Tax and Legal Issues in Structuring Mergers & Acquisitions
Mark Cameron White of White & Lee
LLP
One of the two principal means of achieving investor liquidity in privately held companies is for the target company (the "Seller") to be acquired by or merged into another acquiring company (the "Buyer"). Liquidity by acquisition or merger makes sense where the Seller does not meet the profile for going public (an "IPO"), either because the Seller has not achieved significant market share, financial results or technical achievement to attract the attention of the public equity markets - or the equity markets are not prepared, for one reason or another, to accept a new public issuance of the Seller's securities. Acquisition or merger to achieve liquidity might also be attractive for other reasons, such as management's desire to cash-out early and avoid the risks inherent in maturing an emerging growth company - or to avoid the burdens, potential liability and public scrutiny of managing a public company. Finally, acquisition or merger of the Seller might make sense where a solicited or unsolicited offer has been made for the company, and the working capital or other resources to be gained by the transaction can substitute for funds raised in a private financing that might not, for a variety of reasons, be immediately available to the Seller.
*Note: The concepts and issues concerning mergers and acquisitions described in this paper, are largely based upon the following sources: (1) negotiated Acquisitions of Companies, Subsidiaries and Divisions, Lou Kling and Eileen Simon, Law Journal Seminar-Press, 1992; (2) Coopers & Lybrand, Business Acquisitions and Leveraged Buyouts; and (3) Acquiring or Selling the Privately Held Company 1994, Practicing Law Institute.
While the acquisition or merger of the Seller does not usually result in the same high level of investor responsibility and scrutiny of public companies, management must structure the transaction to anticipate significant tax, accounting, securities, intellectual property and employment issues that will fundamentally affect the Seller following the completion of the transaction. Further, while IPOs are highly regulated and uniform in the manner in which they are conducted, acquisitions and mergers are far more creative transactions - resulting in a variety of potential deal structures that are adopted to meet the primary concerns of the parties. While IPOs are, by definition, more public transactions that bring potentially greater returns to the investors - acquisitions and mergers are equally attractive for other reasons, including achieving quicker liquidity for investors without the risk of a public offering. It is also important to note that through the 1980s and now into the 1990s, many larger and even some smaller competitors are acquiring companies with complimentary products and markets as a means to grow in industries undergoing consolidation. This heightens the attraction of these types of transactions for investor liquidity in Sellers that, by themselves, are not likely to survive long-term competitive pressures.
This paper will review certain critical tax, securities, and regulatory issues to be addressed in structuring the successful acquisition or merger of the privately held company. Other issues relating to the identification and tracing of ownership of intellectual property, and issues relating to employee obligations - all of which come into consideration in the context of these types of transaction - are addressed in other White & Lee papers, and so will not be repeated here.
One: Forms of Combination and the Acquisition Process
1. Forms of Combination
There are a variety of ways in which companies can combine. These structures can be used in either taxable or tax-free transactions as follows:
(a) Stock Purchase. This is a simple form of acquisition in which the Buyer purchases the seller's stock from each of its shareholders. Each of the Seller's shareholders may separately decide if they wish to sell to the Buyer, and the result of the transaction is that the Seller becomes either a wholly or partially owned subsidiary of the Buyer, depending on how many shareholders elect to sell.
(b) Asset Purchase. In an asset purchase, the Buyer purchases all or a portion of the Seller's assets, and assumes certain liabilities, sufficient for the Buyer to operate a portion of the Seller's business. The Seller remains separately owned by its shareholders, and the consideration for the purchase is held by the Seller, not its shareholders. To get the consideration to the Seller's shareholders, the Seller must declare a dividend or liquidate - resulting in tax consequences for the Seller's shareholders.
(c) Merger. Mergers take place under state law, and result in the Seller becoming part of the Buyer - and ceasing to exist as a separate entity. For the Seller's shareholders, a merger is similar to a stock sale in that the shareholders give up their stock for the consideration paid by the Buyer, consisting of the Buyer's stock, cash or property.
