“Speed and certainty” of closing is a common mantra in the M&A world. M&A advisers are often asked why M&A deals die. While certain challenges can hinder the speed or terms of a deal, proactive counsel can plan and structure appropriately to enable a transaction to survive hiccups and surprises, including those related to contractual, employment or even tax issues. Maintaining focus on these commonly-faced potential pitfalls – or “deal killers” – can help ensure a successful close.
Transactions involving companies holding government contracts present a unique set of considerations. To avoid a potential pitfall, it is important to identify how a transaction may affect a target’s government contracts.
First, a buyer should consider whether the target qualifies as a “small business concern.” To qualify for this designation, the contractor and its affiliates must have fewer than a specified number of employees and/or receive less than a specified amount of revenue. If any of the target’s material contracts with the government are set-aside for entities that qualify as “small business concerns,” the buyer and its advisers should analyze how the pending transaction might affect the target’s qualification. If, as a result of the proposed transaction, the target would no longer qualify for the designation, it can sometimes continue performance on its existing contacts, but would not be eligible for new small business set-aside contacts or work in the future.
Next, parties to the transaction should consider how the structure of the deal might impact the transaction schedule. A contract with the federal government typically cannot be transferred to a third party without the approval from the government through a process called novation. If the transaction is structured as an asset sale, as opposed to an equity sale, the parties must “novate” any government contracts. Because the applicable U.S. government agency controls both the timing of the novation process and the ultimate decision of whether to grant a novation request, contractors undergoing the novation process have experienced an array of practical and administrative challenges. In consideration of these potential deal killers, a buyer should identify the volume and materiality of a target’s government contracts at the outset of a transaction.
When conducting diligence on a target, buyers should keep an eye out for two types of employee misclassification. First is the misclassification of independent contractors and the question of whether an individual should have instead been classified as an employee. While designating service providers as independent contractors can be more efficient and cost-effective for a company, misclassifications can have costly repercussions, such as tax liability, governmental fines and penalties. In addition, misclassified contractors could be entitled to retroactive participation in employee benefits. To spot this issue in advance, the buyer should request lists of the target’s contractors with summaries of any services provided and copies of individual agreements, understanding that any self-serving language in an agreement will not be dispositive; rather, the substance of the relationship (based on a number of factors) will govern the determination.
The second type of employee misclassification is misclassification of employees as “exempt” or “nonexempt” under the federal Fair Labor Standards Act (FLSA) for minimum wage and overtime purposes. If employees have been misclassified, there may be liability for all unpaid overtime, which can be a significant sum depending on the number of employees at issue and the estimated number of overtime hours worked. To assess whether this is a potential concern, buyers should request that the target provide information on employees’ salaries, classifications, job titles, job descriptions, and any audits of classifications as well as any recent Department of Labor (or similar state agency) audits.
Sales and Use Taxes
When conducting tax due diligence on potential targets, a buyer should determine whether the target was filing sales and use tax returns in jurisdictions where it had “nexus,” and whether the target under-reported its sales and/or use tax liability in the jurisdictions in which it filed returns.
The identification of a material sales tax exposure may impact deal negotiations between a buyer and target. It is standard for sellers to contractually agree in the purchase agreement to indemnify the acquiror for pre-closing tax liabilities, including sales and use tax liabilities, but sometimes particular indemnification procedures also need to be designed and implemented in the purchase if it is determined that post-closing remedial measures need to be pursued.
For example, a buyer may want to expressly retain the right to resolve sales and use tax deficiencies through a post-closing voluntary disclosure agreement (VDA) process or amnesty program available in a particular state. The parties can negotiate the parameters of the VDA process, such as timing and review of the filings, materiality of potential exposure for determining which states will be pursued, and allocation of cost. Experienced deal counsel can propose and craft appropriate provisions to navigate these risks appropriately and allow a deal to close.
An essential part of the due diligence process is identifying employee benefit plan issues. Because benefit plans are highly regulated by the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code, they often present legal and operational issues, and potentially, significant liability exposure for buyers.
As an example, many employers sponsor a 401(k) plan; a decision must be made early on whether the seller’s plan will be terminated pre-closing or assumed by buyer and possibly merged with buyer’s 401(k) plan. Due to an IRS rule, a 401(k) plan typically cannot be terminated by the buyer post-closing, and the buyer may find itself on the hook for correcting compliance issues not disclosed by seller or identified in the diligence process. Common plan administration issues include contribution calculation, employee eligibility and vesting errors which must be corrected though an IRS correction program – usually at considerable time and expense – to preserve tax benefits for both the plan sponsor and the plan participants.
401(k) plans may also create litigation risks from poorly monitored investments or excessive fees. Sellers may reduce risk and simplify negotiations through proactive pre-sale attention to potential benefit plan concerns. Buyers can maximize deal protections and develop a clear understanding of their pre-closing and post-sale alternatives by paying close attention to benefit plan issues early in the diligence process.
While there are a handful of M&A deal killers that can arise, experienced M&A counsel can identify potential issues upfront and help to negotiate potential liabilities to avoid having a transaction crumble. Careful due diligence of the above issues can help set your deal up for success and help navigate common obstacles that may appear.