s proceeds could be left in the corporation and used to build the desired diversified investment portfolio. This tech- nique is most popular when the tax basis of the corporation’s assets is much greater than the shareholder’s stock basis. In such a situation, a corporate sale of assets may produce a relatively low gain, or maybe even a loss, while the sale of the shareholder’s stock may produce a much larger gain. In order to avoid or minimize the imposition of a duplicate tax on portfolio earnings, once to the corporation and a second time to the shareholder(s), this tactic requires either that the corporation invest in securities eligible for the 85% dividends-received deduction so that any double taxation is minimized, or that it qualify as a regulated investment company (more commonly known as a mutual fund), which means that there is at least 100 remaining stockholders. Regulated investment companies are not generally subject to corporate tax if they distribute the income earned to their shareholders. Of course, those stockholders who do desire cash may redeem their shares.
The “recapitalization” is a nontaxable exchange that is typically used to pass control of a corporation to new owners, frequently the younger generation. The recapitalization leaves the former owners with a nonappreciating but safer income-producing equity interest. Appreciation that accrues after the recapitalization is for the benefit of the new common stockholders.
This transaction does not provide current liquidity and generally does not require the involvement of investment bankers, except possibly to evaluate the worth of the business at the time of the recapitalization. This is a relatively old and well-established technique.
ESOP Techniques
ESOPs (Employee Stock Ownership Plans) are frequently used where broad-based employee ownership is appropriate. They are also used occasionally to provide more equity in a LBO. In these transactions the ESOP borrowings are used to purchase stock, thereby providing working capital to the employer corporation. The corporation makes an annual contribution to the plan to cover the ESOP’s debt service. The contributions are fully tax deductible, even though they are comprised of interest and principal components.
Partial Sale Transactions
If the owner desires to maintain a substantial continuing equity position, he may wish to consider a transaction in which he sells only a portion of his interest in the business. The following transactions might accomplish this objective:
• Public offering of a minority position. • Private placement of a minority position. • Syndication of business real estate.