1. Structuring the Deal: Tax and Accounting Considerations

2. One person of integrity can make a difference, a difference of life and death. —Elie Wiesel

3. Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities Part IV: Deal Structuring and Financing Part II: M&A ProcessPart I: M&A Environment Ch. 11: Payment and Legal Considerations Ch. 7: Discounted Cash Flow Valuation Ch. 9: Financial Modeling Techniques Ch. 6: M&A Postclosing Integration Ch. 4: Business and Acquisition Plans Ch. 5: Search through Closing Activities Part V: Alternative Business and Restructuring Strategies Ch. 12: Accounting & Tax Considerations Ch. 15: Business Alliances Ch. 16: Divestitures, Spin-Offs, Split-Offs, and Equity Carve-Outs Ch. 17: Bankruptcy and Liquidation Ch. 2: Regulatory Considerations Ch. 1: Motivations for M&A Part III: M&A Valuation and Modeling Ch. 3: Takeover Tactics, Defenses, and Corporate Governance Ch. 13: Financing the Deal Ch. 8: Relative Valuation Methodologies Ch. 18: Cross-Border Transactions Ch. 14: Valuing Highly Leveraged Transactions Ch. 10: Private Company Valuation

4. Learning Objectives Primary Learning Objective: To provide students with knowledge of how accounting treatment and tax considerations impact the deal structuring process. Secondary Learning Objectives: To provide students with knowledge of –Purchase (acquisition method) accounting used for financial reporting purposes; –Goodwill and how it is created; and –Alternative taxable and non-taxable transactions.

5. Accounting Treatment Background Statement of Financial Accounting Standard 141 (SFAS 141) required effective 12/15/01 purchase accounting to be employed for all business combinations by allocating the purchase price to acquired net assets. Limitations included difficulty in comparing transactions (e.g., those with minority shareholders to those with none) and mixing of historical and current values (e.g., staged purchases). Pooling of interest method was grandfathered. Effective 12/15/08, SFAS 141R required that acquirers must –Recognize, separately from goodwill, 1 identifiable assets, and assumed liabilities at their acquisition date 2 fair values; 3 –Recognize goodwill attributable to non-controlling shareholders; 4 –Revalue acquired net assets in each stage of staged transactions to their current fair value; –Compute fair value of contingent payments 5 as part of total consideration, revalue as new data becomes available, and reflect on income statement; –Capitalize “in-process” R&D on acquisition date with indefinite life until project’s outcome is known (amortize if successful/write-off if not); and –Expense investment banking, accounting, and legal fees at closing; capitalize financing related expenses 1 Goodwill is an asset representing future economic benefits from acquired assets not identified separately (i.e., control, brand name, etc.) 2 Acquisition date is the point at which control changes hands (i.e., closing). 3 Fair value is the amount at which an asset could be bought or sold in a current transaction between willing parties with access to the same information. 4 An acquirer must recognize 100% of the goodwill even if they acquired less than 100% of the target’s assets, if they have a controlling interest giving them effective control over 100% of the assets. 5 Recognize as a liability on balance sheet.

6. Purchase (Acquisition) Method of Accounting Requirements: –Record acquired tangible and intangible assets and assumed liabilities at fair market value on acquiring firm’s balance sheet. –Record the excess of the price paid (PP) plus any non-controlling interests 1 over the target’s net asset value (i.e., FMV TA - FMV TL ) as goodwill (GW) on the consolidated balance sheet, where FMV TA and FMV TL are the fair market values of total acquired assets and liabilities. These relationships can be summarized as follows: –Purchase price: PP = FMV TA – FMV TL + FMV GW –Goodwill estimation: 2 FMV GW = PP – FMV TA + FMV TL = PP - (FMV TA - FMV TL ) 1 The balance sheets of acquirers with a controlling interest that is less than 100% ownership must still record 100% of goodwill reflecting their effective control over all of the target firm’s assets and liabilities. 2 Goodwill and net acquired assets must be checked annually (or whenever a key event such as the loss of a major acquired customer or patent takes place impacting value) for impairment.

7. Example of Estimating Goodwill On January 1, 2009, Acquirer Inc. purchased 80 percent of Target Inc.’s 1,000,000 shares outstanding at $50 per share for a total value of $40,000,000 (i.e.,.8 x 1,000,000 x $50). On that date, the fair value of total Target net assets was $42,000,000. What is value of the goodwill shown on Acquirer’s balance sheet? What portion of that goodwill is attributable to the minority interest retained by Target’s shareholders? 100% of Goodwill shown on Acquirer’s balance sheet: FMV GW = PP 1 – (FMV TA – FMV TL ) = $50,000,000 - $42,000,000 = $8,000,000 Goodwill attributable to the minority interest (GWMIN): FMV GWMIN =.2 x PP 1 –.2 x (FMV TA – FMV TL ) =.2 x $50,000,000 -.2 x $42,000,000 = $10,000,000 - $8,400,000 = $1,600,000 1 Purchase price as if acquirer purchased 100% of target firm (i.e., $50/share x 1,000,000 = $50,000,000).