(d) Forward and Reverse Subsidiary Mergers. These are 3-party transactions involving the Buyer, a Subsidiary of the Buyer, and the Seller. In a forward subsidiary merger, the Seller merges and dissolves into the Subsidiary, and the shares of the Seller's shareholders are exchanged for cash, property or stock of the Subsidiary. This is the same result as a simple merger, except that the Seller, by being merged into the Subsidiary, itself becomes a wholly-owned subsidiary of the Buyer - with the primary advantage that the liabilities of the Seller are separate and not assumed by the Buyer. In a reverse subsidiary merger, the Subsidiary of the Buyer merges into the Seller such that the Seller is the surviving entity. In this type of transaction, the shares of the Seller are exchanged for cash, property or stock of the Subsidiary which, by virtue of the merger, become shares of the Buyer at an exchange rate agreed to by the parties. On the conclusion of a reverse subsidiary merger, the Seller becomes a wholly-owned subsidiary of the Buyer - and the Seller retains its assets and liabilities, including agreements which need not be assigned (as the Seller survives unchanged, except for its ownership).
(e) Short-Form Mergers. Short-form mergers are permitted under the corporate law of certain states in circumstances where the Buyer already owns almost all of the Seller. In California for example, under California Corporations Code ("CCC") Section 1110, where the Buyer owns at least 90% of the Seller, the merger of the Seller into the Buyer for cash, property or stock of the Buyer can be effected without the need of filing a merger agreement with the Secretary of State, and without the need of obtaining approval of the Seller's remaining shareholders. This is an expedited form of merger. Note, however, that avoidance of the need for approval of the Seller's shareholders does not prohibit these shareholders from exercising their "dissenter's rights" in order to assure the payment of fair consideration for their shares.
2. The Acquisition Process
Though the process of entering into and completing an acquisition or merger varies by such factors as the complexity of the transaction, the regulatory approval required, the familiarity of the parties with each other and market considerations for the introduction of products and services of the combined companies, the following steps are present in most transactions:
(a) Preliminary Discussions and Basic Terms. Corporate partners can be identified from existing suppliers or customers, competitors in the same or related industries - or even from unrelated industries in which the Buyer wishes to diversify. The search for a partner can be conducted by the participants themselves, or with the assistance of investment banks or M&A firms. The Seller can either itself initiate discussions with an Buyer - or be the recipient of unsolicited inquiries from a Buyer. Where the Seller is a privately-held company or a publicly-held company, the Board must seriously consider unsolicited inquiries to determine whether the proposed transaction is in the best interests of the Seller's shareholders. Even where the transaction has been initiated by the Seller, the Seller's Board must still consider whether the transaction terms are the most favorable that may be obtained for the shareholders.
Typically, in the case of friendly discussions, the parties first exchange confidentiality agreements before exchanging any proprietary information about their intentions, prospective plans or respective businesses. After an exchange of general information, the Buyer usually presents the Seller with a Letter of Intent ("LOI") setting forth the proposed structure, price, conditions, and procedures for the transaction. Obviously, the Seller must provide a fair amount of financial information to the Buyer in order for a price to be determined. The LOI may be general, so as to give a certain momentum to the deal before the tough details are worked out in one or more definitive agreements -or the LOI may be detailed, so as to flush out resolution to critical issues before either party commits emotionally to the transaction. It is most common for the LOI to address the principal business terms of the transaction - and leave the finer legal points to the definitive agreements.
The LOI is almost always a non-binding expression of intent - with no obligations on either side except (i) the covenant to continue to negotiate in good faith, (ii) the enforceability of confidentiality covenants, (iii) arrangements on the payment of expenses, and (iv) in some cases, the terms of a "lock-up" preventing the Seller from soliciting offers from other potential buyers. The parties may, however, cause the LOI to be a binding agreement in circumstances where the Buyer wishes to publicly announce the acquisition or merger for competitive reasons. In that case, the LOI is very detailed - and due diligence frequently is conducted in advance
(b) Between LOI and Execution of Transaction Documents. During this period, the parties continue their due diligence - and the attorneys and accountants become involved to confirm the financial, business and corporate status of each party, and to negotiate and finalize the definitive agreements. Full disclosure of all material information concerning each party must be made to avoid post-closing claims of investor fraud and misrepresentation -though certain detailed information may be withheld by either party contingent on certain other events occuring, such as the ability of the Buyer to obtain financing to complete the transaction.
