drafting stock purchase agreements: price, reps...

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Presenting a live 90-minute webinar with interactive Q&A

Drafting Stock Purchase Agreements: Price,

Reps, Warranties, Indemnification, Taxes,

Securities Laws and More

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, FEBRUARY 4, 2016

Allen Sparkman, Partner, Sparkman & Foote, Denver and Houston

Neal A. Jacobs, Managing Attorney and Principal, Jacobs Law Group, Philadelphia

Matthew A. Cole, Corporate Department Chair, Jacobs Law Group, Philadelphia

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Key Provisions in

Stock Purchase Agreements

Matthew A. Cole and Neal A. Jacobs

Jacobs Law Group, PC

Strafford CLE Webinar-February 4, 2016

Drafting Stock Purchase Agreements

Key Provisions in Stock Purchase

Agreements

Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC

A. Purchase Price

B. Representations and Warranties

C. Indemnification

D. Miscellaneous Key Provisions

6

Purchase Price – How calculated

Defining the amount of the purchase price:

1. Stated Purchase Price Amount: i.e., • $11,000,000

• $1.0 MM escrowed at signing to be released at

closing.

• $8.0 MM at closing.

• Or other staged releases

• $2.0 MM held in escrow to be released 2 years from

closing

• Subject to any set off or indemnity claims

Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 7


2. Stated Purchase Price Amount with adjustments

for balance sheet items (working capital

adjustments): • Preliminary Purchase price established as of signing.

• Anticipated account balances as of the anticipated closing

date.

• Typically focused on working capital account balances

• Preliminary Purchase Price will be adjusted at closing

based on the actual closing date account balances.

• Risks are allocated to Seller

• Price paid may go up or down depending on whether

projected account balances are hit on the closing date



Defining the amount of the purchase price:

3. Stated Purchase Price Amount based on last

audited statements:

• Pricing locked-in on signing.

• Buyer has risk of leakage, losses in account

balances reflected as of closing date.

• Buyer has the benefit of income and cash flow

from the date of signing.

4. Stated Amount with adjustment for performance

based earn-outs



4. Stated Amount with adjustment for performance

based Earn-outs. • Earn-Out creates a variable purchase price component

• Only paid if various performance metrics are met

• Seller is given incentive to ensure the success of the Buyer’s acquisition

and operation of the acquired entity.

• Accounting terminology can be key:

• The Metrics -- Financial versus Non-Financial

•Financial:

•EBITDA

•Gross Revenue

•Net Revenue

•Net Income

•Gross Profit

•Net Profit

Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC

Accounting Terminology:

•Cash Accounting

•Accrual

•Accounting

•Tax Accounting

•GAAP

•Other

•Income recognition

formulas

10


4. Earn-outs (Cont’d). Metrics (Cont’d):

Non-Financial:

•Product Development

•Prototype to Beta

•Beta to Commercial

•Regulatory approval

•FDA

•FCC

•EPA

•Etc.

•Expansion to New Territories

•Quality Measures

•Other Measures (opening of mine, start of production, etc.)

• Earn Outs are typically about 20% of the overall Purchase Price.


Purchase Price – What Type of

Consideration?

1. Cash

2. Promissory Note

3. Buyer Stock

4. Combination of two or more of the above


Purchase Price – Cash

•“Cash in Hand is the Noblest Work of God” Anonymous Lawyer:

•“Show me the money” Rod Tidwell to Jerry Maguire”

Jerry Maguire 1996

•Sellers typically want cash. •Seller is immediately giving up control and wants an immediate

compensatory amount in exchange for doing so.

•Typically require the buyer to pay by wire transfer or

cashiers/bank/certified check. •Note that wire transfers in the late afternoon, on Fridays and on the last or first business

day of the month sometimes do not arrive that day. This should be considered when

scheduling a closing.


Purchase Price – Promissory Note

• Why a promissory note? • Sometimes a note is used due to tight credit markets

• Difficulty in obtaining acquisition financing

• Buyer may have cash flow issues,

• Possible need for funds above the escrow to use for anticipated indemnity claims

(set off against the installment payments under the promissory note).

• Considerations: • Existing bank debt

• Acquisition financing

• Subordination

• Personal guaranties

• Percentage of deal locked up in Promissory Note

• Acceleration provisions

• Is note negotiable or non-negotiable

• Pledges of collateral, assets and/or stock

• Default terms

• Enforcement rights. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs

Law Group, PC 14

Purchase Price – Promissory Note

(Cont’d.)

• Default and enforcement can prevent unique challenges:

• If a default in payment, does the seller have the right to

step back in as an owner; a right to manage the

company; impact on company, employees and creditors.

• Guaranties by individuals or parent entities that are

owners of the buyer may be requested as well.


Purchase Price – Buyer Stock or

Other Equity Securities

• The buyer’s use of stock for all or part of the purchase

price usually only occurs if the buyer is a public

company.

• With public company stock as deal currency, the seller

has a ready means of determining value and liquidity

because of the ability to sell the shares on the open

market.


Purchase Price – Buyer Stock or

Other Equity Securities (Cont’d.)

• There are many complexities to using buyer stock as part

of the purchase price for both buyer and seller,

particularly complying with securities laws and

determining what type of liquidity the buyer is willing to

provide the seller for the shares. For example, if the

buyer is not willing to register the shares with the

Securities and Exchange Commission, the seller may not

be able to sell the shares quickly even though the buyer

has a public market for its shares generally.


Combinations of Purchase Price

Consideration

• The most often seen combination for sales of privately-held

businesses is a combination of cash and promissory note. The

blend (and interest rate on the purchase price balance) may

be heavily negotiated, though common “down payments” at

closing on the purchase price are in the 10-30% range.

• For sellers to public companies, there may be a strong incentive

to avoid a purchase price solely in buyer stock. The reasons

for this range from:

• Uncertainty about the future stock price;

• Desire to diversify economic interest and reduce risk;

• To simply not wanting to be an investor in someone else’s business.


Earn-outs

The Contingent Purchase Price

• An “earn-out” refers to contingent post-closing purchase price payments that are made if various targets are met by the acquired business.

• Buyers favor earn-outs. Sellers generally do not (or at least should strongly consider not accepting an earn-out unless they are in control of:

• means of achieving the earn-out post closing, for example:

• Sales;

• Production and delivery of product or service;

• Regulatory approval of product or service; and

• Company competitive offerings.

• the accounting policies and procedures used to track the achievement of the earn-out.

• Gross Revenue;

• Cost of Goods sold;

• SG &A;

• EBITDA; and

• Other financial metrics.


Earn-outs –

The Contingent Purchase Price

• Whether a Seller should accept an earn-out depends on the

level of control post closing and the obligation on the Buyer to achieve the earn-out.

Reasonable efforts;

Reasonable commercial efforts;

Commercially reasonable efforts;

Diligent efforts;

Commercially reasonable and diligent efforts;

Good faith efforts;

Commercially reasonable best efforts;

Every effort; and

Best Efforts.


Earn-outs – Why Have They Become More Popular in Recent

Years?

• Multi-decade trend towards transactions in the internet economy and/or service economy where businesses may not have significant track record of profits.

• These types of transactions may lead to a widening “Valuation Gap” between buyers and sellers.

• The wider the gap, between the parties’ views on value, the more likely the parties will head towards an earn-out as a gap filler.


The Valuation Gap and Earn-outs

• Earn-outs seem to be a way for buyers and sellers to avoid the

difficult negotiations required to reach final agreement on a

purchase price. Avoidance comes at its own price: the

likelihood that disputes between seller and buyer will occur

later, post-closing.