8. Example of Purchase Method of Accounting (Assumes Acquirer Pays $1 Billion for Target’s Equity) Pre-Acquisition Book ValueTarget Fair MarketAcquirer Post- AcquirerTargetValueAcquisition Value ($Millions) Col. 1Col. 2Col. 3Col. 4 (= Col. 1 + Col.3) Current Assets12,000.001,200.00 13,200.00 Long-Term Assets7,000.001,000.001,400.008,400.00 Goodwill-- 100.00 2 Total Assets19,000.002,200.00--21,700.00 Current Liabilities10,000.001,000.00 11,000.00 Long-Term Debt3,000.00600.00700.003,700.00 Total Liabilities13,000.001,600.00--14,700.00 Common Equity2,000.00300.001,000.00 1 3,000.00 Retained Earnings4,000.00300.000.004,000.00 Total Equity6,000.00600.00--7,000.00 Equity + Total Liabilities19,000.002,200.00--21,700.00 1 The fair value of the target's equity is equal to the purchase price; target's retained earnings implicitly included in the purchase price paid. Note the change in the acquirer's pre-and post-acquisition common equity value equals the purchase price. 2 Goodwill = Purchase price - FMV of Net Acquired Assets = $1000 - ($2600 - $1700) = $1,000 - $900 = $100

9. Practice Problem: Purchase Method of Accounting On January 1, 20XX, Acquirer Inc. purchased 100% of Target Inc.'s outstanding shares for $900 million. Using the data on the following table, fill in the blanks containing question marks to show how the deal could have been presented for financial reporting purposes.. Pre-Acquisition Book ValueTarget CurrentAcquirer Post- AcquirerTargetFair Market ValueAcquisition Value ($Millions) Col. 1Col. 2Col. 3Col. 4 Current Assets4,000.001,500.00 ??? Long-Term Assets5,000.001,000.001,200.00??? Goodwill-- ??? Total Assets9,000.002,500.00--??? Current Liabilities3,000.001,200.00 ??? Long-Term Debt2,000.00900.00800.00??? Total Liabilities5,000.002,100.00--??? Common Equity3,200.00300.00??? Retained Earnings800.00100.00??? Total Equity4,000.00400.00--??? Equity + Total Liabilities9,000.002,500.00--???

10. Discussion Questions 1.Acquirer and Target companies reach an agreement to merge. Describe how the purchase method of accounting would impact the income statement, balance sheet, and cash flows statements of the combined companies. 2.Goodwill is an accounting entry equal to the difference between purchase price and the fair market value of net acquired assets. As a business manager, what do you believe goodwill represents? How could the factors that goodwill represents actually contribute to improving the combined firm’s future cash flows? 3.Contingent payments under SFAS 141R must be revalued as new information becomes available. How might this affect the popularity of earnouts from the acquirer’s perspective?

11. Choosing the Right Deal Structure Consider the Following Factors: –Tax impact (Immediate or Deferred) –Acquirer and Target Shareholder Approvals –Exposure to Target Liabilities –Payment Flexibility –Target Survivability –Limitations on Restructuring Efforts (e.g., tax-free status of spin-offs 2 years before and after tax-free deal could be jeopardized)

12. Alternative Tax Structures Mergers and acquisitions can be structured as either tax-free, partially taxable, or wholly taxable to target shareholders. Taxable Transactions: –The buyer pays primarily with cash, securities, or other non-equity consideration for the target firm’s stock or assets –Absent a special election, tax basis of target’s assets will not be increased to FMV following a purchase of stock –338 election: Buyer can elect to have a taxable stock purchase treated as an asset purchase and acquired assets increased to FMV. Taxes must be paid on any gains on acquired assets. –Impact of asset write-up on EPS and potential taxable gains must be weighed against improved cash flow from tax savings Tax-Free Transactions (Treated as reorganizations rather than sales): –Mostly buyer stock used to acquire stock or assets of the target –Buyer must acquire enough of the target’s stock and assets to ensure that the IRS’ continuity of interests and business enterprise principles are satisfied

13. Alternative Tax-Free Structures A tax-free transaction is also known as a tax-free reorganization since it must generally satisfy the continuity of interests and business enterprise principles to avoid being classified as an actual sale 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 reverse 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)

14. How the IRS Views Tax-Free Reorganizations “A” reorganizations involve one corporation acquiring another in exchange for mostly acquirer nonvoting or voting stock “B” reorganizations involve one corporation acquiring the stock of another in exchange solely for acquirer voting stock “C” reorganizations involve one corporation acquiring “substantially all” of the assets of another in exchange for acquirer voting stock “D” divisive reorganizations involve a corporation transferring all or some of its assets to a subsidiary it controls in exchange for subsidiary stock or securities

15. Qualifying as a Tax-Free Reorganization Four conditions must generally be met: –Continuity of ownership interest (in certain instances may be satisfied if purchase price at least 50% acquirer stock) 1 –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) 2 –Valid business purpose (other than tax avoidance such as the sole reason for buying the target is to acquire its NOLs) –Step transaction doctrine (must not be part of larger plan intended to avoid a taxable transaction) 1 May be as low as 40% under some circumstances, if the acquirer has effective control at that level of ownership. 2 ”Substantially all” requirement does not apply if the acquiring subsidiary is a so-called disregarded unit such as a limited liability company.