The transaction documents may include, depending on the structure of the transaction, (i) a stock purchase, asset purchase, merger or reorganization agreement, (ii) employment or consulting agreements for key personnel continuing to conduct the Seller's business, (iii) a non-competition agreement to be executed by key persons, (iv) intellectual property, or product/service distribution or license agreements, and (v) other secondary legal documents, such as Board and Shareholder Consents, assignments, legal opinions, regulatory or securities law filings - and disclosure schedules and attachments relating to the status and conduct of the Seller's business. Once these documents are finalized, they are usually approved "substantially in the form" presented for approval - so that non-material changes may be made without the need of further approval. Board approval must first be obtained, with the Board's recommendation for the transaction to be presented to the shareholders for approval. Depending on the size of the Seller, and number and sophistication of the Seller's shareholders, shareholder approval might be obtained after disclosure of the material terms of the transaction and effect on the Seller and its shareholders - as described in a shareholder "prospectus" or other disclosure document.
Throughout this period, the parties continue their due diligence review of each other. The Seller is mainly reviewed by the Buyer for background information on the Seller's business, plans, capitalization, intellectual property rights, relations with third parties and its financial status as this relates to the Seller's ability to continue to conduct its business following the closing. The Buyer is principally reviewed by the Seller for the Buyer's financial status and capitalization - as this is an indicator of the Buyer's ability to meet its financial obligations to the Seller.
(c) Between Execution and Closing. Approval of transaction then usually results in execution of the definitive agreements. Upon execution, the transaction may or may not close under the terms of the agreements. In simple acquisitions or mergers, the closing may occur at the time of execution of the agreements - as all conditions to the completion of the transaction will have been met. More typically, the closing will occur at some subsequent time in order for filings to be made and approved by appropriate government agencies - such as the Securities and Exchange Commission or state securities agencies in transactions involving the exchange of securities, or government agencies such as the Federal Trade Commission and Antitrust Division of the Department of Justice for Hart-Scott-Rodino filings if the transaction will trigger anti-competitive concerns. Other causes in the delay of closing may include the need to assign key agreements to the Buyer, the need for the Buyer to obtain financing, and the need to continue due diligence by the parties.
Two: General Tax Consequences; Pooling of Interest
1. Tax Consequences
The tax consequences of a transaction can only be evaluated in the context of the interests of the parties involved. Generally, the Seller wishes to maximize its after-tax consideration - while the Buyer wishes to maximize the deductible tax basis (or cost) of the Seller, which may be amortized if it has an ascertainable useful life. Each form of transaction has different tax attributes which are critical to the determination of the structure to use. The parties must choose between (i) taxable and non-taxable transactions, and (ii) stock or asset purchases.
(a) Taxable Transactions. In taxable transactions, the Seller is immediately taxed on any gain on the consideration received, and the Buyer obtains a tax basis equal to the purchase price of assets or stock as follows:
(i) Taxable Purchase of Assets.
For the Seller, on a sale of assets, the Seller's gain is equal to the purchase price for the assets less the Seller's tax basis in the asset. This gain must be recognized immediately unless the consideration is paid in an installment sale. The character of the gain is determined by the nature of the asset sold, such that (A) assets that produce ordinary income in the course of business (such as inventory and accounts receivable) produce ordinary gain, and (B) assets that are capital in nature (such as securities and intellectual property) produce a capital gain. If the aggregate losses equal or exceed the gains, then the aggregate net losses are treatable as an ordinary loss.
Note that the Seller's gains may be taxed twice, first to the Seller and then again to its shareholders when distributed as a dividend - or as gain on the shareholder's exchange of stock on liquidation of the Seller as a corporate entity. Gain will also be recognized by the Seller upon payment of installment notes - resulting in the ongoing obligation to pay tax. Further note that the Seller will be taxed on gain in the event that the Seller selectively redeems the stock of certain of its shareholders - rather than pay out acquisition proceeds as dividends. These tax consequences are the same for a forward subsidiary merger - in that the Seller and its shareholders are taxed as described above, with the exception that the Seller's gain is now recognized by the Buyer (inasmuch as the Buyer assumes all tax liabilities of the Seller in that type of a transaction). The Seller's recognition of gain can be delayed with delivery of an installment note as payment - provided the note is secured such that payment assured, and provided that the note is not itself transferred or pledged for consideration to the Seller.
The Buyer in a sale of assets acquires a basis in the assets acquired equal to the purchase price allocated to particular assets.
(ii) Taxable Sale of Stock.
