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Merger & Acquisition Focus February/March 2009 Strategic alliances When two is better than one Snake in the grass Employee-related liabilities can poison your deal M&A insurance can shield your deal from risk Ask the Advisor ThiNganHang.com www.herrera.com 600 Jefferson, Suite 1080 ♦ Houston, Texas 77002-7363 (713) 978-6590 ♦ Fax (713) 978-6599 ThiNganHang.com
Strategic allianceS When two is better than one Astrategic alliance may be an option for grow-ing companies when a sale or acquisition isn’t solution. Joint ventures require participating companiesto create a separate legal entity (generally a corpora- feasible. In fact, carefully chosen and executed tion, limited liability company or partnership), of which alliances can yield many of the benefits of a success- all participating companies are partners and through ful merger — including increased revenue and market which the new business will be conducted under strict share and the acquisition of key employees — but operating agreements. without the time, cost or hassle. Venturing out Say you need to raise capital to effectively compete in Help ensure a successful partnership your market, but also want to retain ownership and full by choosing a company that control of your company. A joint venture — a common, but complex type of strategic alliance — may be the shares similar values and business philosophies. Though joint ventures can face many of the same integration challenges of standard mergers — plus the additional challenges involved in jointly managing a company — they allow you to share some of the risk. They can also potentially gener- ate valuable synergies that, for example, yield more robust product lines, greater geographical reach and cost reductions related to scale while enabling participating companies to manage their own core competencies. In addition, pooling your resources in a joint venture may enable you to: v Take on projects that are larger than you would normally accept, ThiNganHang.comvv Boost your bidding power and bonding capacity,Tap the unique skills and ideas of a differentorganization — possibly revitalizing your own, and v Increase your ability to raise capital. A joint venture maintains its own accounting records and produces financial statements that are independent of each participating company’s 2 financial records (though the joint venture is noted in those companies’ financial statements). Your percentage of ownership and level of control in the joint venture dictate the accounting method — cost, ThiNganHang.com
equity or full consolidation — used to report joint venture activity. Most joint ventures are limited in looking for less commitment? scope to a single project or product, but they can also operate indefinitely. Contractual alliances may allow companies to contractual arrangements partner with one another without making major legal or financial commitments. By no means a Contractual arrangements offer a simpler form of one-size-fits-all business model, contractual alli- strategic alliance. These short-term collaborations ances run the spectrum to include cooperative: may be appropriate when you don’t require a formal management structure. The contract’s specific provi- v Marketing efforts, sions will depend on the complexity of the business arrangement, but it should discuss the duties and v Licensing, responsibilities of each party, confidentiality and non- v Product design, competition, payment terms, and intellectual property. v Sales or distribution, Also be sure you enter a contractual arrangement with an exit strategy in mind. v Manufacturing, v Technology development, A contractual alliance might be formed when two businesses partner to distribute products, but share v Research and development, few financial resources. (See “Looking for less com- v Intellectual property, and mitment?”) On a larger scale, two companies might v Service agreements. both make significant financial contributions to fund capital-intensive investments such as those in facili- ties and equipment. also miss out on future business opportunities with your strategic partner’s competitors. Help ensure a successful partnership by choosing a company that shares similar values and business phi- losophies. For example, if you have an entrepreneurial spirit and believe in taking calculated risks, partnering with a company that follows a more conservative, risk- averse approach is likely to lead to conflict. During the screening process, investigate your poten- tial partner’s financial and labor resources, strengths and weaknesses, bonding capacity and production output. Request copies of the company’s financial records for the past five years, interview its clients, and research records for litigation and other legal proceedings in which the company may be involved. You may also want to check legal records for civil Many contractual alliances grow into more significantbusinesses for their participants. So regardless ofthe type of alliance you choose, seek expert advice toThiNganHang.comactions such as a divorce. An ex-spouse or creditorcould attempt to claim your joint business revenue.Bearing fruit assess your initial legal, financial and operating risks A strategic alliance can provide growth prospects and benefits as well as those that potentially come for its participants when cash is tight and a merger into play down the road. isn’t possible. These alliances always harbor risks — a perfect match particularly if the partners aren’t financial equals. But if you carefully enter an arrangement and put 3 You should never enter into a strategic alliance without plenty of forethought into what you hope to achieve carefully considering the risks. These include corporate strategically and financially, it can be an extremely culture clashes and loss of control over operations fruitful relationship. n and proprietary information and technology. You might ThiNganHang.com
