Whether the recent spate of M&As within the industry is attributable to last December’s Tax Cuts and Jobs Act (TCJA), the cash it freed up or the new lower corporate tax rate, M&As are on the upswing with a great deal of the action involving smaller deals.
Viva la difference
While often synonymous, the terms “merger” and “acquisition” are separate transactions. A merger occurs when two separate entities combine forces to create a new, joint organization in which both (theoretically) are equal partners.
An acquisition refers to the purchase of one entity by another. A new nursery does not emerge from an acquisition, rather, the acquired business, or “target,” is usually consumed and ceases to exist with its assets becoming part of the acquiring business.
M&As can include other transactions, including:
- Consolidation: This creates a new entity where shareholders in both entities approve the consolidation, after which they receive equity shares in the new firm.
- Tender offer: One business offers to purchase the outstanding stock of the other business for a specific price. The acquiring business communicates the offer directly to the other business’s shareholders, bypassing the management and board of directors. This usually involves larger, often-publicly-traded businesses.
- Acquisition of assets: One business acquires only the assets of another firm. Asset purchases are common during bankruptcy proceedings, where other businesses bid for various assets of the bankrupt business, which is liquidated after the final transfer of assets to the acquiring business.
Paying for it all
Because M&As are expensive, adequate funding is a necessity. Fortunately, financing and M&A transaction with stock is both safe and relatively inexpensive option since both parties sharing the risk. In a typical share-exchange transaction, buyers exchange shares in their own business for shares in the selling business. Paying with stock is advantageous for a buyer, especially if their shares are overvalued.
In a merger, shareholders on both sides can reap long-term benefits from a stock swap as they usually receive an equal amount of stock in the newly-formed operation, rather than simply receiving cash for their shares.
Paying with cash is the most obvious alternative. Cash transactions are instant and relatively mess-free and
Assuming the burden of debt
For many nursery operators, debt is the reason for the sale. Debt all-too-frequently reduces a seller’s value, often to the point of worthlessness. From a buyer’s point of view, this strategy offers a relatively cheap means of acquiring needed, additional assets.
Being in control of a large quantity of an operation’s debt means an increased management role in the event of a liquidation since owners of debt
Mezzanine financing is a hybrid of debt and equity financing involving senior debt such as loans from sources such as banks, secured by liens on specific assets of the nursery or growing business. Equity is usually in the form of preferred stock, but buyers aren’t usually required to give up as much control to lenders.
The size of the mezzanine finance industry has grown in recent years. In fact, quite a few mezzanine groups have been sponsored by the SBA. But, that’s not the only way the SBA can help in an M&A transaction.
Many M&As and owner buyouts of private, rather than publicly-traded businesses, qualify for SBA loan guarantees. The SBA’s 7(a) program is the most popular loan program, providing up to $5 million for refinancing, working capital or to buy a business. Even larger transactions are possible with so-called “mezzanine” financing or when real estate is included.
The large component of goodwill and the lack of tangible assets so common in smaller M&A transactions isn’t a deterrent. The SBA’s programs focus on lenders where minimal collateral is acceptable, especially when there
SBA M&A financing is generally through the SBA Preferred Lender program, often with additional working capital loans and lines of credit for financing packages in excess of $5 million. Since the SBA has eliminated its personal resource limitations, borrowers and investor groups with high net worth and liquidity are now usually eligible.
Much of the risk normally associated with M&A transactions can be eliminated with an often-overlooked type of insurance. First introduced in the 1970s, Warranty and Indemnity (W&I) insurance has evolved into a popular and sophisticated tool for protecting buyers and sellers from financial losses in M&As.
W&I insurance essentially removes the risk, in whole or in part, with the promise that insurance underwriters will be standing behind the warranty claim. However, by offering more protection against downside risk, W&I insurance also negates the requirement for the use of escrow or indemnities, providing certainty and finality to both parties.
With a seller’s W&I policy, the seller gives warranties and indemnities as is customary, but then
A buyer’s W&I policy covers damages following breaches and/or fraud as well as defense costs. With a buyer policy, if the seller commits fraud, the policy would still
Taxing the M&A
Despite the new, lower 21-percent corporate tax rate, many nurseries are likely to continue pursuing tax-free M&A transactions. Tax-free M&A transactions are considered “reorganizations” and similar to taxable deals except that in a reorganization, the buyer uses its stock for a significant portion of the sale price rather than cash or debt.
Reorganizations, while not usually taxable at the entity level, are not completely tax-free to the seller. A reorganization is immediately taxable to the target’s shareholders for any “boot” received.
Other provisions of the TCJA, such as the full-expensing of asset costs, may cause many to weigh their effects on any transaction. The ability to do a taxable asset transaction and take advantage of front-loaded deductions may encourage growers to complete a taxable deal instead of a tax-free transaction.
Consider a situation where a seller really wants cash while the buyer is pushing for a tax-free acquisition. The tax law’s Section 338 permits a nursery to make a “qualified stock purchase” of another business and choose to treat the acquisition as an asset rather than a share acquisition. The stepped-up basis in the qualifying assets can be immediately expensed and written off, dramatically changing the bidding dynamic on the transaction.
Recent trends involve more cash-ready buyers, but with more aversion to risk. Buyers are generally unwilling to enter into transactions if the warranty package is too limited or there are concerns over
These challenges are not insurmountable, and deals continue to emerge with and without tax breaks, alternative financing
Mark’s tax and financial features have appeared in leading business magazines and trade journals for more than 25 years.