In this type of transaction, the Seller's shareholders are taxed at capital gains rates on the difference between their basis and the purchase price of the stock. The Seller itself is not taxed. The Buyer obtains basis in the Seller's stock equal to the purchase price - and the Seller's assets retain their pre-transaction basis.
If the Buyer purchases at least 80% of the Seller's stock, the Buyer can make a Section 338 Election. As a result of this Election, the transaction is treated as a sale of assets - with the Seller being taxed on gain on the sale, and the Buyer receiving stepped-up basis. The Seller's shareholders are taxed the same (gain on the sale of their stock). This Election is only useful if the Buyer can offset the Seller's gain with a non-operating loss carryover which would otherwise expire.
(iii) Indemnities and Escrows.
Indemnities by the Seller do not reduce gain recognition by the Seller unless amounts are actually paid to the Buyer out of the indemnity. With escrows, no taxable gain will be recognized until amounts are released and paid out of the escrow.
(b) Tax-Free Reorganizations.
If the transaction qualifies as a "reorganization" under Section 368 of the Internal Revenue Code ("IRC"), in which the Buyer's stock is exchanged for the stock or assets of the Seller, then generally no tax will be assessed on any of the parties to the transaction on the exchange of stock or securities. Gain will be recognized, of course, at the time that the stock that is received is resold following the transaction. Further, gain is generally recognized on the non-stock consideration received - called "boot". The basis on assets acquired in the reorganization remains unchanged.
Given that the rationale behind the non-recognition of gain is that the Seller's shareholders have merely changed the form of their interest in the Seller - there have evolved a number of statutory and judicial tests intended to show that, in substance, there is a "continuity of interest" of the Seller's shareholders in the Seller after the transaction. A tax-free reorganization is deemed to have occurred only where:
* there is continuity of equity interest;
* there is continuity of business interest;
* there is continuity of business enterprise; and
* a series of related transactions are considered as part of a single plan.
The structure of transactions that may be used to fit the continuity of interest tests, as generally defined under IRC 368 include the following:
* an "A Reorganization", which is a statutory merger or forward subsidiary merger in which up to 50% of the consideration can be boot and not stock. Note that reverse subsidiary mergers are also treated as A Reorganizations, provided that at least 80% of the consideration to the Seller consists of the Buyer's stock.
* a "B Reorganization", in which the Buyer's stock is exchanged for at least 80% of the Seller's stock - with no boot allowed as consideration.
* a "C Reorganization", in which (a) substantially all of the assets of the Seller are acquired for the Buyer's stock and limited boot constituting no more than 20% of the value of the assets acquired, and (b) the Seller liquidates and distributes the consideration received to its shareholders. For a C Reorganization, "substantially all assets" equals 90% of the Seller's net assets, and 70% of its gross assets.
2. Pooling of Interest
Generally, business combinations are accounted for either under the "pooling of interests" method or the "purchase" method. In purchase accounting, the surviving company must amortize "goodwill", thereby reducing future profitability. Goodwill is equal to that amount that the purchase price exceeds the fair market value of assets acquired (consisting of assets less liabilities) - which is then amortized over the expected life of the assets not to exceed 40 years (or 15 years in the case of intellectual property). For technology based companies, the amount of goodwill can be substantial.
Pooling avoids goodwill amortization. In pooling, the ownership interest of the combining companies are joined by an exchange of voting securities - resulting in the financial statements of the companies being combined for all accounting periods.
To qualify for pooling treatment, the combining companies must comply with 12 rules that assure that the companies were independent prior to the combination, and that they will operate as a single entity afterwards. These rules break down into a series of pre-combination, combining and post-combination rules. Prior to the combination, management need generally only be concerned about the following 3 rules:
* No Company Control Within 2 Years. Another company cannot have owned over 50% of any combining company within the 2 year period prior to the combination.
* Independence. Each of the combining companies must be independent of the other, and none may hold more than 10% of the voting common stock of the other at the initiation of the combination.
* Maintain Equity Interests. No company may alter the equity interests of its voting stock, or the interests of its shareholders, in contemplation of the combination within the 2-year period prior to the combination. This generally permits companies to make dividend distributions to shareholders in the ordinary course - but not to issue share bonuses, options, or change the terms of stock plans in anticipation of a combination.