Snake in the grass emPlOYee-related liaBilitieS can POiSOn YOur deal Overpaying and poor integration planning arefrequently cited as major reasons mergers go awry. Discussed less often — but still potentially devastating — is a buyer’s failure to con- sider the seller’s employee benefits. For example, who will be liable for the target’s employee pension plan? Make sure you consider such issues well before your transaction closes. Biggest balance sheet liability Even the most thorough due diligence process won’t ferret out every acquisition risk and liability. But involving your human resources team in the process can help you spot and assess employee benefit- related issues that might otherwise elude you. At the top of your priority list should be employee pensions. They can be the most onerous liability on risky vacation policies a company’s balance sheet — often amounting to as If your deal is structured so that the seller must much as 200% of the company’s value. Determining terminate all employees and you immediately hire the size of a potential target’s pension deficit and most or all of them back (which is true in many corresponding annual contributions with the help of a asset-purchase deals), both parties must decide professional valuator can help prevent you from over- how to handle employee accrued vacation or paid paying, or worse, buying a long-term financial burden. time off. Because their employment will technically be terminated by the seller, employees may be a healthy company entitled to payment for accrued vacation, even Next, consider health and welfare benefits. Will though they still have a job. your transaction make any of the target company’s employees eligible for COBRA (which guarantees This potential liability can be dealt with in one of employees the right to continue coverage after they several ways: lose their job)? Some could be COBRA-eligible inde- v You may choose to accept existing vacation balances pendent of the transaction (for example, divorced under your own policy, former spouses), and continue to be so after the deal closes. In these cases, determine whether coverage v The seller may pay out the full vacation balance in will be provided under the seller’s or your health plan.ThiNganHang.comcash, or Although COBRA rules assign responsibility to provide v You might assume some or all of the cash-out cost. coverage in merger situations, parties are free to change them by mutual agreement. In some cases, you might want to ask employees to consent to the transfer of vacation balances or to Also look at any health or other welfare benefits your waive rights to vacation pay. target offers its retirees and determine what type of postdeal responsibility you’ll have for them. If you If you’re making a stock purchase deal, pay attention intend to provide them, be sure you perform thor- to potential risk in vacation policies that may create 4 contractual liability, or that make it difficult or impos- ough due diligence by reviewing all plan documents, including summaries and participant communications. sible for you to implement your own policies. Some Determine whether these benefits can be modified or companies, for example, make written promises in terminated, or whether participants are vested and policies that buyers find difficult to keep, such as have the right to receive them for life. vacation day accrual policies and expense approvals. ThiNganHang.com
employment claims trigger change-in-control or other severance that’s Also obtain information about any pending employee payable to your target’s executives. If payment of claims or outstanding litigation. Review the target’s such benefits significantly reduces the company’s history of employment-related litigation, searching net worth, be sure to include it in the formula you for trends that suggest habitual noncompliance in use to determine a starting bid. areas such as discrimination, harassment and safety violations. Ensure that your purchase agreement taking responsibility includes seller representations regarding compliance In any acquisition, buyers must review employment with federal and state employment laws. issues and uncover related risks and liabilities, as well as determine how benefit program changes If you must reduce the workforce you’re acquiring, are likely to affect employees and the integration scrutinize your target’s severance policies and plans process. Be as knowledgeable about your target’s to determine the content of severance packages liabilities as you are of its assets and you’ll help and whether you or the seller will be responsible for prevent unpleasant postdeal surprises. n them. Further decide whether the transaction will M&A insurance can shield your deal from risk Most M&A transactions