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What to Expect When You Are Expecting A Private Equity Exit

What to Expect When You Are Expecting A Private Equity Exit

Posted on November 19, 2024

Authors: William B. Helbling and Colleen D. Campbell

Originally published in November 2024

This article has not been updated for current law since the date of its posting on the website. This article is not intended to provide any legal advice. Please seek advice of your professional council.

Any U.S. federal and state tax advice contained in this communication is not intended or written by the Knox Law Firm to be used, and cannot be used by you, for the purpose of: (i) avoiding penalties under the Internal Revenue Code that may be imposed upon you, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

Choosing to Sell to Private Equity

Why Do Clients Sell Their Business?

I do not have the ability to transition the business to a son, daughter, or other key employee.
I am tired of dealing with back office and administrative duties.
I need a strategic partner to grow.
I want to liquidate the value of the business.
I just want to do what I love.

Types of Buyers in the Market

Key Employee/Immediate Family Member(s)
Larger Business Competitors
Vertical Business Integrators
Private Equity Buyers

Types of Private Equity Buyers

There are numerous Private Equity Funds in the mergers and acquisitions market that specialize and invest predominately in the following industries:

Manufacturing
Software and Tech
Insurance
Healthcare

In a recent article from Harvard Law, Private Equity backed buyers make up about 36% of the entire mergers and acquisitions deal volume on an annual basis (Private Equity-2023 Outlook, The Harvard Law School Forum on Corporate Governance (2024)).

Why Clients Sell Their Business to Private Equity Buyers

Higher business valuations.
Equity purchase price consideration (keeping chips on the table).
Numerous PE Buyers in the mergers and acquisitions market.
Continued role in the business post-closing of the transaction.

Why Clients Do NOT Sell to Private Equity Buyers

Level of involvement in the business post-closing of the transaction.
Delay of full business exit.
Fear of business being torn apart.
More rigid financial reporting post-closing.

Acquisition Goals of Private Equity Buyers

Increase Business Efficiencies
Vertical Integration
Package Business Operations for Larger Exit

How Private Equity Deals Are Structured

Private Equity Organizational Structure

Investors aggregate funds to create Sponsor Entity (the “PE Fund”).
Sponsor Entity creates holding company or purchases large industry target (the “Portfolio Company”).
Subsequent Targets to be Subsidiaries and Tuck-Ins under Portfolio Company.

What is the client selling?

Asset Purchase Transaction – Sale of all or substantially all of the operational assets of a business.

Stock Purchase Transaction – Sale of all or majority share of the equity in a business (common stock, LLC membership interests or partnership interests).

Hybrid Transactions – Transaction structures that allow for a deal to be a Stock Purchase Transaction for legal purposes and an Asset Purchase Transaction for tax purposes. Such transaction structures include:

Section 338(h)(10) and 336(e) Transactions;
F-Reorganizations; and
LLC/Partnership Equity Transactions.

Why do Private Equity Buyers Love Hybrid Transactions?

Stock Deal for Legal Purposes:

Continuity of Seller’s business operations
Least amount of disruption of Seller’s relationships with vendors/customers/employees

Asset Deal for Tax Purposes:

PE Buyers get to allocate the purchase price among the operational assets of a target business to obtain a step-up in basis in such assets for depreciation/amortization purposes.

Private Equity's Preferred Hybrid Transaction

F-Reorganization

An “F” reorganization is a tax-free reorganization for Subchapter S corporations under Section 368(a)(1)(F) of the Internal Revenue Code that changes the identity or form of a corporation (I.R.C. § 368(a)(1)(F)).

Less restrictions and mutually prepared filings that come with 338(h)(10) and 336(e) elections.
Isolation of S-Election Issues.

F-Reorganization Steps

Formation of a new corporation (“NewCo”).
Shareholder(s) contributes all of his/her/its common stock of existing corporation (“Oldco”) to NewCo in exchange for all of the issued and outstanding shares of NewCo.
NewCo elects to treat Oldco as a qualified subchapter S subsidiary by filing IRS Form 8869 (no IRS Form 2553 needs to be filed by NewCo) (Rev. Rul. 2008-18).
Oldco files conversion documents to become a limited liability company and makes a check-the-box election on the IRS Form 8832 to be deemed a disregarded entity.

Private Equity Deal Considerations

Overview

Valuation
Upfront Cash Consideration
Rollover Equity Consideration
Contingent Consideration

Valuation: How is the Purchase Price Determined?

Multiple of EBITDA - Earnings before Interest Taxes Depreciation and Amortization.
Multiple of Gross Revenue – Multiples of revenue is usually utilized in smaller PE backed transactions.
Pro-Forma “Adjusted” EBITDA – Most large PE backed transactions are valued based on a multiple of Adjusted EBITDA. Such Adjusted EBITDA calculation serves as the new framework for the Seller’s operations post-Closing of a transaction, which can be utilized to determine growth for contingent purchase price consideration.

Private Equity Purchase Price Consideration Structure

Part Contribution of Assets (Rollover Equity Consideration)

Part Sale of Assets (Upfront Cash Consideration and Contingent Consideration)

Rollover Equity Structure

Contribution of Assets in Exchange for Equity in PE Buyer

Section 721 Contribution/Exchange – Sellers contribute immediately prior to the sale transaction a certain portion of its operational assets in exchange for “Rollover Equity” in the Portfolio Company (I.R.C. § 721).
Tax Deferred Treatment – If properly structured, Seller defers tax on Rollover Equity until future buyout, sale or recapitalization event.