Three: Determining the Transaction Price; Structuring Compensation
1. General Pricing Parameters
Seller's will try to maximize the value of the company by applying a forward-looking valuation methodology - such as the Discounted Cash Flow Technique ("DCF"). The DCF accounts for the going-concern value of the company as indicated by the present value of the company's projected cash flows for a determined maturity period of from 3 to 5 years. These cash flow projections are derived from (a) assumed revenue generation on product sales, less (b) operating costs and debt repayment on capital investments (not including interest payments), plus (c) an estimate of the Company's residual value at the end of the 3 to 5 year period. These projections are then discounted back to the present by the risk-adjusted, weighted-average cost of capital. This cost of capital accounts for the interest payments and/or equity return expected by investors in the company over the projection period. As this valuation method pegs the company's value on the growth of future markets - the valuation will generally be high based on the potential for the targeted market.
Critical to the DCF analysis is a determination of 4 key areas, including (a) the assumptions underlying the projections, (b) the length of the projection period, (c) the company's residual value at the end of the projection period, and (d) the discount rate (cost of capital). Please see White & Lee's paper entitled "The Valuation of Newly-Formed Technology Companies" for a more detailed discussion of this subject.
In applying the DCF, the Seller must consider the value of the company when operating in combination with the Buyer. For this purpose, the Seller must understand the Buyer's business - and how the Seller will be used by the Buyer after the transaction. If the Buyer is a private company - this will involve a fair amount of speculation by the Seller on what the Buyer actually intends. This task is a bit easier if the Buyer is a publicly-traded company in which detailed information concerning the Buyer's business can be obtained.
Unlike the Seller, the Buyer will try to avoid pegging valuation on future markets or on the Buyer's plans. Rather, the Buyer will minimize value by looking at the maturity of Seller, the risks inherent in operating the Seller's business, and the additional investment the Buyer will have to make in company in order to tap the targeted market. Essentially, the Buyer will tell the Seller what it is willing to pay - based on its subjective view of the attractiveness of the company, and what it thinks other competitors might pay if they were also to pursue the Seller.
This does not mean that the Seller should not value its business on DCF. Instead, the Seller should based its price on DCF - and question the Buyer on its assumptions in setting its price. This might have the effect of raising the price, if the Seller can objectively argue value that the Buyer can verify to its satisfaction.
2. STRUCTURING THE PAYMENTS.
Tax considerations aside - the stock, cash or property paid in the transaction can be paid on the date of closing, into an escrow account as security for the Seller's indemnification obligations to the Buyer, or in the form of an earn-out (with the consideration kept in escrow - or paid by the Buyer directly at the time that payment is due). The interests of the Buyer and Seller in the structuring of payments is summarized as follows:
(a) Payment on Closing. In taxable transactions, payment on closing is particularly important to the Seller - as sufficient sale proceeds must be available for the Seller to pay taxes when due. Proceeds to be paid under installment notes or as contingent earn-out compensation is not taxable until earned - so the Buyer should not be concerned about the tax effects on Seller for these contingent payments. The Buyer will want to minimize up-front consideration primarily in order to key payment to the actual financial performance of the business after the transaction. Further, as mentioned, the Buyer will want to set up an escrow reserve to serve as an offset to indemnity obligations Seller has to the Buyer for material misrepresentations made by the Seller to induce the Buyer to complete the sale.
(b) Payment into Escrow. Generally, the Seller may find escrow payments to be acceptable if (i) this will raise the entire consideration to be paid in the transaction, (ii) the escrow serves as secured source of earn-out payments (not subject to the Buyer's own ability to pay in the future), and (iii) if a reasonable portion of the total consideration is escrowed. The Seller may attempt to minimize the amount of escrow payments by agreeing to lower the transaction price - or lessen the restrictions tied to the escrow by providing for the frequent and early release of escrow payments tied to acceptable time periods or achievable milestones. The Buyer obviously has opposing interests - and can justify a longer escrow of larger amounts by (i) holding the Seller to its own projections for the performance of the company after the transaction, and (ii) identifying specific and significant risks associated with the company that should not alone be assumed by the Buyer.