• The Delaware Chancery Court has noted in a relatively recent

case that “since value is frequently debatable and the

causes of underperformance equally so, an earn-out often

converts today’s disagreement over price into tomorrow’s

litigation over the outcome.” Airborne Health, Inc. v. Squid

Soap, LP, 984 A.2d 126, 132 (Del. Ch. 2009).


Stock Purchase Agreement

Representations and Warranties

1. The meanings of the terms “representation” and

“warranty”

2. Who is making the representations and warranties?

3. What purpose do representations and warranties serve?

4. Some Representations and Warranties with Significant

Liability Exposure


Do “Representation” and “Warranty”

have the same meaning?

• Typically, stock purchase agreements refer to

“representations and warranties” interchangeably.

Sometimes, this is not a good practice as described below.

• However, there are some differences that are useful when

drafting buyer disclaimers and non-reliance provisions.

These provisions are usually requested by the seller, who

wants to limit the universe of representations and

warranties on which the buyer may claim reliance in

entering into the deal.


The meaning of “Representation”

A statement from a party about certain facts regarding

the business or events that have occurred with respect to

a business as of a certain date. Usually, the date is the

signing of the stock purchase agreement and,

additionally, the date of a later closing.

Remember a representation is a statement of “a fact”.


The meaning of “Warranty”

• This is essentially a guaranty regarding certain characteristics relevant to the business, such as regarding title to assets.

• The use of the term “warranty” in the business sale context is somewhat different, however, than the more commonly understood meaning of the term, such as a warranty of good working condition for an appliance for 1 year from the date of purchase.

• This is because a warranty in the business sale context, like a representation, is typically as of a certain date, and not typically a guaranty of a set of facts or characteristics over a period of time.


Who makes the representations and

warranties?

• The seller provides many representations (and warranties) in a stock purchase agreement. The buyer provides relatively few, which is logical as the buyer needs to confirm many different facts regarding the existing business whether the parties structure the purchase as an asset sale or stock sale.

• If a significant portion of the purchase price is being paid by promissory note, the seller may ask the buyer for more representations and warranties than is customary in order to determine the financial soundness of the buyer in its role as a debtor to the seller.

• The concern here may be the solvency of the buyer and

• Potential claims for fraudulent conveyances or preferences

• Representations and warranties typically serve different purposes for the buyer and seller.


The Purpose of Representations and

Warranties in Stock Purchase Agreements –

Buyer Perspective

• Negotiating the representations and warranties in a purchase agreement is part of the due diligence process for the buyer.

• Depending on the type of business, a buyer will want to review financial statements, accounts receivable and payable records, key customer and supplier contracts, tax returns and many other documents to form an opinion on whether the business is profitable and not burdened by major liabilities.

• As a supplement to this investigation, the buyer may want to ask for very broad representations and warranties about the seller’s business.


The Purpose of Representations and

Warranties in Stock Purchase Agreements –

Seller Perspective

• The representations and warranties that a seller can obtain from a buyer are usually limited. The selling shareholders often not only own but also work actively in closely-held businesses, so the due diligence necessary or even desirable regarding the buyer will not be extensive.

• The typical representations a buyer may be willing to provide include that the buyer is validly formed and in good standing, the buyer has the power and authority to enter into the transaction, the buyer does not need another person’s consent to enter into the transaction, and that entering into the transaction will not cause the buyer to violate any agreement, judgment or governmental order.

• The seller will also provide these representations to the buyer, and will also provide numerous additional representations.


Liability Issues for Some Key

Representations and Warranties

• Some Representations and Warranties in Stock Purchase Agreements that tend to have significant liability associated with them include:

i. Title to Shares

ii. Due Authorization

iii. Taxes

iv. Environmental

v. Employee Benefits

• We are focusing on seller representations and warranties because the seller makes far more representations and warranties to the buyer, and has far greater exposure if they are false, than does the buyer.


Liability Issues for Some Key

Representations and Warranties (Cont'd.)

• Note that, unlike in an asset purchase agreement, some of these representations concern the corporation’s operations (Taxes, Environmental, and Employee Benefits) and others concern the state of facts about the shareholders themselves (Title to Shares, Due Authorization).

• One cannot take a “one-size-fits-all” approach to which representations and warranties may cause the most liability for sellers because some of those listed above do not even apply to all sellers.

• For example, a seller that is a multi-office executive search firm may have little likely exposure for environmental representations if the seller does not own the real property where its offices are located.


Limiting Liability for Representations

and Warranties

There are many different ways for a seller to attempt to limit his liability for various representations and warranties. Below is a brief list of some of these techniques:

i. Knowledge Qualifiers - “To the knowledge of the selling shareholder, after reasonable inquiry . . . .”

ii. Materiality Qualifiers – These concern eliminating selling shareholder liability for representations and warranties that may be breached for reasons that are immaterial, e.g., a reasonably prudent buyer would not think that the breach was significant enough to require renegotiation of the price or other economic terms of the stock purchase.

iii. Quantitative Qualifiers – These set a bright line standard for whether a selling stockholder has breached a representation or warranty.

iv. Deductibles, Baskets, and Caps under Indemnification Provisions- discussed briefly below.


Indemnification in Stock Purchase

Agreements

1. A Sample Basic Indemnification Provision

2. Indemnification Procedures

3. Introduction to Escrows and Set-Offs- Further Buyer

Protections

4. Introduction to Baskets and Caps- Limiting Seller

Indemnification Liability


A Sample Basic Indemnification By

Seller Provision

• “If Selling Shareholder breaches (or in the event any third

party alleges facts that, if true, would mean that Selling

Shareholder has breached) his representations,

warranties, and covenants contained in this Agreement,

Selling Shareholder will indemnify, hold harmless and

defend each Buyer Party from and against any Adverse

Consequences that any Buyer Party may suffer resulting

from, arising out of or caused by the breach or the

alleged breach.”

• We will now briefly analyze each of the highlighted terms

in this provision.


Seller: the Likely Indemnitor

• Many agreements contain mutual indemnification

obligations, but the limited number of representations and

covenants of the buyer make the indemnification

obligation of the buyer far less valuable to the seller than

the indemnification obligations owed by the seller to the

buyer.

• Indemnification in stock purchase agreements usually is

concerned with breaches by the seller of its

representations, warranties, and covenants to the buyer.


Selling Shareholders’ Representations,

Warranties and Covenants –

A Potentially Large Universe

• While there may seem to be a small universe of representations and warranties for which a selling stockholder could have liability (title to shares, due authorization, a few others), that often is far from the case in many stock purchase transactions.’

• A buyer often wants to understand the nature of the business underlying the stock being sold. Consequently, even if there is management other than the shareholders themselves, the shareholder will be asked to make representations and warranties about the business of the corporation itself.




A Potentially Large Universe (Cont'd.)

• If the selling shareholders have significant bargaining power,

they may be able to avoid this. However, it is more likely that

the selling shareholders will be “on the hook” for many of the

representations about contracts, taxes, intellectual property

and other matters that would typically be the responsibility of

the corporation itself in an asset sale.

• Because of these circumstances, a selling shareholder’s

indemnification burden may be significantly greater than at

first glance would appear to be the case.




The Materiality Scrape

Very pro-Buyer:

A Materiality Scrape provision excludes and disregards all materiality qualifiers contained in sellers reps and warranties.

Renders materiality a nullity.

Thus any violation is a breach.