Rollover/Subscription Agreement

Private Securities Considerations – Rollover Equity are securities that are not registered with the SEC or any respective state securities authority (E.g. Pennsylvania Banking and Securities).
Accredited Investor Questionnaire – Given that Rollover Equity is not a registered security, PE Buyers need to rely on certain federal securities registration exemptions. Such exemptions require that the recipient of the Rollover Equity are “Accredited Investors” under SEC Regulation D (17 CFR § 230.501). Sellers receiving Rollover Equity will most likely need to deliver a completed Accredited Investor Questionnaire to self-certify that it is an Accredited Investor.
Joinders to Governing Documents (Including Spouses) - A Seller’s rights to the Rollover Equity are usually governed under an LLC Agreement/Operating Agreement/Partnership Agreement. As a result, individual owners of the Sellers are require to join such governing documents with their spouses upon receipt of Rollover Equity.
83(b) Election Considerations - If a Seller’s Rollover Equity rights are tied to an individual owner’s post-closing employment status, professional advisors need to consider making a protective 83(b) Election for the individual owner.

Ownership Rights to Rollover Equity

What happens to my Client’s Rollover Equity upon:

Death;
Disability; and
Termination of Employment.

The “trigger events” above result in a valuation and buy-out option. Termination of employment with cause usually results in a buy-out at a discount.

Distribution and Liquidation Preferences - Generally, holders of Rollover Equity will receive economic rights in the Portfolio Company that are below preferred ownership (E.g. the PE Fund). Such economic rights tied to the Rollover Equity need to be discussed in the letter of intent stage of the transaction.

Voting Rights – Generally, holders of Rollover Equity have no voting rights in the Portfolio Company. All governance rights will reside with the PE Fund and their designated governing board and officers for the Portfolio Company.

Contingent Purchase Price

Earnouts – PE Buyers may agree to a Contingent Purchase Price component of a transaction. Usually, Contingent Purchase Price comes in the form of an “Earnout Payment,” which is based on maintenance or growth of revenue or Adjusted EBITDA.

Tax Considerations

Maximum Earnout Consideration – Seller’s and its tax advisors should consider proposing a maximum amount for any Contingent Purchase Price. Without a stated maximum amount for the Contingent Purchase Price, Seller may have issues recouping losses if Earnout Payments are lower than expected.

Preserving Installment Treatment – Seller’s and its tax advisors should have a plan of action to preserve installment sale treatment of all Contingent Purchase Price for tax purposes. Without proper planning, Seller’s may accelerate tax liabilities associated with Contingent Purchase Price before such amounts are earned.

Private Equity Transaction Process and Due Diligence Matters

PE Transaction Timeline

Confidential Information Memorandum (Usually If Broker is retained)
Non-Disclosure Agreements to Potential Buyers/Initial Due Diligence
Letter of Intent
Financial/Legal Due Diligence
Negotiation of Purchase and Ancillary Agreements
Closing

Role of a Transactional Attorney in a PE Transaction

Draft and/or Review Definitive Agreements
Help with Due Diligence Process
Address the following transaction terms: Title/Transition, Representations and Warranties, Indemnification Obligations, Ensure Documents align with Business Terms, and Tax Structure.

When Selling to PE…Get your House in Order! Help your Client Audit its Business!

Organizational and Ownership Documents
Non-Operational Assets
Contracts
Regulatory/Tax Considerations
Benefit Plans
Insurance

Organizational and Ownership Documents

Bylaws/Operating Agreement – Review governing documents to ensure there are no transfer restrictions, right of first refusals or other governing terms that would hinder a sale transaction.

Share Certificates/Ledger – With hybrid transaction structures, it is important that stock ledgers, share certificates and capitalization tables are up to date and accurate well before closing of the transaction.

Non-Operational Assets

Sellers need to take inventory of certain non-operational assets that are owned by the business. Certain non-operational assets include:

Vacation Homes
Vehicles
Boats
Golf Simulators
Tanning Beds
Season Tickets to Sports Teams

With a hybrid transaction structure, it is imperative that Clients consider how to properly remove such non-operational assets.

Contracts

Compile and review all contracts of a Seller, including:

Real Estate Leases
Loan Agreements
Vendor Agreements
Employment Agreements
Independent Contractor Agreements

While the foregoing contracts won’t be “assigned” to a PE Buyer under a hybrid transaction, it is important to determine if there are “change of control” provisions in existing contracts.

Regulatory/Tax

Business Permits – Do any permits held by Seller required notice/consent upon a change of control/ownership

Tax Filings – Has a Seller prepared and filed all application tax returns?

S-Corporation Considerations: Second class of stock issues and inconsistent provisions in governing documents.

Benefit Plans

Obtain all documents relating to the following types of benefit plans of the Seller:

401(k) Plans
Cash Balance Plans
Simple IRA Plan
Profit Sharing Plan

Generally, PE Buyers require all benefit plans to be terminated on or before the closing of the transaction. It is imperative to contact all benefit professionals to discuss termination process.

Insurance

What Insurance Policies are currently in place?

Occurrence Based Policies
Claims Made Policies: PE Buyers generally will require tail/extended reporting coverage for all Claims Made Insurance Polices of a Seller for at least a period of 3 years.

Why cure/mitigate existing issues with a Client’s business?

Due Diligence Survival – Preventing a transaction process from ending due to pre-existing issues with a business. Not providing a PE Buyer with leverage in negotiations.
Indemnification Issues - Preventing a Client from coming out of pocket for pre-closing liabilities.
Transition of Business – Ensuring the business operations and employees are properly transferred to a PE buyer.
Profit Center Framework – Ensuring the business is in a better financial position to grow to Earnout targets and improve value of Rollover Equity.

Authors: William B. Helbling and Colleen D. Campbell

Originally published in November 2024