Intricacies within a Merger and Acquisition Transaction

When buying or selling a company, it is important to recognize and understand the intricacies within a merger or acquisition in order to circumvent potential issues prior to closing.  Those familiar with mergers and acquisitions (M&A) understand the importance of key transactional aspects within M&A transactions such as the letter of intent, due diligence, purchase price allocations, working capital (as explained in last month’s Tax Advisory), and purchase agreements.

However, there are intricacies within those aspects that play a major role in a timely formidable closing.  This article aims to highlight some potentially overlooked or unnoticed issues that occur in M&A transactions. Educated advisors can avoid potential disputes that may arise and ultimately delay closing.  The issues include matters of employee vacation and benefits packages and indemnification through baskets and caps. First, we will examine employee vacation and benefits packages, such as paid-time-off (PTO).  In a stock sale, the Buyer essentially steps into the Seller’s shoes leaving initial employment to remain unchanged.

However, in a typical asset sale, the Seller would terminate all of its employees and the Buyer would immediately rehire the employees of its choice.  The issue arises when the employees to be terminated have accrued vacation or PTO.  Depending on a number of aspects including the state the transaction takes place, the employment agreement between the Seller and employee, or the Employee Handbook, the vacation or PTO is either a liability to be paid at closing by the Seller or liability to be assumed by the Buyer.

Moreover, depending on the number of employees, types of benefits, and accrual period, the vacation and PTO can be a large liability that must be addressed prior to closing.  It’s vital to understand the type of calculation necessary to adjust for a mid-year transaction in order to best protect your client from overpaying on a liability.  Issues specifically regarding employee vacation and PTO can be a point of contention and negotiation between the Buyer and Seller, therefore the importance of recognizing and remedying an understanding between both parties is vital for a timely closing.

Another important consideration that arises in a merger or acquisition are indemnification provisions, most commonly referred to as “baskets” and “caps.”  Indemnification from an M&A standpoint means that one party (generally the Seller) will defend, hold harmless, and indemnify the other party (generally the Buyer) from specified claims or damages.  A “basket” and “cap” pertain to the indemnification provisions within a purchase agreement that generally serves as the sole source of recovery from the Seller for any loss or damages suffered by the Buyer as a result of the transaction.  “Baskets” and “caps” are typically included with the representations and warranties made by the Seller in the purchase agreement.

When the Seller makes such representation or warranty, indemnification protects the Buyer from the Seller’s representations and warranties being inaccurate.

A “cap” is the upper dollar limit of the Seller’s indemnification obligations to the Buyer.  The “cap” represents the total amount of losses and damages the Buyer is entitled to recover from the Seller.  Naturally, the Seller will seek the lowest cap possible while the Buyer will attempt to seek no cap at all.  This point of potential contention and negotiation must be on the radar of your M&A team.  A “basket” (sometimes called a “deductible”) is a threshold number of losses and damages the Buyer must incur before it is entitled to any indemnification from the Seller.

Once the Buyer has incurred losses equal to the agreed amount, the Buyer is entitled to full recovery of all losses beginning from the first dollar of loss, this is known generally as the “first-dollar method.”  For example, under the first-dollar method, if the basket is $300,000 then any claim up to $300,000 would not be paid.  However, if a claim exceeds $300,000 and is 310,000 due to a Seller’s inaccurate representation or warranty, the entire $310,000 amount would be paid to the Buyer.

These are only two of many various issues that arise during an M&A transaction.  It is important to understand the intricate details and issues that help put your company in the best position to prosper.  If you need representation buying or selling a company, contact the professionals at the Center for Financial, Legal & Tax Planning, Inc.  We have the staff to evaluate and put your deal in the best position to succeed.  Please contact our office at (618)-997-3436.

black and white image of bart basi headshot black and white image of roman basi headshotRoman A. Basi and Dr. Bart A. Basi of The Center for Financial, Legal & Tax Planning, Inc., advise owners and advisors on Mergers and Acquisitions, Business Valuations, Succession, Estate, & Tax Planning. (www.taxplanning.com)