A company merging with or acquiring another firm should make sure to perform its due diligence with regard to previously granted incentives before entering into the transaction.
It’s not surprising that in the face of a global pandemic and its economic impact, merger and acquisition activity is gearing up. It’s inevitable that in periods of economic downturn, stronger and better positioned companies acquire struggling businesses. However, it’s also common for both acquirers and the communities in which they operate to overlook opportunities and pitfalls in a merger or acquisition.
So how do you take advantage of the first and avoid the second? One path that yields great results is thoughtful economic incentive due diligence, which offers specific and unique opportunities for an acquirer related to each of the three phases of an acquisition:
M&A Transaction Phases
While some acquirers may recognize and incorporate incentives into the final integration phase, very few recognize the opportunities and pitfalls that exist in the first two phases.
Did I just pay too much for that business?!
Despite teams of accountants, lawyers and consultants, it is uncommon to have a nuanced incentive expert on the team. Many incentives are not necessarily obvious in the financials, let alone considered as something that matters or could be influenced to the benefit of the buyer.
Example: A targeted 250,000-square-foot production facility is the beneficiary of a 50 percent tax abatement and the company is only in the fifth year of a 20-year deal. It’s currently paying $0.70 PSF for a total of $175,000 per year, while saving an equal amount. That benefit could expire in a number of ways — restrictive provisions in the incentive agreement, an asset transaction in which the agreement is not assigned to the buyer, integration or technological advancement that puts the acquirer in a default position relative to prior job and operations maintenance covenants, or simply the natural end of the incentive term.
Assuming a valuation multiple of 10, missing this in due diligence could potentially cost the acquirer a $1.75M purchase price reduction. To make matters worse, the hit to the P&L over the next 15 years could add up to $2.6M in potentially avoidable additional operating expense.
Choices, choices: strategic abandonment, continuation or improvement of pre-existing incentives?
When acquirers identify existing incentive agreements before the transaction, they put the power of choice in their own hands. Often the best options are to continue or improve the existing agreements. Beginning negotiations prior to the transaction is the typically the best way to accomplish those results.
Improvement can come in several forms, including an extension of term, increase in benefits, decrease in requirements, etc. This opportunity may present itself when:
- There are real concrete integration plans involving meaningful retention or expansion of operations;
- There are specific challenges intrinsic to the property, workforce, infrastructure or industry that provide substantive reason for additional offsetting public partnership;
- Evolution of law, regulation, policy or politics has resulted in an environment more amicable than what existed when the original agreement was struck.
Continuation may be the best choice in a number of cases where the existing incentive cannot be improved for the following reasons:
- Evolution of law, regulation, policy or politics has resulted in an environment less amicable than what existed when the original agreement was struck;
- The incremental benefit opportunity is outweighed by the cost of pursuit or new less favorable requirements and covenants;
- Strategic plans are not clear enough upon which to make a new commitment.
Abandonment of incentives can be the right thing to do in cases where the conditions for Improvement or continuation do not exist or are complicated by:
- Covenants preventing sound sustainable business decisions (e.g., investment in new technology that jeopardizes minimum employment commitments);
- Physical reorganization, combination or elimination of operations to increase productivity, realize efficiencies;
- Impending and unavoidable difficult decisions (e.g., layoffs) that would damage the acquirer’s reputation and goodwill if it utilized incentive benefit in the interim;
- Unclear strategic plans upon which to make a new commitment.
Can the transaction structure make a difference?
Surviving the transaction. There is really one main aspect about the proposed transaction structure that may impact pre-existing target incentives — the continuity of the contracting entity subject to the incentive agreement. If the entity subject to the agreement — often also the taxpayer, employer of record, and titleholder of assets — does not survive the transaction, then the agreement may be voided without an assignment.
Often, the public entity providing incentive benefits may require an approval for such assignment. If that approval requires a public action (e.g., board or council approval), the ability to secure an assignment prior to the transaction could be tricky — especially in the case of publicly held companies subject to the SEC and other regulatory bodies.
The cost of overlooking incentives can be in the range of $30–60K per employee and/or 5–20% of hard asset value.
Depending on the type of benefit, an asset sale, a stock sale deemed an asset sale for tax purposes, or a merger wherein the transaction structure involves dissolving or replacing the predecessor entity, the incentive contract may be voided.
Triggering an incentive “pop.” There are circumstances where an asset or deemed asset purchase may yield otherwise unexpected benefits. Although many of these benefits are unintended and have been legislated out of existence, there still are isolated opportunities. These anomalies are typically in the statutory tax credit genre vs. discretionary “incentives.”
The basic premise is that when an acquiring company redeploys assets and human capital, it represents an entirely new business venture for an unrelated company. People rehired to a new employer may be considered “new” for credit and incentive purposes. Likewise, assets are booked at reset values and may be considered new investment for purposes of tax credits.
There are bona fide reasons to employ this kind of rationale for negotiated incentives as well. Take the example of a failing company whose community stands to lose that company’s operations and jobs. The community’s best interests may be to find “new” employment and investment, which may come in the form a well-capitalized and operationally sound suitor that is willing to acquire the ailing company’s operations. That acquirer's temporary reduction in operating and operating costs through incentives could provide the incentive or stability needed to justify the initial risk.
Mission Critical — What MUST I do before the transaction closes?
In the case of acquisitions where the target company survives the transaction, and final commitment to material changes in operations will be post-transaction, many opportunities can wait, despite potentially losing some incremental negotiating leverage. However, acquirers should start, if not complete, efforts to take advantage of certain opportunities to achieve upside or avoid pitfalls:
- Pricing considerations: Assessment of potential incentive losses should be factored into pricing.
- Transaction form: Consider whether the form of the transaction (e.g., asset or deemed asset vs. stock) and employer entity continuity will negatively impact the continuity of the incentive agreement or, in certain circumstances, create value in and of itself.
- Timing constraints: Will there be enough time between the transaction and operational commitments to fully negotiate new or modified incentives?
- Incentive agreements: Do existing agreements prohibit sales or require approvals of transfers or assignments?
Learn how Cushman & Wakefield’s Incentives Practice can assist you.