Example: “For purposes of this Article 12 [indemnification article], any inaccuracy in or breach of any representation or warranty made by the Seller in this Agreement shall be determined without regard to any materiality, Material Adverse Effect or other similar qualification contained in or otherwise applicable to such representation and warranty.”


Indemnification for a Contract Party’s

Acts – a Necessity?

• One issue to consider is whether a seller should be required to indemnify the buyer against claims the buyer has against the seller itself (as opposed to buyer indemnification rights for third party claims involving a seller’s breach of representations/warranties or covenants).

• This argument is that the buyer has a contract claim against the seller for breaches of the contract, so why do they also need indemnification? While there may be some sound principles in a seller making this point, most buyers will reject it and want the comfort of indemnification.


What does “to indemnify” mean?

A leading commentator on drafting contracts, Kenneth

Adams, has cited a Black’s Law Dictionary’s definition:

1. “To reimburse (another) for a loss suffered because of

a third party’s or one’s own act or default. . . . “

Adams, Kenneth A. A Manual of Style for Contract

Drafting, 2nd ed., Section 12.131.


Do not forget “Defend”

(if you are the indemnitee)

• Most indemnification provisions contain the introductory clause “Seller hereby

indemnifies, holds harmless and will defend” or some variation of these words.

• The “defend” magic word is very important, because it is shorthand that the buyer will

not only be reimbursed for losses from a seller breach of its

representations/covenants, but also that the seller will defend the buyer against

litigation.

• As Kenneth Adams notes, however, it is best to provide for this in more detail in a

provision regarding defense procedures so what was intended by the parties is as

clear as possible: “[y]ou’d be better off omitting it [the word ‘defend’] and instead

addressing in the provisions governing indemnification procedures how defense of

nonparty claims is to be handled.” Adams at Section 12.147.

• Despite Adams’ suggestion, we would not advise removing the word “defend” from

the introductory clause as, even if it seems redundant when a detailed indemnification

procedure exists in the agreement, it unambiguously signals to anyone trying to

interpret the indemnification provision what was intended by the parties at the

beginning of the indemnification section.


“Buyer Party” Term

• Attorneys need to think carefully about who is entitled to

indemnification.

• A Buyer will argue for anyone potentially related to

Buyer having the right to be indemnified for Seller’s

breaches and the consequences flowing from the breach.

• The Seller needs to consider how much including everyone

in the Buyer’s world could potentially significantly increase

not only total indemnification exposure, but the number of

indemnification claims that may be made.


“Adverse Consequences” Term

• This is an exceptionally buyer-favorable definition because it

covers all aspects of loss or damage, including attorney’s fees,

that the Buyer Parties may incur in connection with a Seller

breach.

• Sellers may want to try to place some limits on the breadth of

this definition, or at least consider this definition’s expansive

coverage, in light of any baskets or caps that Seller is able to

negotiate (as discussed below) to limit Seller’s overall

indemnification liability.


Drafting Indemnification Procedures

• As noted above, this provision covers the defense of

indemnification claims by the indemnitor (the Seller for our

discussion).

• These procedures can involve a fair amount of negotiation,

including how quickly indemnification claims must be made to

the Seller, who chooses counsel for the related legal work, who

pays for counsel (again, it is best to be clear that the Seller is

required to defend the Buyer Parties), and rights of the Seller

to settle different types of claims (monetary, equitable,

contract versus tort, for example).


Set-Offs of Purchase Price

Promissory Notes

• As is common, a Buyer will pay a portion of the purchase price

in a promissory note. One way for the buyer to quickly be

“reimbursed” for an indemnification claim and related

expenses is to permit the buyer a right of set off under that

note. This would reduce the balance of the purchase price

(and the accruing interest) that Buyer must pay Seller.

• Sellers often resist this because, while it is not money out of

pocket, it may encourage Buyer indemnification claims because

it is such an easy remedy for Buyer to use.


Escrows of a Portion of the

Purchase Price

• This is another heavily negotiated concept. Particularly for

potentially large liabilities discovered in due diligence such as taxes

and environmental matters, a Buyer may insist that a portion of the

purchase price be escrowed for a period of time.

• The Seller will resist this, especially if it is for a large percentage of

the total purchase price and for a lengthy time period. One way to

mitigate the harshness of an escrow is for it to “burn-off” and be

paid the Seller in installments, either after certain events occur or

based on the lapse of time periods.

• One issue both parties must carefully consider is who will serve as

escrow agent. It has become less desirable for the attorneys for one

party to serve as escrow agent than it has in the past, so a true third

party, such as a bank, may need to be retained.


Baskets and Caps- Limiting Seller

Liability

• A “basket” refers to the threshold dollar value of

indemnification claims that must be made before a Buyer can

actually obtain payment (or set-off) from Seller.

• The purpose of baskets is to prevent Buyers from making

repeated claim for a few thousand dollars that need to be

addressed, a time-consuming and possibly costly process for

Seller. In effect, the amount below the “basket” threshold is a

deductible.

• For example, if Buyer is purchasing a Selling Shareholder’s

stock for $2,000,000, the parties may agree to an

indemnification “basket” that Buyer may not submit

indemnification claims to Seller unless they total in excess of

$75,000. Copyright 2016, Matthew A. Cole and Neal A. Jacobs, Jacobs Law Group, PC 47

Baskets and Caps- Limiting Seller

Liability (Cont’d.)

• Once the Buyer exceeds this threshold, the parties will need to

provide for whether the Buyer’s claims are from the first dollar or

whether the $75,000 is a true deductible, meaning that the Buyer

can only make indemnification claims, and be paid for them, for

amounts exceeding $75,000.

• The parties may negotiate different baskets and deductibles

depending on the type of claim. (e.g., tax versus employee benefits)

• A cap is another tool by which Seller’s limit their indemnification

liability. This allows the Seller to have a pre-determined maximum

liability amount for all indemnification claims, third party or direct,

of Buyer. There may be multiple caps or even sub-caps, depending

on the type of indemnification claim made.


Stafford Webinar

February 4, 2016


Allen Sparkman

SPARKMAN + FOOTE LLP

1616 17th St., Ste. 564 P.O. Box 609

Denver, CO 80202 Houston, TX 77204

303.396.0230 (voice) 713.401.2922 (voice)

303.748.8173 (cell) 713.859.7957 (cell)

1.720.600.6771 (fax) 1.218.783.6986 (fax)

[email protected] www.sparkmanfoote.com

mailto:[email protected]

mailto:[email protected]

http://www.sspattorneys.com/

Stock Purchase Agreements—Representations

and Warranties—Sandbagging

SPARKMAN + FOOTE LLP 50

Assume Seller represents that Seller has $10,000,000 of

product in inventory. In the course of due diligence, Buyer

learns that Seller’s inventory is actually only $8,000,000.

Will Buyer nevertheless be permitted to recover on a claim

that Seller has breached this representation?




This will depend on whether their agreement

contains or does not contain an anti-sand-

bagging provision and what law applies.




The Private Target Mergers and Acquisitions

Deal Points Study (M&A Committee, ABA

BLS) reports that 41% of the deals it

reviewed included a provision permitting

sandbagging, that 10% included a

prohibition and that 49% were silent.




If the agreement is silent, the law of some states, e.g.,

Colorado, would say that Buyer could not recover because,

knowing before closing of Seller’s misrepresentation, Buyer

could not have relied on Janie’s representation. Associates

of San Lazaro v. San Lazaro Park Properties, 864 P.2nd

111 (Colo. 1993) (Buyer discovered inaccuracies due to its

own independent investigation after signing and

consequently did not rely on the seller’s information at

closing and thus waived its warranty claim).




