Question

1. Explain, in your own words, characteristics that make a firm a good candidate for an LBO.

2. Explain, in your own words, what is a contingent payment, why is it used and what are the common types of contingent payments.

3. Explain, in your own words, why there might be a conflict of interest in a management buyout.

4. Explain, in your own words, what an earnout agreement is and how it shares the risk of a merger deal between the target and acquirer?

5. Explain, in your own words, the pros and cons of an asset deal.

Answer 1

1..Characteristics of a Good LBO Candidate
The following characteristics define the ideal candidate for a leveraged buyout. While is it very unlikely that any one company will meet all these criteria, some combination thereof is need to successfully execute an LBO.

Strong, predictable operating cash flows with which the leveraged company can service and pay down acquisition debt
Mature, steady (non-cyclical), and perhaps even boring
Well-established business and products and leading industry position
Moderate CapEx and product development (R&D) requirements so that cash flows are not diverted from the principle goal of debt repayment
Limited working capital requirements
Strong tangible asset coverage
Undervalued or out-of-favor
Seller is motivated to cash out of his/her investment or divest non-core subsidiaries, perhaps under pressure to maximize shareholder value
Strong management team
Viable exit strategy

2.Contingent payments- companies require payment upon delivery of products or services, but this isn't always the case. Instead, a company or business person may arrange a contingent payment, which means the payment depends on a particular event or level of performance. For example, lawyers often set contingency payments that only require clients to pay if they win their cases.

Occurrence
The most common type of contingency payment involves legal representation, but other types of businesses may use them, as well. For example, an advertising firm could set payment contingent on its ability to help a company increase its sales, though this may prove more common when the company is just starting out and proving itself. Sometimes a company may set contingency payments for loans. For instance, it may make the amount of the loan payment contingent on the debtor's current income and resources

Types
Companies can set contingency payments in all sorts of forms. Often, contingency payments involve a percentage of the amount the paying party earns or receives. For example, a client may agree to pay a lawyer a percentage of the money he receives if he wins his case. Sometimes, companies also set commissions based on reaching certain sales levels. In some cases, however, contingent payments may also include lump-sum payments or installment payments set to begin when a particular event occurs.

Contract
Both the payor and the payee must agree to contingency payments. In most cases, parties to such an agreement draft a contract spelling out how the contingency arrangement will work. Such a contract usually includes the amount of the contingency payment and the names of the parties who will provide and receive the payment. Likewise, these agreements usually include details about what happens if a party wants to cancel the agreement and how the parties will handle disputes over payment amounts and late payments or defaults

3.

Management Buy Outs (“MBOs”) became popular in the United States in the late eighties and early nineties. Though MBOs have many potential benefits, they also bring with them difficulties as they may place the board and management of a corporation in positions of potential conflicts of interest.

MBO defined

It is important to be clear on what exactly a MBO is and how it differs from other going private transactions such as leveraged buyouts (“LBOs”) or a regular sale of the corporation to an arm’s length third party. A MBO is a transaction in which the ownership of a business passes out of its existing ownership to its managers in whole or in part. Commonly, instead of the usual two parties (the seller and the buyer), there will normally be three, namely the seller, the managers and the person or institution providing the bulk of the finance for the purchase. The defining criterion of a MBO is the “who”; specifically that it is the managers of the corporation who acquire a meaningful ownership interest in the business through the purchase.

On the other hand, a LBO is defined by the “how”, specifically that the buyer acquires a corporation through a secured loan with assets of the acquired corporation charged as collateral. The buyer in a LBO can involve management (i.e. a MBO is often a sub-species of a LBO), but this does not have to be the case. Similarly, while many MBOs are leveraged, they do not necessarily need to be.

The key difference then between a MBO and a regular sale process is that while in a regular sale process the management is independent of the buyer, and its interests are generally aligned with those of the corporation, in a MBO the management is aligned with the buyer and as such its interests will diverge from those of the corporation, putting management in a clear conflict of interest.

