Author: Sean Abbey, CFA

Lower middle market (“LMM”) M&A transactions frequently involve F reorganizations (“F reorgs”) of S corporations (“S-corp”).  F reorgs are often a critical part of structuring the purchase and sale of S corporations.  If you plan to take your S-corp LMM business to market and anticipate the transaction will be structured as a stock sale, you will likely encounter buyers seeking to structure the deal as an F reorg.  How should sellers view an F reorg and what are the implications of this type of transaction structure?   

Why Are They Used?

In short, to maximize a transaction’s tax benefits and minimize risk. M&A transactions can be structured as a stock sale versus an asset sale for a variety of reasons, including buyers facing a competitive M&A market and being forced to acquiesce to a seller’s request for a stock sale or the target possesses difficult to transfer contracts, licenses, or assets.  When a buyer acquires an S corporation and wants to maximize its depreciation or amortization deductions after the acquisition, it will generally need to choose between several alternatives: an F reorganization; a section 336(e) election; or a section 338(h)(10) election.  Each allows the treatment of a stock sale as an asset sale for U.S. federal income tax purposes.  However, both the 336(e) election and the section 338(h)(10) election requires a valid S election for basis step-up.  Unfortunately, it is not uncommon for S-corps, particularly older S-corps, within the LMM to inadvertently blow their S-corp election status[1], a risk that buyers have a difficult time mitigating.  Further, both the 336(e) election and the section 338(h)(10) election limits the ability of a seller to achieve a tax-deferred rollover of their equity in a transaction.  In the section 338(h)(10) election, the buyer must acquire at least 80 percent of the total voting power and value of the stock of the target in a taxable transaction a qualified stock purchase (“QSP”), while under the Section 336(e), the seller must sell at least 80 percent of the shares in the target, by both vote and value in a taxable transaction a qualified stock disposition (“QSD”).  Restructuring S-corps using an F reorg can solve many problems that may impact the buyer’s ability to get a step-up in basis or the seller’s ability to achieve a tax-deferred rollover. 

How They Work

Despite the “tax and legal jargon”, an F Reorg is relatively simple to consummate.  The basic steps include the following:

1. The equity holders of the S corporation target company form a new corporation (“Newco”)
2. The shareholders then contribute all of the equity of the S corporation target company to Newco in exchange for equity of Newco (the S corporation target company is a wholly owned subsidiary of Newco at this stage, and the former equity holders of the target company are now the equity holders of Newco)
3. Newco then makes a Form 8869 tax filing to treat the target company as a “qualified subchapter S subsidiary” or “QSub”, to make Newco a permissible owner of the target company

• Newco makes a filing to convert the target company (“Oldco”) from a corporation to an LLC

5. Once the F reorg is complete, the buyer purchases the equity of the target company (which is now a single member LLC (the “Target LLC”) that is treated as a “disregarded entity” for federal income tax purposes)

Potential Benefits for Sellers

Many LMM businesses have been structured as S corporations, an entity type that offers tax benefits, such as corporate income and gains being taxed once, at the shareholder level, while losses, deductions and credits get passed through to the shareholders, among other benefits.  As a result, S corporations have become one of the most predominant forms of business organization in the LMM.  LMM buyers frequently encounter targets structured as S-corps and M&A transaction structures of stock sales for S-Corps often include F-reorgs to achieve a pathway for a buyer to obtain a step-up in tax basis while avoiding potential issues with the target’s historic S election. 

Satisfying a buyer’s desire for the tax benefits of a step-up in tax basis is nice, but what is in it for the seller?  The primary answer is in preserving the tax-free rollover of equity for sellers.  Many buyers in the LMM request or require that sellers retain some portion of ownership in the business as part of the transaction to create alignment.  (Note: read our article on rollover equity for a deeper discussion on why rollover equity is a factor in deals).  If the rollover amount in the transaction is around 20 percent, taxpayers may have an issue with the section 338(h)(10) or section 336(e) election because the IRS may disagree on the valuation of the stock and the QSP or QSD may be challenged.  If the section 338(h)(10) or section 336(e) election turns out to be invalid, the taxpayer will not receive the step-up in basis.  In an F reorg, there is no limitation on the rollover amount or amount that must be acquired in a taxable transaction, providing flexibility.