Delaware courts hold that the warranties and

representations in a purchase and sale agreement serve

an important risk allocation function and that, accordingly, a

seller’s breach of its representations and warranties

constitutes a breach of contract and does not require the

buyer to demonstrate reliance. Universal Enterprise

Group, L.P. v. Duncan Petroleum Corporation, (Case No.

4948-VCL, Del. Ch. 2013).




State law treatment of sandbagging claims depends on

whether the state treats breach of a representation or

warranty as a tort or as a breach of contract. See generally,

Charles K. Whitehead, “Sandbagging: Default Rules and

Acquisition Agreements”, 36 Del. J. Corp. L. 1081 (2011).

Tax Benefitting Claims


Buyers should resist seller requests to

“tax-benefit” any claims paid by the

seller to the Buyer.


A common ploy by Sellers is to assert that if the Seller has to pay a claim made

by the Buyer, the Seller’s payment should be reduced by the tax benefit the

Buyer receives from the payment. The Private Target Mergers and

Acquisitions Deal Points Study (hereafter, “Deal Points Study”) reports that

52% of deals provided for a reduction in the Seller’s liability for the tax benefit

to the Buyer. Moreover, according to the Deal Points Study, 44% of deals

included an express requirement that the Buyer mitigate losses. A mitigation

requirement may well include an obligation to maximize tax benefits. A

representative purchase and sale agreement contained this simple provision:

“For purposes of this Agreement, any determination of Losses shall be reduced

by any Tax Benefits actually received by the Indemnified Party.” An obligation

on the part of the Buyer to take tax benefits into account raises several

questions.



The Seller’s tax benefit argument is basically that it is unfair to the Seller to

allow the Buyer to receive a gross indemnification payment and also to be able

to enjoy the tax benefit arising from the circumstances upon which the Buyer’s

indemnification claims are based. For example, if the Seller has represented

that there are no closing date liabilities other than those disclosed, but it is later

discovered that there was an undisclosed pre-closing payable of $1,000, the

Buyer would have a breach of representation claim for $1,000, If the Seller

paid the Buyer a $1,000 indemnification payment because of this claim, the

Seller argues that the Buyer could also claim an expense deduction on its

income tax return with respect to this pre-closing liability that would save the

Buyer (at the 35% rate) $350 of federal income tax.



The problems include that the Buyer most likely will not be able to deduct its

payment but, instead, will have to include it as a capital cost of purchasing the

Seller’s assets or equity. There are some provisions in the regulations under

IRC § 461 that appear to allow a buyer to deduct a liability where the target

sells buyer a trade or business and, as part of the sale, buyer “expressly

assumes” a liability described in IRC § 461(h), but it appears unlikely that a

buyer would be considered to have “expressly assumed” the liability it pays

because of the seller’s misrepresentation. Another significant problem is what

happens if a dispute arises between the Buyer and Seller with respect to

whether the Buyer realized a tax benefit and, if so, how much. Will the Seller

be permitted to examine the Buyer’s income tax returns? Will the Seller be

able to require the Buyer to take a position on its tax return that may

disadvantage the Buyer in some way?


Overview of Tax Considerations

A fundamental issue is whether the parties wish to structure the transaction as

one that will be wholly or partially tax-free:

Acquisition for all cash or partly cash and debt will be taxable. Sellers ordinarily will have long-term capital gain except for recapture items.

Buyer will obtain cost basis in stock or assets acquired.

Special considerations if stock of S corporation is acquired.

Acquisition for Buyer’s stock may be tax-free.

Incorporation on eve of acquisition to attempt to have tax-free treatment.


Overview of Tax Considerations

Taxable acquisition Buyer will ordinarily want to acquire assets

Tax basis in assets rather than acquired stock

Avoidance of seller liabilities

Seller of course will ordinarily prefer sale of stock.

Combination of taxable acquisition and tax-free incorporation As an inducement to senior owners/management, the buyer may arrange an opportunity for

such persons to participate in the formation of an affiliate of the buyer in a transaction that is

intended to be tax-free under IRC § 351.


Tax-Free Reorganizations

Of the 8 different types of tax-free reorganizations (Section 368 of the Internal Revenue Code), the most common are:

Type A reorganization (incl. statutory direct merger or consolidation; forward and triangular mergers)

Type B reorganization (stock-for-stock acquisition)

Type C reorganization (stock-for-assets acquisition)

Type D divisive reorganization (spin-offs, split-offs, and split-ups)


TAX-FREE REORGANIZATIONS

Four conditions must be met:

Continuity of ownership interest (usually satisfied if

purchase price at least 50% acquirer stock) (may

be as low as 40% in some circumstances)

Continuity of business enterprise (“substantially all

requirement” usually satisfied if buyer acquires at

least 70% and 90% of FMV of target gross and net

assets)

Valid business purpose (other than tax avoidance)

Step transaction doctrine (must not be part of larger

plan that would have resulted in a taxable

transaction)


Type A Reorganization

To qualify as a Type A reorganization, transaction must be a statutory merger or consolidation; forward or reverse triangular merger

No limits on composition of purchase price (except in reverse triangular merger)

No requirement to use acquirer voting stock (except in reverse triangular merger)

At least 50% of the purchase price must be in acquirer stock


Type A Reorganization (cont.)

Advantages:

Acquirer can issue non-voting stock to target shareholders without diluting its control over the combined companies

Acquirer may choose not to acquire all of the target’s assets

Allows use of more cash in purchase price than Types B and C reorganizations

Disadvantages:

Acquirer assumes all undisclosed liabilities

Requires acquirer shareholder approval if new shares are to be issued or number of new shares exceeds 20% of the firm’s shares traded on public exchanges.

Limitations of asset dispositions within two years of closing


Purpose: To ensure that subsidiary mergers do not resemble sales, making them taxable events

Continuity of interests: A substantial portion of the purchase price must consist of acquirer stock to ensure target firm shareholders have a significant ownership position in the combined companies

Continuity of business enterprise: The buyer must either continue the acquired firm’s “historic business enterprise” or buy “substantially all” of the target’s “historic business assets” in the combined companies. Continued involvement intended to demonstrate long-term commitment by acquiring company to the target.

1These principles are intended to discourage acquirers from buying a target in a tax free transaction and immediately selling the target’s assets, which would reflect the acquirer’s higher basis in the assets possibly avoiding any tax liability when sold.

Continuity of Interests and Business Enterprise Principles1


Direct Statutory Merger (“A”

Reorganization)

Acquiring Firm

Target Firm (

(assets and liabilities merged

with acquirer)

Target Shareholders

(Receive voting or

nonvoting acquirer stock

in exchange for target stock

and boot)

Assets &

Liabilities

Acquirer Stock &

Boot

Target Stock

Contracts may need to be assigned or transferred. Under some state laws, e.g. C.R.S § 7-90-204, a merger does

not constitute a conveyance, transfer, or assigment. Remaining target assets/liabilities assumed by acquirer;

acquirer & target shareholder approval required in most states; dissenting shareholders may have appraisal rights.

No asset write-up. Target’s tax attributes transfer to acquirer but are limited by Section 382 and 383 of Internal

Revenue Code (IRC). SPARKMAN + FOOTE LLP 67

Statutory Consolidation (“A” Reorganization)

Company A

(Contributes assets &

liabilities to Newco)

Company B

(Contributes assets &

Liabilities to Newco)

Company A

Shareholders

Company B

Shareholders

New Company

(Newco)

Assets/Liabilities

Newco Stock

Comment same as Slide 20.