Conflict of Interest in MBOs

Most sales processes involve a real or perceived conflict of interest for management of a corporation, who may for example seek to entrench themselves. In a MBO, the corporation’s directors or officers who are members of the management buyout group (the “Management Buyers”) have a more acute and clear conflict of interest which puts far greater strain on their abilities to fulfil their fiduciary duties. The interests of the Management Buyers conflict with those of the corporation, because the Management Buyers have personal interests in acquiring the corporation for less, while it is in the best interests of the corporation that the corporation is either not sold, or is sold for more.

Intensifying this conflict is the fact that the Management Buyers are uniquely well placed to negotiate a lower price for the corporation due to their insider knowledge and control of the day to day management of the corporation. As a result, there is almost always a lingering suspicion that any top executives who are Management Buyers are timing the buyout to pay a discounted price or are otherwise taking advantage of their unique knowledge and influence.

This also puts the Management Buyers in a precarious position insofar as their personal liability as officers is concerned, because the Management Buyers are, by virtue of this conflict, far less likely to be accorded the benefits of the “business judgement rule” by a court. In normal business circumstances the decisions made by management are given deference by courts, regardless of whether they eventually result in success or failure for the corporation, as long as they are taken in good faith and based on a diligent, well informed evaluation process. Where the management has put itself in a clear conflict of interest, the decisions they take are far less likely to receive the protection of this deference and the Court may approach them with great scepticism. For example, where management makes a mis-step in the business, a court will likely be less deferential if there is a reasonable basis for suspecting that management is deliberately trying to reduce their purchase price as buyers.

Another concern is that the Management Buyers may be able to force a sale of the corporation where a standalone plan is in fact more desirable, or prevent other potential buyers from offering a competing bid. Even if the Management Buyers do not take active steps to prevent other alternatives being considered or to dissuade other bidders, the very fact that there is a MBO proposal can serve to deter consideration of other alternatives or keep other bidders away.

Finally, even directors who are independent of the Management Buyers, may be influenced into approving the MBO, simply because they feel there is no choice and that if the board says no they will be left not only without a deal, but with very dissatisfied management or may lose key members of management.

4. earnout is a financing arrangement for the purchase of a business in which the seller finances a portion of the purchase price, and payment of this amount is contingent on achieving a predetermined level of future earnings. An earnout is often used to bridge a valuation gap.

The risk of a merger deal between the target and acquired is if you're considering an earnout agreement with the purchaser of your company, understand the risk factors. You will still be working for a company you no longer control, and you are no longer making major business decisions. If the buyer makes risky or bad business decisions, your earnout is in jeopardy. Many earnout agreements include noncompete clauses, so you can't start or join a similar operation. To protect your interests, work with an experienced merger-and-acquisitions attorney to receive the largest upfront payment possible. Make sure the agreement spells out all necessary targets for the earnout precisely. Also make sure you have your own employment contract, so the new owner cannot demote or replace you.

5.

When buying or selling a business, the owners and investors have a choice: the transaction can be a purchase and sale of assets or a purchase and sale of common stock. The buyer of the assets or stock (the “Acquirer”) and the seller of the business (the “Target”) can have various reasons for preferring one type of sale over the other. This guide examines the Asset Purchase vs Stock Purchase decision in detail.

Most acquisitions can be structured either as an asset transaction or as a stock transaction. Where an asset transaction is favored, a variety of issues must be considered – as the transaction is actually the sum of the sales of each of the individual assets and an assumption of agreed upon liabilities.

Conversely, where the transaction is structured as a stock acquisition, by its very nature the acquisition results in a transfer of the ownership of the business entity itself, but the entity continues to own the same assets and have the same liabilities

In doing an asset sale, the seller remains as the legal owner of the entity, while the buyer purchases individual assets of the company, such as equipment, licenses, goodwill, customer lists, and inventory.