Our View

LMM M&A transactions involving a company with difficult to transfer contracts, assets, licenses, employment agreements, or regulatory approvals, will likely result in a stock sale.  Because of the proliferation of S-corps within the LMM, F reorgs are a common feature of the landscape.  As a business owner of an S-corp you should be aware of this structuring technique and understand the general benefits of the F reorg prior to negotiating a transaction.  If your buyer insists that you rollover some equity in the transaction, the F reorg helps ensure that the rollover’s tax-free treatment is preserved.  While the structure is well-known and the steps to complete an F reorg are relatively simple, there can be complicating factors that should be evaluated by tax experts.  An important feature of the F reorg is treating the stock sale transaction as an asset sale for U.S. federal income tax purposes.  Sellers should be aware that depending on the assets contributed to the Target LLC, sellers may recognize both capital gains and ordinary income.  The buyer can provide a gross-up to account for the extra taxes (including additional state taxes) compared to a stock sale.  A seller’s ability to ask for and receive the gross-up is a matter of negotiation driven in large part by the competitiveness of the M&A environment and the nuances of the deal valuation and structure negotiations.

Vail Valley Asset Management – Full Service Investment Management for Business Owners

We offer a highly differentiated investment solution for lower middle market business owners centered around our unwavering commitment as fully aligned fiduciaries.  We view our clients’ business ownership as their most important asset that is at the core of our portfolio management process.  At Vail Valley Asset Management, we are 100% fiduciary 100% of the time, and offer a source of objective advice to business owners.  Building and operating a business is complex, requiring dedication, vision, and perseverance.  Selling your company attracts sell-side service providers motivated by success fees and other deal-related fees.  You deserve a trusted and unbiased advocate with a deep understanding of private markets to guide you through the complexities of the M&A process.   If you are a business owner looking for a financial advisor with expertise in private markets and the M&A process, contact us at Vail Valley Asset Management to schedule a consultation.

[1] Some of the disadvantages of the S-corp classification is that the corporation is limited to 100 shareholders or less at a time, only one class of stock is permitted, and all shareholders must be “eligible”, which generally includes individuals, estates, and certain trusts. The “one-class-of-stock” rule applies to economic rights of the S-corp shareholder and requires that all equity owners receive allocations of income and loss (as well as distributions of cash or property) in strict proportion to their ownership percentages.  It is common for an S election to be invalidated because of disproportionate distributions, failing to get spousal signatures for taxpayers living in community property states, or transfers to ineligible shareholders.  Blowing an S-corp election will trigger a reversion to a regular C corporation status and its second layer of taxation, which could have a severe financial effect on the business owner.  Buyers planning to use a section 338(h)(10) or section 336(e) election will often review the past five years of Forms K-1 to ensure that the rules of subchapter S have been respected. 

Owners of lower middle market (“LMM”) businesses contemplating a sale or majority recapitalization should be aware of trends in rollover equity in M&A transactions.  As a seller of a LMM business, you may be expecting to have a full exit from your business at the closing table.  Sellers may be surprised when their investment banker broaches the topic of rolling equity in a transaction and the terms of Indications of Interest (“IOIs”) and then Letters of Intent (“LOI”) include references to rollover equity in the proposed capital structure of a transaction.  What is rollover equity, why is it used, and why can’t sellers always have a clean economic break from their business?

What Is Rollover Equity?

Within an acquisition, rollover equity refers to the portion of the sale proceeds reinvested by the seller(s) or ownership group of a company into the equity of the post-acquisition company, typically referred to as “Newco”.  Newco is the new or acquiring entity formed by the buyer to facilitate the acquisition.  The biggest reason to use rollover equity in an acquisition is to align interests through shared economic ownership.  Rollover equity gives the seller(s) a “second bite at the apple”, and rollover equity is also tax-deferred if structured properly.  From the perspective of a business owner, rollover equity is among the most important economic aspects of any deal and is often a focal point of deal negotiations since rollover equity reduces the sale proceeds at closing and economically ties the seller to the business for an extended period of time.

Why is Rollover Equity Used

While the overall driver to use rollover equity in an acquisition is to align interests through shared economic ownership, other factors can play a role.  Creating skin in the game for sellers who may be viewed as critical to the continued operations or reputation of a business can be important to buyers.  Continuity of key customer and supplier relationships may be aided by the sellers’ continued ownership interest in the business.   Certain buyers may also be looking for rollover equity as a source of capital to help fund the deal and close gaps in the proposed capital structure given issues with equity capital capacity or limitations on borrowing capacity.  Private equity buyers may have internal fund policies requiring rollover equity in deals. 

In some deals, sellers may have sufficient conviction in the prospects of their business to insist on rollover equity to preserve exposure to the upside of the future success of the business.  In our experience, a seller’s willingness to include rollover equity signals confidence in the business.  After all, buyers always face some aspect of asymmetric information- a seller will always know more about their business than the buyer.  Rollover equity serves as a practical mitigant to this issue and a refusal to consider rollover equity can be seen as a red flag by buyers.