(c) Earn-Outs. The Seller should resist earn-outs that depend largely on the Buyer's ability to successfully operate the business. The Buyer can attempt to overcome this concern by hiring the Seller's key management and employees - so that, in essence, the Seller continues to operate the business. The Seller should respond by insisting on obtaining from the Buyer the resources and working capital needed for the Seller to meet the business objectives identified to the Buyer at the time of the acquisition. Further, the Seller will want to separate its payment from the performance of management that moves with the acquisition to the newly reorganized company. Given this back-and-forth, typically the earn-out is structured as a sharing of risk between the parties. Ideally the risk should lie more heavily on the Seller if the consideration is largely tied to future performance - and with the Buyer if the consideration is primarily based on the past performance of the company.
(d) Other Forms of Consideration. The Seller will want to increase the total transaction price by proposing that separate consideration be paid for other items of value to the Buyer, such as lock-ups, non-competition, employment and consulting fees, and break-up fees. Lock-ups bar the Seller from shopping the company to other potential purchasers, and if the Seller has value -it should rightfully be paid for the lost opportunity of foregoing potentially better terms and a higher acquisition price. The Buyer will typically agree to allocate a portion of the total acquisition price as a non-refundable deposit, and credit the acquisition price on closing. The Seller might propose that the lock-up has separate value that should be added to the acquisition price. Regardless of how it is characterized, the Buyer will view the lock-up as part of the total acquisition price. Non-competition provisions, while generally not enforceable in California, are enforceable in the context of a merger or acquisition where goodwill is sold - and the Buyer should have the opportunity to recoup the value of its investment from the Seller. Typically, these provisions are heavily negotiated, and the Seller might seek separate consideration for the non-compete given the implications on future opportunity. Here, as this type of provision usually pertains to specific employees, the Seller may be able to negotiate a separate payment to these persons for foregoing the ability to compete. Employment and consulting fees are another means of funneling additional consideration to selected persons. Inasmuch as these fees are paid for future value given to the Buyer - and are not paid for the Seller as it exists today - these fees should be treated separately from the base acquisition price. Break-up fees may be paid either to the Seller or the Buyer for termination of the transaction under certain circumstances. These fees are usually intended to reimburse the parties for their accrued transaction costs or compensate for lost opportunity. As it is not clear at the outset of a transaction which party will be more heavily damaged if the transaction is not completed, these fees are not usually found in the acquisition of private companies.
Four: Securities, Anti-Trust and Bulk Sale Regulations
1. Securities Regulations
In any transaction in which securities are paid or exchanged, the federal and state securities laws must be complied with. The definition of what constitutes a security is typically quite broad. For example, under Section 25019 of the Calif. Corp. Code, a security includes, among other instruments, any note, stock, evidence of indebtedness, investment contract, put, call or option - even if not evidenced by a written document. Generally, any purchase or sale of securities must be registered with the Securities and Exchange Commission ("SEC") at the federal level, or the applicable state securities agency at the state level - unless an exemption from registration applies. In the acquisition or merger of privately held companies, private offering exemptions can usually be applied.
(a) Federal Exemptions. Section 4(2) of the Securities Act of 1933 (the "Securities Act") exempts from registration "transactions by an issuer not involving a public offering". Regulation D is a safe-harbor rule under the Securities Act that, if complied with, firmly establishes the existence of a private offering, and the consequent avoidance of the need to register the offering. The transaction need not meet all the requirements of Regulation D in order for the offering to be exempt as a private offering under Section 4(2).
(i) Section 4(2). The availability of the Section 4(2) exemption is a matter of judgement based on various judicial and administrative interpretations. Generally, the factors to be considered in establishing a private offering include an examination of (i) the number of offerees and their relationship with the issuer, (ii) the number of units offered, (iii) the size of the offering, and (iv) the manner of the offering. None of these factors by themselves are determinative of whether the exemption is available. Further, the purchasers of the securities must not intend to buy and resell the securities - as this implies the purchaser is acting as an underwriter in a public offering. For this reason, typically the purchaser of securities is required to represent to the seller that the purchaser has bought the securities for the purpose of "investment" only. Finally, the offering of securities in the transaction must not be part of a broader scheme or plan of financing - that in total would constitute a public offering (such as might be the case with a series of related financings). This is not likely to occur in an isolated merger or acquisition of a privately held company.