Forward Triangular Merger (“A” Reorganization)

Acquiring Company

Subsidiary (Shell created by parent and funded by parent’s cash or stock)

Target Firm (Merges assets

and liabilities with the parent’s wholly-owned

subsidiary)

Target Shareholders (Receive voting or nonvoting stock held by parent’s wholly

owned subsidiary in exchange for target stock)

Parent’s Stock & Boot

Target Assets and Liabilities

Subsidiary’s Stock

Parent’s Stock/Cash

“Substantially all” and “continuity of interests” requirements apply. Flexible form of payment. Avoids transfer taxes and may insulate parent from target liabilities and eliminate acquirer shareholder approval unless required by stock exchange or new shares issued exceed 20% of acquirer’s outstanding shares. No asset writeup. Target tax attributes transfer but subject to limitation. Target shareholder approval required. However, as target eliminated, nontransferable assets and contracts may be lost.

Target Stock


Reverse Triangular Merger (“A” Reorganization)

Acquiring Company

Subsidiary (Shell created by parent and funded by

parent’s voting stock merged into target firm)

Target Firm (Receives assets and liabilities of acquiring

firm’s wholly owned subsidiary)

Target Shareholders (Receive parent’s voting stock

held by parent’s wholly owned subsidiary in

exchange for target stock)

Parent’s Stock & Boot

Subsidiary’s Assets and Liabilities

Subsidiary’s Stock

Parent’s Voting Stock

Target survives as acquirer subsidiary. Target tax attributes and intellectual property and contracts transfer automatically; may insulate acquirer from target

liabilities and avoid acquirer shareholder approval. At least 80% of purchase price must be in acquirer voting shares. No asset writeup. Acquirer must buy

“substantially all” of the FMV of the target’s assets and target tax attributes transfer subject to limitation.

Target Stock


Type “B” Stock for Stock Reorganization

To qualify as a Type B Reorganization, acquirer must use only

voting stock to purchase at least 80% of the target’s voting stock and at least 80% of the target’s non-voting stock

Cash may be paid in lieu of fractional shares

Acquirer may pay expenses of target if creditor paid directly.

Used mainly as an alternative to a merger or consolidation

Advantages:

Target may be maintained as an independent operating subsidiary or merged into the parent

Stock may be purchased over a 12 month period allowing for a phasing of the transaction (i.e., “creeping acquisition”)

Disadvantages:

Lack of flexibility in determining composition of purchase price

Potential dilution of acquirer’s current shareholders’ ownership interest

May have minority shareholders if all target shareholders do not tender their shares


Type “B” Stock for Stock Reorganization

Acquiring Firm

(Exchanges voting

shares for at least 80%

of target voting & non-

Voting shares”)

Target Shareholders

Wholly-Owned

Shell Subsidiary

Target Firm

(Merged into acquiring

firm’s subsidiary)

Target Stock

Acquirer Voting Stock

(No Boot)

Buyer need not acquire 100% of target shares, shares may be required over time, and may insulate acquirer from

target liabilities. May insulate parent from target’s liabilities and tax attributes transfer subject to limitation. Suitable

for target shareholders with large capital gains and therefore willing to accept acquirer shares to avoid capital

gains taxes triggered in a stock for cash sale.

Target Assets

and Liabilities

Shell

Stock


Type “C” Stock for Assets Reorganization

To qualify as a Type C reorganization, acquirer must purchase 70% and 90% of the fair market value of the target’s gross and net assets, respectively.

The acquirer must use only voting stock

Boot cannot exceed 20% of FMV of target’s pre-transaction assets (value of any assumed liabilities deducted from boot)1

The target must dissolve following closing and distribute the acquirer’s stock to the target’s shareholders for their canceled target stock

Advantages:

Acquirer need not assume any undisclosed liabilities

Acquirer can purchase selected assets

Disadvantages:

Technically more difficult than a merger because all of the assets must be conveyed

Transfer taxes must be paid

Need to obtain consents to assignment on contracts

Requirement to use only voting stock potentially resulting in dilution of the acquirer shareholders’ ownership interest

1Value of assumed liabilities viewed as part of purchase price.


Type “C” Stock for Assets

Reorganization Acquiring Firm

(Exchanges voting shares

for at least 80% of FMV of

Target assets)

Target Firm

(Liquidates and transfers

Acquiring Firm shares and

any remaining assets

to shareholders)

Target Shareholders

Acquirer Voting

Stock & Boot

Target Assets

Acquirer Voting

Stock & Boot

Enables buyer to be selective in choosing assets and any liabilities, if at all, it chooses to assume. Avoids

transfer taxes, requires consents to assignment, and potentially dilutive to acquirer shareholders. No asset

writeup. Tax attributes transfer to acquirer subject to limitation.

Target

Cancelled

Stock


Type D Divisive Reorganizations

Type D Divisive Reorganizations apply to spin-offs, split-ups, and

split-offs

Spin-Off: Stock in a new company is distributed to the original

company’s shareholders according to some pre-determined formula.

Both the parent and the entity to be spun-off must have been in

business for at least five years prior to the spin-off.

Split-off: A portion of the original company is separated from the

parent, and shareholders in the original company may exchange

their shares for shares in the new entity. No new firm created.

Split-up: The original company ceases to exist, and one or more

new companies are formed from the original business as original

shareholders exchange their shares for shares in the new

companies.

For these reorganizations to qualify as tax-free, the distribution of

shares must not be for the purpose of tax avoidance. SPARKMAN + FOOTE LLP 75

Implications of Tax Considerations for Deal Structuring

In taxable transactions, target generally demands a higher purchase price

Higher purchase price often impacts form of payment as buyer tries to maintain PV of transaction by deferring some of purchase price

Buyer may avoid EPS dilution by buying target stock or assets using a non-equity form of payment in a taxable transaction

If buyer wants to preserve cash and obtain target’s tax credits, buyer may use its stock to purchase target stock in a non-taxable transaction


Purpose: To ensure that subsidiary mergers do not resemble sales, making them taxable events

Continuity of interests: A substantial portion of the purchase price must consist of acquirer stock to ensure target firm shareholders have a significant ownership position in the combined companies

Continuity of business enterprise: The buyer must either continue the acquired firm’s “historic business enterprise” or buy “substantially all” of the target’s “historic business assets” in the combined companies. Continued involvement intended to demonstrate long-term commitment by acquiring company to the target.

1These principles are intended to discourage acquirers from buying a target in a tax free transaction and immediately selling the target’s assets, which would

reflect the acquirer’s higher basis in the assets possibly avoiding any tax liability when sold.