Overall, rollover equity is common for acquisitions in the LMM.  While no single authority on deal structure related data exists, we have seen previous surveys from M&A transaction service providers suggest that nearly 80 percent of surveyed middle market M&A transactions include some form of rollover equity and the typical amount of equity rolled in a middle market transaction is approximately 20 percent.  Our view is that those figures are likely similar for LMM acquisitions.  Some strategic buyers may not have a desire to use rollover equity, while acquisitions of smaller companies that serve as add-ons to larger platforms may not request rollover equity to avoid diluting the platform owners, particularly if the platform owner is close to exiting.

Potential Benefits for Sellers

A seller’s openness to rollover equity shows commitment and confidence in the business for a buyer.  Retaining some ownership in the business through rollover equity provides sellers with a second bite at the apple.  There are many examples of sellers receiving considerable future economic benefits from rollover equity and the most successful deals can even result in sellers ultimately receiving more proceeds from the rollover equity than from the initial transaction.  Some sellers may have the opportunity to continue their ownership through multiple exits and multiple owners, getting additional subsequent payoffs stemming from the original rollover equity. 

When to be Cautious with Rollover Equity

Despite the upside opportunities, there are some good reasons to be skeptical around rolling equity.  If a seller has justifiable doubts around the future of the business or the industry, reducing your economic exposure to the business is prudent.  Of course, bona fide concerns around the business makes the negotiating process challenging as informed buyers likely harbor similar doubts.   

Rollover equity creates the need for the seller to evaluate the other side of the table.  If a seller doubts the buyer’s ability to execute on the value creation thesis or successfully operate the business, rollover equity poses some challenges.  One area a seller should pay particular attention to is the prudence of the proposed capital structure of the post-close company.   Too much leverage in the form of senior and junior debt increases the financial risk of the deal and may impact the ability of the company to comfortably service the debt load through all operating scenarios, including downside scenarios. 

Sellers also need to pay attention to mezzanine capital as most rollover equity is common stock or similar LLC units.  Rollover equity is almost always at the bottom of the capital stack.  Relatedly, sellers should carefully review whether rollover equity is pari passu with the buyer’s equity.  If the buyers are getting preferred, sellers should focus on receiving preferred as well.  If a seller is encountering a proposal to receive equity that is junior to the buyer’s equity or the buyer’s equity has some type of structural preference to the rollover equity, proceed with caution, particularly in highly leveraged deals. For situations when your business is being acquired by an existing platform and you are being offered rollover equity in the platform, pay close attention to the relative or implied valuation of the platform.  A buyer may be using richly valued or overvalued platform equity as cheap currency to pursue accretive add-on deals, leaving sellers holding the rollover equity at an unattractive or speculative valuation.  

Our View

In the current environment, sellers should expect some form of rollover equity.  Approaching the concept openly of staying economically tied to the business after closing is helpful and will help level-set expectations at the negotiating table.  However, sellers should know the drivers behind a buyer’s request for rollover equity and understand that alignment of interests is only a high-level concept.  A buyer can have a variety of motivations to propose rollover equity.  Situations exist where buyers seek to use rollover equity to establish a more attractive deal structure, leaving sellers junior to the buyer’s equity in a highly leveraged capital structure, with sellers in first loss position in a downside scenario.  Understanding the specific terms of rollover equity is critical.  Sellers should have access to advice and information to help determine if proposed rollover equity terms are within the range of “market”.  In a truly aligned scenario involving the sale a quality business, rollover equity can be a significant economic benefit to sellers, who go along for the value creation ride with the new buyers and receive an attractive future payoff from the second (or third) bite at the apple.

Vail Valley Asset Management – Full Service Investment Management for Business Owners

We offer a highly differentiated investment solution for lower middle market business owners centered around our unwavering commitment as fully aligned fiduciaries.  We view our clients’ business ownership as their most important asset that is at the core of our portfolio management process.  At Vail Valley Asset Management, we are 100% fiduciary 100% of the time, and offer a source of objective advice to business owners.  Building and operating a business is complex, requiring dedication, vision, and perseverance.  Selling your company attracts sell-side service providers motivated by success fees and other deal-related fees.  You deserve a trusted and unbiased advocate with a deep understanding of private markets to guide you through the complexities of the M&A process.   If you are a business owner looking for a financial advisor with expertise in private markets and the M&A process, contact us at Vail Valley Asset Management to schedule a consultation.