(ii) Regulation D. As mentioned, Regulation D provides a statutory safe-harbor for the issuance of securities in a private transaction. Rules 501 through 508 set forth certain restrictive conditions under which the securities are to be sold, including conditions relating to the integration of offerings, information requirements, and limitations on the manner of the offering - and resales of the securities. Rule 504 applies to offerings of up to $1,000,000; Rule 505 applies to offerings up to $5,000,000; and Rule 506 applies to offerings of greater than $5,000,000. Offerings made under Rules 505 and 506 must be made to no more than 35 unaccredited investors (with no limit on the number of accredited investors). In all of these rules, the standard for the disclosure of information to non-accredited investors is higher than to accredited investors - though in all cases full, material information must be provided to all of the investors.
(b) State Exemptions. The purchase or sale of securities must comply with state securities law as well as federal law. This requires an examination of the applicable transactional exemptions in the state - and determination if the exemption applies in the context of the transaction. The securities law in each state in which the issuer and each purchaser is located must be examined. It is particularly important to note that the private issuer transactional exemption may not necessarily apply where securities are issued in the context of a merger or acquisition.
Issuers may rely on a number of exemptions that may be available in the state. For example, in California, exemptions in acquisitions and mergers may be available if (a) the security issued is approved for listing on a national securities exchange (see CCCC Section 25100(o)); (b) the securities exchanged do not involve any class of stock at least 25% of which is owned by California residents (see CCC 25103(c)); (c) limited offerings in exchange reorganizations (see CCC 25102(f); and limited offerings for mergers (see CCC 25103(h)).
(c) Fairness Hearing under Section 3(a)10. Section 3(a)10 of the Securities Act provides a federal exemption from registration for the exchange of securities where the terms of the exchange have been approved in a "fairness hearing" conducted by any state governmental agency. Only 4 states have adopted the enabling legislation to permit fairness hearings, including California, Oregon, North Carolina and Ohio. The qualification of securities in a fairness hearing covers the issuance for both federal and state law purposes.
The advantage of securities approved for issuance in this manner is that the securities received in the transaction are freely tradeable, subject to certain resale restrictions under Rule 145(d) for former affiliates of the Seller, and Rule 144 for those who become affiliates of the Buyer. This is of great advantage to the shareholders of a private Seller acquired by a public Buyer. The Seller's shareholders receive immediately tradeable stock in return for the restricted stock they have exchanged in the transaction. If the Buyer is not public, then a fairness hearing may still be advantageous in providing liquidity in the event that the Buyer subsequently becomes public and the shares held by the former shareholders of the Seller are not included in the IPO. Further, on the subsequent IPO of the Buyer, the shares received under the fairness hearing generally are pre-qualified for issuance in the IPO under the securities laws of many states.
2. Hart-Scott-Rodino Anti-Trust Improvements Act
The transaction may further require prior notification of the Federal Trade Commission and the Dept of Justice, Antitrust Division, under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 ("HSR") if each of the following 3 tests are met;
(a) the Buyer or the Seller is engaged in US Commerce;
(b) securities, assets or net sales of the Seller worth $10,000,000 or more are being acquired by a Buyer with assets or net sales of $100,000,000 or more (or assets/net sales of a $100,000,000 Seller are acquired by a $10,000,000 Buyer); and
(c) on completion of the transaction, the Buyer will hold 15% or $15,000,000 of the assets or securities of the Seller.
Certain exemptions to HSR may apply, including (a) acquisitions in the ordinary course not involving substantially all of the assets of an operating business; and (b) acquisition of 10% or less of the issuer if the purchase is made solely for investment.
3. Bulk Sales Laws
The bulk sales law found in Article 6 of the Uniform Commercial Code adopted by most states, provides a mechanism under which Sellers of assets out of inventory must give advance notice to trade creditors - in order to give the creditors an opportunity to protect their interests. A "bulk transfer" generally includes the sale of inventory out of the ordinary course located within the state in which the statute is applied. If applicable, the Buyer and Seller must (a) prepare a list of creditors, (b) prepare a schedule of property, and (c) give notice of the transfer. The notice typically must be provided to the Seller's creditors at least 10 days prior to the transaction.
- If the notice is not properly given, then the sale is ineffective against the Seller's creditors, and the assets may be levied against by the creditors for debts owed by the Seller. This will result even if the asset have been sold to the Buyer without the assumption of liabilities associated with these assets.
These are only some of the issues that must be considered in the proper structuring of mergers and acquisitions. Competent legal, accounting and financial advice on all issues is critical to receive at the outset before the transaction is structured and completed.