Continuity of Interests and Business Enterprise Principles1


Acquiring (Transferee)

Corporation

No gain/loss recognized when it receives

assets in tax-free reorganization

Carryover basis of qualifying property

Gain recognized lesser of gain realized or

FMV of nonqualified property received

Carryover holding period


Shareholders & Security

Holders

(1 of 2)

No gain/loss on stock or securities

received if exchanged solely for stock or

securities as part of reorganization plan

Gain recognized lesser of gain realized or

cash plus FMV of other property received


Shareholders & Security

Holders

(2 of 2)

Basis of stocks & securities received

Adjusted basis in stocks & securities given

up

+ Gain recognized on the exchange

- Money & FMV of other property received

= Basis of nonrecognition property received


Divisive Reorganizations

Part of corporation’s assets transferred to

a second corporation which is owned by

either the original corporation or its

shareholders

Divisive D reorganizations

Split-off

Spin-off

Split-up


Split-off

Corporation transfers assets to a

controlled subsidiary in exchange for

subsidiary’s stock

Subsidiary’s stock then transferred to one

or more shareholders in exchange for

parent corporation stock


Spin-off

Corporation transfers assets to subsidiary

in exchange for subsidiary’s stock

Parent distributes subsidiary’s stock to all

parent shareholders on a pro rata basis

Parent receives nothing in exchange for

distribution of subsidiary stock


Split-up

Existing corporation transfers all assets to

two or more new controlled subsidiaries in

exchange for subsidiaries’ stock

Parent distributes all stock of each

subsidiary to existing shareholders in

exchange for all outstanding parent stock

and liquidates


Judicial Restrictions on

Reorganizations (1 of 2)

If judicial restrictions are not met,

reorganization loses its tax-free status

Continuity of proprietary interest

Old owners must continue ownership

Continuity of business enterprise

Old assets must be used in new business


Judicial Restrictions on

Reorganizations (2 of 2)

Business purpose

Valid business purpose for transaction

Step transaction doctrine

IRS may collapse series of independent

transactions if all part of same plan


Tax Attributes

Tax attributes follow assets

NOLs, capital losses, E&P, general business

credit, inventory methods

Acquiring corporation obtains control of

both assets & attributes in A, C, and

acquisitive D reorganizations

Asset ownership does not change in B

reorganizations


Limitation on Use of Tax

Attributes (1 of 2)

§§382 & 269 prevent assets or stock

purchases if primary purpose is obtaining

loss carryovers

§§382 & 269 also prevent a loss

corporation from purchasing a profitable

corporation if primary purpose is using its

existing losses


Limitation on Use of Tax

Attributes (2 of 2)

§383 restricts tax credit and capital loss carryovers if

§382 applies

Restrictions similar to NOLs

§384 prevents pre-acquisition losses of either acquiring

or target corporation (loss corporation) from offsetting

built-in gain recognized during 5 yrs after acquisition by

another corporation (gain corporation).


Incorporation on Eve of

Acquisition ( 1 of 22)

Only corporations may engage in tax-free

reorganizations under IRC § 368.

A target LLC may want to incorporate to

be able to engage in a tax-free

reorganization.



Acquisition ( 2 of 22) Incorporation of an LLC ordinarily will be

tax-free under IRC § 351.

IRC § 351 requires, inter alia, that “[n]o

gain or loss shall be recognized if property

is transferred to a corporation by one or

more persons solely in exchange for stock

in such corporation and immediately after

the exchange such person or persons are

in control . . . of the corporation.” SPARKMAN + FOOTE LLP 91



Section 351 defines “control” as the

ownership of stock possessing at least 80

percent of the total combined voting power

of all classes of stock entitled to vote and

at least 80 percent of the total number of

shares of all other classes of stock of the

corporation.




Incorporations on the eve of a stock swap or initial

offering may raise questions under the step-transaction

doctrine regarding whether the incorporators had control

“immediately after” the incorporation. If an LLC converts

to a corporation, it will be treated for federal income tax

purposes as a transfer of all the assets of the LLC to the

corporation in exchange for the stock of the corporation,

followed by liquidation of the LLC and distribution of the

stock to its members.




If the members of an LLC enter into a

stock exchange agreement with another

corporation after converting the LLC to a

corporation, the IRS may seek to treat the

transaction as a taxable exchange of the

acquirer’s stock for LLC interests by

invoking the step transaction or substance

over form doctrines.




In such a case, the IRS would assert that

the LLC members did not actually acquire

control of the corporation formed by

converting the LLC to a corporation, but

rather never had control because they

received the stock of the resulting

corporation as part of a pre-conceived

plan to transfer the stock in the stock

exchange with the public acquiring

corporation. SPARKMAN + FOOTE LLP 95



S. Klien on the Square, Inc. v. Comm’r, 188 F.2d 127 (2d Cir. 1951),

cert. denied, 342 U.S. 824 (1951); Hazeltine Corp. v. Comm’r, 89

F.2d 513 (3d Cir. 1937); Intermountain Lumber Co. v. Comm’r, 65

T.C. 1025 (1976); Rev. Rul. 1979-194, 1979-1 C.B. 145; Rev. Rul.

1979-70, 1979-1 C.B. 144; Rev. Rul. 1970-522, 1970-2 C.B. 81; see

also, e.g., Abegg v. Comm’r, 429 F.2d 1209; King Enters., Inc. v.

Comm’r, 418 F.2d 511 (Ct. Cl. 1969); McDonald’s Rests. of Illinois,

Inc. v. Comm’r, 688 F.2d 520 (7th Cir. 1982); Rev. Rul. 2001-26,

2001-1 C.B. 1297 (all applying step transaction principles to a series

of events taking place over several months).




The regulations under § 368 take seriously

the business-purpose requirement. Treas.

Reg. § 1.368-1(b) states that the

reorganization provisions are concerned

with “readjustments of corporate structures

. . . required by business exigencies.”




Treas. Reg. § 1.368-1(c) provides that a

scheme that involves an abrupt departure

from normal reorganization procedure in

connection with a transaction on which the

imposition of a tax is imminent is not a

plan of reorganization.




This would include a transaction where the

corporate reorganization was considered a

disguise for concealing its real character,

where the object and accomplishment is

the consummation of a preconceived plan

having no business or corporate purpose

other than tax avoidance.




See also Treas. Reg. § 1.368-2(g), which

states that the transactions must be

“undertaken for reasons germane to the

continuance of the business of a

corporation,” and that the statute

“contemplates genuine corporate

reorganizations which are designed to

effect a readjustment of continuing

interests under modified corporate forms.”




To make an LLC reorganization as a corporation

work, the conversion to the corporate form must

be done before an agreement is reached about

the sale; the corporation’s existence should be

at least somewhat “old and cold.” The

conversion of the partnership or LLC to a

corporation should not be completed on the eve

of entering into the stock exchange agreement.




In Weikel v. Commissioner, 51 TCM 432

(1986), a taxpayer transferred a patent he

owned personally to a newly formed

corporation, Dispersalloy, Inc., and then

four months later entered into an

Agreement and Plan of Reorganization for

a share-for-share exchange (similar to a

type B reorganization).




The Tax Court held that the taxpayer had

a substantial business purpose for the

formation of Dispersalloy, Inc. and the

transfer of his patent to it in September

1973. In this case, the taxpayer was in

negotiations with Johnson & Johnson at

the time of formation of his corporation. He

was also talking to other potential

acquirers at the time. SPARKMAN + FOOTE LLP 103



Perhaps most importantly for the

determination of a “business purpose,” the

taxpayer’s attorney had advised him that

he should incorporate whether or not he

did a deal with Johnson & Johnson since:




It was clear that any acquirer would want

to structure an acquisition of the

taxpayer’s business so that it could be

treated as a pooling of interests; and

It made sense to incorporate because the

taxpayer’s business was beginning to

generate profits.




In objecting to the non-recognition of gain

on the appreciated asset (the patent), the

IRS relied on West Coast Marketing Corp. v.

Commissioner, 46 T.C. 32 (1966), and Rev.

Rul. 1970-140, 1970-1 C.B. 73. The court in

Weikel distinguished West Coast Marketing

on the grounds that:




1) The taxpayer in West Coast Marketing

transferred real estate to a new

corporation solely to facilitate a transfer to

an unrelated corporation;

2) All of the detail of the transfer to the

acquiring corporation had been agreed on

at the time of the transfer; and




3) The taxpayer’s corporation was

liquidated soon after the acquisition.