come with a clear andpresent danger: risk. From hidden liabilities, such as contingent liabilities. This type of policytypically provides coverage for three to seven negative tax treatment and valuation issues, years. And the noncancelable policy goes into effect to legal and environmental obstacles, many unfore- when a “breach of a representation and warranty” seen risks could hinder your deal or halt it altogether. is discovered. M&A insurance, however, may be able to protect you from these deal breakers. r&W heads off surprises Some standard business insurance Parties on both sides of the table can benefit from M&A insurance coverage. Representations and policies may adequately address the warranties (R&W) insurance protects buyers from risks attending smaller transactions. postclosing “surprises” such as revenue declines and misrepresentations regarding intellectual prop- erty, major contracts or titles to assets. It may also enable buyers to:v Set their bids apart from competitors in anauction scenario by providing protection beyondThiNganHang.comeUncertainties surrounding potential environmentalliability — such as the extent of soil or waternvironmental risks contamination at a manufacturing site — can stall the customary level of indemnification, an M&A transaction. Four types of environmental v Protect relationships with key employees by insurance are available to help protect buyers and removing buyers from potential future claims sellers, including: against them, or 5 1. Environmental site liability. This type of policy v Purchase a bankrupt company when they have no protects sellers and buyers from costs related to other source of risk protection. cleanup, bodily injury or property damage. It can be R&W coverage also protects sellers from problems structured to cover an entire company or specific that buyers fail to fully disclose or disclose at all, work sites. ThiNganHang.com
2. Remediation cost cap. This policy covers the new Breakup fees — paid by the party that terminates owner in the event of cost overruns associated with a a deal against the other party’s wishes — pose toxic site cleanup. Helpful in guaranteeing the extent another risk. Insurance can cover a potential buyer if of a buyer’s total liability, remediation cost coverage the seller walks away during takeover negotiations. often facilitates transactions in which the parties can’t Reverse breakup fee insurance protects sellers from agree on the amount of known and unknown liabilities. buyers that back out. 3. Blended risk. This coverage protects buyers when Regulatory qualification insurance can protect both they know they’ll be assuming a seller’s environmental parties when a deal is terminated by neither of them. liabilities but need an asset to offset liabilities on For example, a regulatory agency might refuse to their financial statements. These funds could cover approve the merger because it would violate antitrust costs should the government shut down a facility in laws. Or it could fail to meet federal, state or statu- the future. tory requirements, or regulatory or accounting rules. 4. Secured creditors. This policy covers financial legal claims institutions and real estate investors against environ- Finally, litigation buyout insurance assumes the mental risks when they back real estate transactions. risk of known or pending lawsuits. It can cover a Benefits are paid out when a buyer defaults on a loan broad range of legal actions — including securities, because pollution cleanup that the buyer can’t afford antitrust, product liability, construction, tax and is required. intellectual property litigation. tax liabilities and breakup fees Typically, this type of policy is purchased to protect Tax liability insurance can reduce or eliminate contin- against unfavorable rulings and to transfer litigation gent tax exposure when a transaction fails to qualify from the liability column of the defendant’s financial for an expected federal income tax treatment. This statements. At times, it’s also obtained to hedge coverage can be useful if you’re involved in a tax-free against the reversal of a favorable verdict upon appeal. merger or spinoff, tax-exempt financing, or a deal that involves tax credits. Coverage, which typically is avail- getting started able in noncancelable terms of four to seven years, To determine how M&A insurance might affect your also can be extended to state and foreign taxes. proposed deal and long-term business strategy, review your existing general business insurance poli- cies for gaps that could become gaping holes during the merger process. Look in particular at your poli- cies’ limits and deductibles and determine whether you may need to combine or segregate coverage. Because M&A insurance can be expensive, traditional forms of business insurance may — depending on the size and scope of your deal — provide a more cost-effective solution. Some standard business insur- ThiNganHang.comance policies may adequately address therisks attending smaller transactions.is it right for you? Whether you’re on the buying or selling end of a deal, M&A insurance may be able to shield you from deal-damaging risks — known and unknown — and 6 protect your investment down the line. Talk with your M&A advisors to determine if this coverage can help mitigate the chances that something will go wrong with your next deal. n ThiNganHang.com
