Mergers & Acquisitions: Bargain hunting

Some recent mergers and acquisitions of major aggregate producers may have smaller producers thinking.

Surprisingly in today’s uneven and uncertain economic climate, two recent reports show that mergers and acquisitions (M&A) are on the upswing, with most of the action involving smaller deals (and a couple very large ones in Martin Marietta Materials’ purchase of Texas Industries and the Lafarge/Holcim union). Obviously, not every aggregate producer is in a position to buy, but weak earnings and declining market share create great buying opportunities for good managers.

For many small sand, gravel and crushed-stone business owners/operators, mergers are a way of cutting overhead costs, increasing efficiency, battling a larger competitor or acquiring a permit. M&As are often based on the belief that a profitable, better-managed business can get more out of the assets of an underperforming business than was possible under its current ownership.

Admittedly, most small aggregates businesses tend to grow “organically,” that is by slowly adding customers, employees, new services or products, equipment and physical space. Others grow by merging with or acquiring another operation – or by being acquired. In fact, an economic downturn often creates greater opportunities for buyers to take advantage of depressed business valuations, providing an opportune moment to do a deal.

Mergers and acquisitions typically take one of two forms: an “acquisition,” in which an aggregates business folds a new company into its existing operations (or vice versa, if the business is being acquired), or a “merger” where both businesses are typically dissolved and a new business entity formed or created.

A merger is a tool used by many businesses to expand operations, often aiming at an increase in long-term profitability. Usually, a merger occurs on a consensual basis where the owners/operators/management from the target business help those from the purchaser to ensure that the deal is beneficial and profitable for both parties.

Acquisitions can also happen through a so-called “hostile” takeover by purchasing the majority of outstanding shares of a business in the open market against the wishes of the target company’s management and/or directors. This approach is, however, rare among smaller, privately-held businesses.

Buying a going business
In most cases, buying an existing business is less risky than starting from scratch. When a business is purchased or acquired, the target is usually already generating cash flow and profits. After all, the aggregates operation to be acquired usually has an established customer base and reputation as well as employees who are familiar with all aspects of the business.

On the downside, buying a business is often more costly than starting from scratch. Fortunately, even today it is often easier to get financing to buy an existing business than the funding necessary to start a new one. Bankers and investors generally are more comfortable dealing with a business that already has a proven track record.

Paying for it all
When it comes to financing, there are a number of strategies for financing mergers or acquisitions:

■ Use the seller’s assets. Finance companies, factors (companies that buy accounts receivable) and some investors will lend money based on purchase orders. Factors, finance companies and banks will lend money on receivables. Finance companies and banks often lend money on inventory. Equipment can also be sold and then leased back from equipment-leasing companies.

■ Joint venture. Where an acquisition may be out of reach for one aggregates business, buying in conjunction with another party may make the acquisition affordable. To find a likely partner, ask the seller for a list of those who were interested in the business, but did not have enough money to buy.

■ Employee Stock Ownership Plans (ESOPs). ESOPs offer a way to get capital immediately by selling stock in the business to employees. By selling only non-voting shares of stock, control can be maintained. Imagine using an ESOP to acquire a business for as little as 10 percent of its purchase price.

■ Assume liabilities or decline receivables. Reduce the sales price by either assuming the business’s liabilities or having the seller retain the receivables.

Unfortunately, buyers and sellers who fail to address the tax issues of a merger or acquisition risk leaving money on the table. Because of its significant impact on the bottom line of any M&A transaction, formulating the right tax-efficient strategy can play an important role in the success or failure of any deal.

While no two deals are the same, the start of every M&A transaction depends on whether it is taxable or tax-deferred. In a tax-deferred transaction, the seller typically gets a substantial part, if not all, of its proceeds in the form of stock in the buyer’s business. Because the seller continues to hold an interest in the surviving business – without realizing a gain – there are no tax consequences until the stock is sold. This alternative often makes sense for sellers who do not need immediate liquidity provided, of course, they think the buyer’s shares are a good long-term investment.

Reorganizations
A so-called “qualified reorganization” is tax-free if it falls within the transactions outlined in the tax rules:

■ A Type A reorganization is a merger or consolidation under state or federal corporation laws.

■ A Type B reorganization is the acquisition by one corporation of the stock of another corporation in exchange solely for all, or part of its own or its parent’s voting stock. The acquiring corporation generally controls the other corporation after the acquisition.

■ A Type C reorganization involves the acquisition by one corporation of substantially all of the properties of another corporation, in exchange solely for all or a part of its own controlling parent’s voting stock, followed by the acquired corporation’s distribution of its property under a reorganization plan.

■ Type D reorganizations involve a transfer by an incorporated quarry or aggregates business of all or a part of its assets to another corporation where, immediately after the transfer, the transferor, or one or more of its shareholders is in control of the corporation to which the assets were transferred.

■ Type E reorganizations would be better labeled as a “recapitalization.”

■A Type F reorganization is a mere change in identity, form or place of organization of one corporation.

■ Type G reorganizations refer to a transfer by a corporation in bankruptcy of all or part of its assets to another corporation on a tax-free basis.

Taxable but flexible
In a taxable M&A transaction, where the government usually takes its cut in the first year, two of the most critical factors influencing the negotiations between the buyer and seller are:

■ What the buyer is purchasing – assets versus stock.

■ The legal structure of the seller.
In most M&A transactions, the buyer either purchases the seller’s assets (after which the seller becomes a shell and is liquidated) or acquires stock. From a tax standpoint, buyers benefit by assigning more of the purchase price to fast-depreciating assets such as inventory and equipment – while allocation of the purchase price to longer-term assets such as land, generally favors sellers.

In general, “S” corporations and limited liability companies (LLCs) are the most tax-efficient when a business is up for sale. Since the tax liability that a regular “C” corporation incurs on an asset sale is often subjected to the “double tax,” aggregate operations planning to go on the market should at least consider converting to “S” corporation status.

(An “S” corporation is an incorporated business whose shareholders have chosen to have all of the operation’s gains and losses passed on to them, to be reported on their individual tax returns. Thus, like an LLC, a partnership, the “S” corporation is a “pass-through” entity with all of the liability protections of a regular, ordinary, everyday corporation – sometimes referred to as a “C” corporation.)

Taxes and more taxes
There are other tax-related issues that will have to be addressed by both buyers and sellers. State and local governments, for example, assess income, sales, transfer and property taxes that vary considerably – particularly if one or both parties do business in multiple states. Above all, don’t forget that a merger or acquisition mainly for tax benefits is a no-no, easily and legitimately undone by the IRS.

Acquiring control of another business to evade or avoid income taxes by securing the benefits of a deduction, credit or other allowance also means the deduction, credit or other allowance may be lost. The tax rules explicitly authorize the IRS to deny acquiring corporations, carryovers and other tax benefits including losses, acquired as part of the acquisition of another corporation.

Even if it is not a deal breaker, the tax aspects of an M&A transaction can be significant enough to make or break a deal helping sellers maximize their after-tax proceeds. Buyers can minimize their costs, and better position the new company emerging from the deal for success.

Yet another study recently revealed large numbers of businesses are looking to sell or spin-off businesses during the next three years. In fact, many of these deals are expected to involve businesses that the sellers attempted to get rid of before, but were never sold.

Now may be an excellent time for every well-managed aggregate company to think about acquiring another business for increased profits, lower costs or strategic growth. Still, others are thinking about the many benefits of merging with another operation, perhaps even a competitor. Obviously, professional tax advice is almost always necessary.

Mark E. Battersby is a freelance writer who has specialized in taxes and finance for the last 25 years.