Likewise, the court distinguished Rev. Rul.

1970-140 on the basis that the taxpayer in

the ruling had already agreed to transfer

the stock of the new corporation before the

taxpayer incorporated it and transferred

property to it. In both cases, the new

corporation was not “old and cold” before

the transaction was finalized.




Weikel illustrates the importance of

establishing a business purpose for the

incorporation of the LLC apart from the

potential acquisition and incorporating the

LLC before there is a binding agreement

to dispose of the shares received by the

members.




Interestingly, in a case arising out of the

same transaction that was held in

abeyance pending the decision in Weikel,

Johnson & Johnson argued that its

acquisition of Dispersalloy should be

treated as a taxable purchase. Johnson &

Johnson wanted a cost basis.


Corporate Inversions The basic concept of an inversion is a

transaction in which a United States parent

becomes a subsidiary of a new foreign

parent corporation (“NFP”).

If done alone under NFP, it is a “self-inversion”

If done in connection with a target (typically

foreign), it is a combination migration

transaction


Corporate Inversions

Inversions offer four main areas of

potential tax benefits: Future foreign expansion under NFP outside of U.S. tax “net.”

Tax efficient leverage on the group’s U.S. operations.

Restructuring of foreign legacy operations owned by the U.S.

group.

Better access to offshore cash for NFP dividends, share

buybacks, etc.



The IRS issued regulations under IRC §

367 in the mid 1990’s that require in self-

inversions and other combination

transactions that the U.S. shareholders of

the U.S. parent recognize gain (but not

loss) on the exchange of their U.S. parent

stock for stock of NFP.



In 2004, Congress added section 7874 to

the IRC to limit inversion transactions

(mostly self inversions) not at the

shareholder level with a tax (although

those rules were retained) but at the NFP

level (and sometimes at the U.S. parent

level.



Section 7874’s main weapon is to treat the

NFP as a domestic corporation for all U.S.

tax purposes if three conditions are met:



The three conditions are: A foreign corporation acquires substantially all of the

assets or stock of a domestic corporation or

partnership;

Former equity holders of the U. S. company own

more than 80% of the NFP; and

The overall group, tested after the deal, does not

have “substantial business activities in the country

where the NFP is incorporated.



If the above three conditions are met except that former

equity owners of the U.S. company own 60% or more

but less than 80% of the stock of the NFP, an excise tax

is imposed on the untaxed value of officers’ and

directors’ stock-based compensation, and limits are

placed on the use of the U.S. company’s tax attributes

with respect to transactions with the NFP and other

related foreign corporations.


Corporate Inversions-IRC §

7874 Example

Canadian Newcorp, publically traded on

Toronto stock exchange, acquires all of

the membership interests of a domestic

LLC taxed as a partnership.



7874 Example

Canadian Newcorp, as a result of section

7874 is treated as a U.S. corporation for

all purposes of U.S. taxation.

But is still a Canadian corporation as far

as Revenue Canada is concerned.



7874 Example

Canadian shareholders who receive

dividends from Newcorp are taxable in

U.S.

Revenue Canada views them as having

received dividends from a Canadian

corporation.



7874 Example

Unclear of effect on this of U.S.-Canada

income tax treaty.

Shareholders may have to rely on foreign

tax credits to be made whole.


Securities Law Issues in

Stock Purchase

Transactions

Matthew A. Cole




Sales of 100% of a Corporation’s Stock

are Securities Offerings…? Yes.

Copyright 2016, Matthew Cole, Jacobs Law Group, PC

• If you are selling some or all of the stock you own in a

corporation, you are engaging in a securities offering.

• The United States Supreme Court in Landreth Timber Co. v.

Landreth, 471 U.S. 681 (1985) ruled that a sale of a business

structured as a stock purchase involved the sale of a security

under federal securities law.

• Note that in an asset sale, this issue does not arise.

124

Other Equity Sales and the

Securities Laws


While the courts and regulators have sometimes held that

other types of equity interests, such as membership interests in

limited liability companies, are not “securities” under federal

or state law, it is prudent to treat all equity sales of a

business as securities offerings.

125

Consequences for Sellers and

Buyers


• Unless there is an applicable exemption from registration,

securities offerings and sales must be registered with the Securities

and Exchange Commission and possibly state regulators, a costly,

time-consuming process.

• Sellers need to conduct some due diligence regarding their

buyers.

• Sellers may want to obtain various securities exemption-related

representations and warranties from buyers to qualify for

particular exemptions.

126

Consequences for Sellers and

Buyers (Con’t.)


• If the buyer is a private equity fund or other institutional purchaser, it is much

easier to handle this issue because the financial strength of the buyer will often

determine whether various securities registration exemptions apply.

•There may also be added complications if the purchaser is not an accredited

investor (someone who meets certain minimum income or asset (other than

primary home) requirements). The available securities exemptions may be

limited or less certain to apply if the purchaser is not an accredited investor.

• If the sale of the business is a securities offering, the sale is subject to the anti-

fraud rules of the federal and state securities laws, such as Rule 10b-5. These

concern whether the seller has disclosed all material information that would be

of interest to an investor regarding the stock and the underlying business being

sold.

127


• Attorneys are often surprised to learn that a purchase price

promissory note is a security.

• Purchase price promissory notes may seem different from a

bond or other debt securities because they often are secured

notes, the collateral being the stock sold, and thus do not “feel”

like securities.

• However, , promissory notes generally are securities. This is

because the Securities Act of 1933, which regulates the offer

and sale of securities in the United States, includes the term

“notes” in its laundry list of “securities.”

Are Purchase Price Notes

Securities? Generally, Yes.

128


• A United States Supreme Court case, Reves v. Ernst & Young, 494 U.S.

56 (1990), provides that notes are presumed to be securities unless

they meet one of four factors in a “family resemblance test.”

• The application of the test centers on whether the note seems more

like an investment or is more similar to non-investment commercial

instruments. For example, home mortgage notes and notes made by

small business borrowers secured by the business’ assets are not

securities.

• There are gray areas here that may be difficult to analyze, so careful

consideration is necessary regarding the nature of the purchase price

promissory note.

The Supreme Court on Notes as

Securities

129


Purchase Price Notes as Securities

• The note offering may raise more securities law compliance issues than the

stock sale itself raises.

• One reason for this is the nature of the seller versus the buyer. A single

buyer, even an individual, who is purchasing all stock of a corporation may

be more likely to qualify for various accredited investor-related exemptions

than a group of sellers.

• If there are multiple individual sellers of stock, some of those sellers may own

a small portion of the outstanding stock and may not have the financial

qualifications to be sophisticated investors.

• An adult grandchild who inherited a few percent of the stock in a closely

held corporation or an employee of the seller would be simple examples of

sellers who might not qualify as accredited investors.

130


Purchase Price Notes as Securities

(Con’t.)

• Unless there is an applicable exemption from registration, securities

offerings and sales must be registered with the Securities and

Exchange Commission and possibly state regulators, a costly, time-

consuming process.

• Buyers need to conduct some due diligence regarding their sellers for

these reasons.

• Buyers may also want to obtain representations and warranties from

sellers regarding whether they are accredited investors as well as on

other securities law-related matters. The existence of non-accredited

investor can result in difficulties in finding appropriate securities law

exemption.

131

Paying Brokers or Finders Fees in a

Stock Sale


• Securities regulators have historically treated a finder’s fee or

other payment tied to the sale of stock as an impermissible finder’s

fee.

• To be eligible to receive these fees, a finder would have needed

to register as a broker-dealer or affiliate with one under

applicable securities laws.