16. Continuity of Interests and Business Enterprise Principles 1 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. 1 These principles are intended to require buyers to demonstrate an ongoing commitment to the target firm such that the transaction is not actual sale but rather a reorganization in which the target shareholders continue to have a significant ownership stake in the combined firms.

17. Type A Reorganization To qualify as a Type A reorganization, transaction must be a direct statutory merger or consolidation; forward or reverse triangular merger Advantages (applies to all merger types, except as noted): –Except for reverse triangular mergers, only form of tax free reorganization in which a substantial portion of the purchase price can be something other than acquirer equity –Target assets and liabilities automatically transfer to the acquirer by “operation of law” –Target tax attributes automatically transfer subject to limitation under Sections 382 and 383 of the tax code Disadvantages (applies to all merger types): –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 –No writeup (step up) in basis of acquired assets as transaction already tax-free 1 As low as 40% in some circumstances; however, for reverse triangular mergers, the purchase price must consist of at least 80% acquirer voting common or preferred shares.

18. Direct Statutory Merger (“A” Reorganization) Acquiring Firm Target Firm (Liquidated as book value of assets and liabilities merged with acquirer) Target Shareholders (Receive voting or nonvoting acquirer stock and boot in exchange for Target stock) Assets & Liabilities Acquirer Stock & Boot Target Stock Target merges into acquirer, with acquirer surviving. Acquirer and target shareholder approval required in most states; dissenting shareholders may have appraisal rights. Flexible form of payment (as little as half of the purchase price may consist of acquirer non-voting or voting stock).

19. Statutory Consolidation (“A” Reorganization) Company A (Contributes book Value assets & liabilities to Newco) Company B (Contributes book value of assets & Liabilities to Newco) Company A Shareholders Company B Shareholders New Company (Newco) Assets/Liabilities Newco Stock A & B merge with Newco, with Newco surviving the transaction. A and B’s shareholders must approve the deal with dissenting shareholders having appraisal rights. Flexible form of payment (as little as half of the purchase price may consist of acquirer non-voting or voting stock). Structure appropriate for merger of equals.

20. Forward Triangular Merger (“A” Reorganization) Acquiring Company Subsidiary (Shell created by parent and funded by parent’s cash or stock) Target Firm (Merges book value of assets and liabilities with the parent’s wholly- owned subsidiary) Target Shareholders (Receive voting or nonvoting stock and boot 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 Viewed by IRS as an asset purchase as target liquidated. Flexible form of payment (as little as half of the purchase price may consist of acquirer non-voting or voting stock). 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. However, as target eliminated, nontransferable assets and contracts may be lost. Target Stock

21. 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 and boot 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 Viewed by IRS as a purchase of stock since Target survives as acquirer subsidiary. Intellectual property and contracts transfer automatically; may insulate acquirer from target liabilities and avoid acquirer shareholder approval. Acquirer must buy “substantially all” of the FMV of the target’s assets and target tax attributes transfer subject to limitation. The major disadvantages are that the acquirer must purchase at least 80% of the target’s outstanding shares and that purchase price must consist of at least 80% parent voting common or preferred stock. Target Stock

22. 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 used only to acquire fractional shares 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 –No writeup (step up) in basis of acquired assets

23. 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. Tax attributes transfer subject to limitation as no asset write-up. 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

24. 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 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 –No writeup in basis of acquired assets 1 Value of assumed liabilities must be deducted from boot and often results in purchase price consisting of all acquirer stock.

25. Type “C” Stock for Assets Reorganization Acquiring Firm (Exchanges voting shares for at least 70% & 90% of FMV of target net & gross assets) Target Firm (Liquidates and transfers Acquiring Firm shares and book value 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; consequently, tax attributes transfer to acquirer subject to limitation. Target Cancelled Stock

26. 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 separated 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.

27. 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

28. Discussion Questions 1.Explain how tax considerations affect the deal structuring process? From seller’s perspective? From buyer’s perspective? 2.What is a Type A reorganization? When does it make sense for a buyer to use a Type A reorganization? 3.What is a reverse triangular merger? Under what circumstances would a buyer wish to use this type of reorganization? 4.How might the buyer structure the transaction in order to avoid EPS dilution? (Hint: Consider the factors that make a transaction taxable or non-taxable.)

29. Things to Remember For financial reporting purposes, all M&As must be accounted for using purchase accounting. Taxable transactions: –Direct cash merger –Cash purchase of assets –Cash purchase of stock Tax-free transactions: –Type A reorganization (Incl. direct statutory merger or consolidation; forward and reverse triangular merger) –Type B stock-for-stock reorganization –Type C stock-for-assets reorganization