ask the advisor Q. How can a business valuation help me plan my exit strategy? A: Whether your decision to move on is motivated and determine a formula for calculating it, so that by a planned event such as retirement or a new ownership can be transferred at fair market value. professional challenge, or by unforeseen circum- stances such as a health crisis or financial trouble, And because the value of your company will affect the an accurate business valuation is essential. tax-related costs of gifting or bequeathing business interests, if you choose to pass the business to your Naturally, you want to get a fair price for your family or loved ones, a valuation can prevent you from company. A professional valuation provides insight improperly estimating value. Otherwise your heirs into its financial state, market position, and overall could end up with a sizable estate tax bill that could strengths and weaknesses — enabling you to set force them to sell your company after your death. a base price and make improvements that could help maximize your profit. Primed for sale When you enlist the help of a valuation expert, he or she will prepare your financial statements for buyer scrutiny by making various adjustments to earnings — a process called “normalizing.” Your valuator, for example, might remove one-time or discretionary items from your balance sheet and income state- ments, such as owner-specific and nonrecurring capital expenditures. This will provide the buyers with a more accurate picture of the business’s potential Valuators use a variety of methods, most of which performance when it comes under their control. use some variation of market multiple — operating cash flow, revenue or book value –– as a benchmark To enhance your company’s perceived value, a valua- to assess a business’s purchase price. Your valuator tor might also advise you to pay down debt, beef up will likely perform a complex analysis using several your internal controls and ensure that legal documents, methods that suit your company, balancing quantita- such as contracts, are in order. Sometimes, experts tive financial techniques with qualitative analysis of suggest more drastic measures, such as cutting staff,freezing expenditures to reduce overhead, implementingaccounting practices that increase inventory turnover,or divesting businesses of a poorly performing unit.ThiNganHang.comgeneral business performance, economic conditionsand your industry’s specific circumstances.Your role in the process To help your valuator make a fair and accurate Order to business affairs appraisal and get the most from the engagement, Even if a sale isn’t in your immediate future, a valua- gather all pertinent data and contractual agreements tor can provide you with the information necessary to relating to financials; marketing and sales; opera- draft a buy-sell agreement. This agreement provides a tions; and products and services. Also be prepared plan to follow in the event you or a business partner to provide this expert with information related to unexpectedly dies, becomes disabled or otherwise the value of intangible assets — something many withdraws from the company. A valuator will help business owners forget to consider, but which could name and define your agreement’s standard of value be a major contributor to your company’s worth. n This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. ©2009 ThiNganHang.comMAFfm09
Gilbert A. Herrera, founder of Herrera Partners was previously the Director of Coopers & Lybrand’s Southwest region corporate finance group, responsible for building a new practice consisting of private placements, merger and acquisition advisory services and valuations. As the senior investment banker for Underwood, Neuhaus & Co.’s corporate finance department, he revitalized the firm’s private placement and merger and acquisition effort. Mr. Herrera graduated from the University of Texas at Austin, where he is a member of the Dean’s Council for the McCombs School of Business, the Longhorn Foundation for Intercollegiate Athletics, the Littlefield Society and the Executive Committee of the Chancellor’s Council of the University of Texas System. By appointment of the Texas Supreme Court, Mr. Herrera served two terms as a member of the Commission for Lawyer Discipline from 1993 to 1999. In 2001, Mr. Herrera was appointed by Governor Rick Perry as Chairman of the General Services Commission and its transition to the Texas Building and Procurement Commission. He currently serves on the board of directors of the Harris County Housing Authority, the Houston Hispanic Chamber of Commerce and CHRISTUS Health Gulf Coast. He is a past President of the Houston Chapter of the Turnaround Management Association, the leading education and advocacy group dedicated to the corporate renewal industry. Merger and Acquisition Advisory Services ♦ Debt and Equity Placements ♦ SEC Compliance Services, Valuations and Fairness Opinions ♦ Expert Testimony ♦ Restructurings, Turnarounds and Reorganizations Specializing in Value-Added Distributors and Contractors ThiNganHang.comServing the Energy, Telecommunication, Food Products and Health Care Markets.www.herrera.com 600 Jefferson, Suite 1080 ♦ Houston, Texas 77002-7363 (713) 978-6590 ♦ Fax (713) 978-6599 ThiNganHang.com
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