• This, however, is not only the finder’s problem. A buyer might be

able to have a stock sale unwound because of the involvement of

a finder not registered as a broker dealer.

• This issue does not arise in an asset sale.

132

Limited SEC Relief for M&A

Finders


• A few years ago, the SEC issued a no-action letter (interpretive guidance that

is only applicable to the person who requested the letter but is often used as

persuasive authority) relaxing its position that all finders involved in stock sales

need to register as broker-dealers. M&A Brokers, 2014 SEC No-Act. LEXIS 92

(Jan. 31, 2014, revised Feb. 4, 2014).

• The finder does not need to register if a number of criteria are met, including:

The finder must not have any authority to bind any parties in the

transaction

Following the transaction, the buyer must control and actively operate

the business purchased through the stock sale

The finder must not take possession of funds or securities involved in the

transaction

The finder must not provide financing for the transaction or assist in

forming any buyer group involved in the transaction.

133

Drafting Mistakes in

Stock Purchase

Agreements

Matthew A. Cole




(Some) Drafting Mistakes in Stock

Purchase Agreements


• Many drafting mistakes are the same as those that tend to occur in

commercial contracts generally.

• “Boilerplate” and “Miscellaneous” sections of stock purchase

agreements should be read more carefully than they generally are.

For example, if you have a somewhat outdated notice provision in

your stock purchase agreement, e.g., one that does not provide for

at least fax, and more preferably, email notices and communications,

you need to consider whether that is appropriate for your type of

deal.

• Likewise, consider the strong financial impact that some provisions

often appearing in the “miscellaneous” section, such as “loser pays”

and poorly drafted arbitration clauses may have on your client in a

stock purchase transaction.

135

Providing for venue in a jurisdiction

differing from the governing law


While occasionally parties may have a reason for having different

state governing law and state jurisdiction, it is not typically a good

“compromise” to provide for Delaware governing law and a venue

in New York or California. This is because one does not usually

want a court in a particular state ruling on any other law than that

with which it is most familiar.

136

Not obtaining representations and

warranties about the business itself


When purchasing 100% of the outstanding equity securities of an

entity, a buyer should not merely be concerned with

representations and warranties about the securities sold. Because

the buyer is indirectly purchasing the entire business,

representations and warranties regarding the entity itself, such as

its material contracts, financial statements, intellectual property,

compliance with laws, and other common representations and

warranties in an asset purchase agreement are equally valuable

for a buyer in a stock purchase transaction.

137

Failing to define accounting

terminology carefully


Buyers and sellers may want to consider consulting with an

accountant to define properly various accounting terms, such as

“revenue,” “net income” and the like. Consider, for example,

whether these terms should be as defined in GAAP, or Generally

Accepted Accounting Principles.

138

Including Vague Earn-Out Provisions


• Earn-out provisions are difficult to draft. Trying to control how a

business operates after you, the seller, are no longer the

business owner and often not involved in the business post-

closing will be met with strong resistance from the purchaser of

your shares.

• However, not having sufficient control procedures in the stock

purchase agreement may mean that the selling shareholder will

never be able to be certain whether earn-out milestones have

been met or whether a buyer has been able to manipulate the

business’ finances to avoid paying the selling shareholder an

earned earn-out.

139

The date as of which representations

and warranties are being made


If the stock purchase transaction is one in which the agreement is

signed and the closing is some days (or even months later), both

parties need to consider as of which date the representations and

warranties should be made. Most Buyers will want to the

representations and warranties to be true as of both the contract

signing and closing date. Sometimes, stock purchase agreements

do not provide for this.

140

The survival of some or all

representations and warranties

• Even if the drafters of the stock purchase agreement are

careful to provide that the representations and warranties must

be true as of the signing as well as later closing date,

problems may arise for Buyers who do not carefully consider

what representations and warranties should “survive” the

closing date.

• Providing for survival allows the Buyer to discover and make a

claim of breach even if the Buyer discovers post-closing (but

before the expiration of the survival period) that a Seller

representation or warranty was untrue as of the closing date

(or even the signing date).

141 Copyright 2016, Matthew Cole, Jacobs Law Group, PC


representations and warranties (Con’t.)

• A basic contract law principle is that post-closing discovery of

representations and warranty breaches by a Buyer are not

actionable unless provisions have been inserted for the

representations and warranties to “survive” the closing date.

• Some parties will heavily negotiate which representations and

warranties survive and for how long.



representations and warranties (Con’t.)

• As noted above, Buyers may request longer survival period for

the Seller representations and warranties that, if breached,

will be more costly to the Buyer.

• Defective title to stock, taxes, environmental matters, employee

benefits, and finder’s fees are some examples of those more

serious representations and warranties.


Permitting Terms of the Agreement

to be Disclosed

• Most parties to a stock purchase agreement enter into a

confidentiality agreement that with respect to the Seller’s

information and, sometimes, Buyer information that will be

disclosed to the Seller (such as regarding a Buyer’s financial

state).

• Some attorneys do not focus, however, on protecting the

confidentiality of the deal itself. The business the Buyer has just

effectively purchased may be harmed if a disgruntled Seller

can disclose sensitive details about the purchase price and

other deal terms.

• Seller and Buyer should consider mutual non-disclosure

covenants to avoid this problem.


Not Preventing Operational Changes

Between Signing and Closing

• How a business is operated post-signing but pre-closing is

critical.

• Not obtaining covenants from the Sellers that they will cause

the entity they own to operate the business in the normal course

consistent during the period between signing and closing may

lead to unwelcome surprises for the Buyer who now owns a

business that is not nearly as robust as the Buyer thought it was

purchasing.


Failing to Obtain Appropriate

Restrictive Covenants from Sellers

• Failing to obtain non-competition and non-solicitation

covenants from the Seller can be a costly problem that will

result in a loss in value of the business just purchased.

• Likewise, Sellers should be wary of overly restrictive non-

competition and non-solicitation covenants requested by Buyer,

particularly because courts are typically willing to enforce

more stringent restrictive covenants against a seller than they

are willing to permit with respect to an employee.


Not Addressing Required Consents

at the Entity Level Properly

• A Seller will typically be asked to represent that selling the shares does not cause a default under any agreement to which the Seller is a party.

• However, a Buyer will also want to be concerned with agreements, such as leases or financing documents, that the corporation whose shares are being sold is a party to and whether a default or consent is required under those agreements. For example, even though the corporation may be a tenant under a lease and the lease is not being assigned, the lease may contain a provision stating that a change in control of the corporation is deemed to be an assignment requiring landlord consent.


Pitfalls in Using Arbitration

• While not that common, some parties will request that an

arbitration clause be used for all disputes under the stock

purchase agreement. Attorneys will want to carefully consider

whether this is in their client’s best interests.

• Arbitration is not necessarily less expensive or faster than a

courtroom hearing.

• The parties bear the costs of the arbitrators directly, which can

be considerable over time. For example, a panel of three

arbitrators can increase the cost of arbitration exponentially

over the use of a single arbitrator.


Pitfalls in Using Arbitration (Con’t.)

• Arbitration awards are not appealable in the traditional sense as there is no appellate forum typically for an arbitration judgment. Moreover, the standards for asking a court to overturn an arbitration decision are very high and rarely met.

• If not drafted properly, the parties’ expectations about finality of the award may not come to pass, and the parties may end up in court eventually.

• There are many other drafting traps to avoid, such as not including specific confidentiality provisions regarding the process and award, which can be one reason a party desires to use arbitration rather than the court system in the first place.


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