Asset sales generally do not include purchasing the Target’s cash, and the seller typically retains its long-term debt obligations. Such a sale is characterized as cash-free and debt-free.

Normalized net working capital is typically included in an asset purchase agreement. Net working capital is comprised of items such as accounts receivable, inventory, and accounts payable.

Asset Purchase vs Stock Purchase: Asset Advantages
Here are several advantages of an asset purchase transaction:

A major tax advantage is that the buyer can “step up” the basis of many assets over their current tax values and obtain ordinary tax deductions for depreciation and/or amortization.
WIth an asset transaction, goodwill, which is the amount paid for a company over and above the value of its tangible assets, can be amortized on a straight-line basis over 15 years for tax purposes. In a stock deal, with the acquirer buying shares of the Target, the goodwill cannot be deducted until the stock is later sold by the buyer.
The buyer can dictate what, if any, liabilities it is going to assume in the transaction. This limits the buyer’s exposure to liabilities that are either unknown or not stated by the seller. The buyer can also dictate which assets it is not going to purchase. If, for example, the buyer determines that the seller has a lot of accounts receivable that are probably uncollectable, then they can simply elect not to purchase the Target’s AR (accounts receivable).
Because the exposure to unknown liabilities is limited, the buyer typically needs to expend less time and money, and fewer resources, on conducting due diligence.
Minority shareholders who don’t want to sell their shares can, effectively, be forced to accept the terms of an asset sale. Unlike the case with a stock purchase, minority shareholders do not ordinarily have to be taken into account in regard to an asset purchase.
The buyer can select which employees they want to retain (and which they do not) without impacting their unemployment rates.

Asset Purchase vs Stock Purchase: Asset Disadvantages
Here are several disadvantages of an asset purchase as compared to a stock purchase:

Contracts – especially with customers and suppliers – may need to be renegotiated and/or renovated by the new owner
The tax cost to the seller is typically higher, so the seller may insist on receiving a higher purchase price.
Assignable contract rights may be limited.
Assets may need to be retitled.
Employment agreements with key employees may need to be renegotiated.
The seller still needs to liquidate any assets not purchased, pay any liabilities that have not been assumed, and take care of any leases that need to be terminated.

Stock Purchase
A stock purchase is simpler in concept than an asset purchase. Therefore, in most instances it’s just basically an easier, less complex transaction.

The Acquirer buys the stock of the Target and takes the Target as it finds it, in regard to both assets and liabilities. Most contracts the Target has – such as leases and permits – effect, transfer automatically to the new owner. For all these reasons, it’s often more straightforward to go with a stock purchase rather than an asset purchase.

Advantages of a Stock Purchase
The following are several advantages of doing a stock purchase:

The acquirer doesn’t have to bother with costly re-valuations and retitles of individual assets.
Buyers can typically assume non-assignable licenses and permits without having to obtain specific consent.
Buyers may also be able to avoid paying transfer taxes.
More simple and commonly used than an asset acquisition. Hedge funds are known for commonly conducting M&A transactions in the form of a simple stock purchase.

Disadvantages of a Stock Purchase
Here are some of the disadvantages of a stock purchase:

The main disadvantage is that an acquirer receives neither the “step-up” tax benefit nor the advantage of handpicking assets and liabilities.
All assets and liabilities transfer at carrying value.
The only way to get rid of unwanted liabilities is to create separate agreements wherein the Target buys them back.
Applicable securities laws, of course, have to be dealt with, and this can complicate the process, especially when the Target has a lot of shareholders. Additionally, some shareholders may not wish to sell their stocks, and this can drag out the process and increase the cost of acquisition.
Goodwill is not tax deductible when it exists in the form of a share price premium.
Choosing the form of an acquisition transaction can have significant tax and other business-related consequences for both buyer and seller. Both parties should explore and consider the benefits and consequences of each type of transaction, with the help of professional financial advisors, to determine whether an asset purchase or stock purchase transaction best suits their wants and needs.