Debt to Equity Conditions

Requirements on conversion of liability to equity

C. Conversion of advances/liabilities to equity

1. A report by an independent CPA on the verification of the advances to be

converted to equity in accordance with the Guidelines on On-site Verification as
provided for in SEC Memorandum Circular No. 6, series of 2008;
2. Detailed schedule of the liabilities to be offset, as of the date of trial balance, as
certified by the company accountant;
3. Trial balance as of the end of the month immediately preceding the submission of
the requirements, which shall include the subject advances or liabilities, as
certified by the company accountant; and
4. Deed of Assignment signed by the creditor or subscriber assigning the advances
as payment for his subscription.

Note: If the advances are reflected in the audited financial statements (item 6 of the basic
requirements), submit a certification from the auditor identifying the creditors and the amount
owed to each, in lieu of item 1

Requirements on merger and consolidation

VI. MERGER/CONSOLIDATION

1. Articles of Merger/Consolidation;
2. Plan of Merger/consolidation;
3. List of stockholders of the constituent corporations before the
merger/consolidation, and list of stockholders of record of the surviving
corporation after the merger/consolidation, as certified by the corporate
secretary;
4. Certification, under oath, by the corporate secretary, on the meetings of the
directors and stockholders of the constituent corporations approving the
merger/consolidation;
5. Audited financial statements of the constituent corporations as of a date not
earlier than 120 days prior to the date of filing of the application in accordance
with PFRS 3 ( Accounting Standard on Business Combination);
6. For absorbed corporations: Long-form audit report of item 5;
7. Certification, under oath, by the president, chief finance officer or treasurer of the
constituent corporations that all creditors (state cut-off date) have been properly
notified of the proposed merger/consolidation;
8. If at least one of the constituent corporations is insolvent: Affidavit of publication
in a newspaper of general circulation of the proposed merger/consolidation.
 Notes:

1. If the surviving corporation will not issue shares of stock or create additional paid-
in capital: Disregard item 6
2. If the merger will be effected via increase of capital stock: Submit also the
requirements for Increase of Authorized Capital Stock
3. For consolidation: Submit also the requirements for the registration of a stock or
non-stock corporatio

Per PFRS conversion of to equity

Capitalizing stockholder advances and loans

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 Capitalizing stockholder advances and loans

Capitalizing stockholder advances and loans

by: TATA D. PANLILIO

Traditionally, corporations generate funds to meet their requirements by way of receiving additional
investments from existing or new stockholders. However, it is not unusual for existing stockholders
especially those belonging to a group of related companies, to infuse additional funds, and where the
requirements are expected to be temporary, to extend advances and/or loans to the corporation.

Unfortunately, due to adverse economic and business conditions, some companies incur chronic losses
leading to capital deficit position and end up being unable to repay the stockholder advances and/or
loans. In these instances, an option frequently considered by the stockholder-grantor is to convert the
liabilities of the company-grantee arising from the advances and/or loans into additional paid-in capital
(APIC) without issuance of new shares. The stockholder-grantor may not opt to receive new shares
mainly because the company-grantee is already majority or wholly-owned by it, or if there is a need
maintain the existing shareholdings either by reason of contractual agreements or of foreign equity
limitations as required by law. The APIC resulting from the conversion of liabilities is then subsequently
applied to wipe-out the capital deficit of the company-grantee.

Before pursuing such conversion of liability to equity, a corporation should carefully consider the tax
implications of such transaction and the related regulatory requirements that must be complied with.

Debt-to-equity conversion through creation of APIC without issuance of shares is a capital transaction
which is not subject to income tax on the part of the company-grantee and to donor’s tax on the part of
the stockholder-grantor. Moreover, since no shares will be issued, the corresponding liability to pay
documentary stamp tax (DST) on original issuance of shares of stock as imposed under the 1997 Tax
Code will not apply.

The foregoing was confirmed by the Bureau of Internal Revenue (BIR) in a 2004 ruling which involved a
stockholder who acted as guarantor to a loan obtained by a company. When the company defaulted on
its loan, the stockholder paid a portion of the loan and thereafter, considered converting its receivable due
from the company into equity in the form of APIC without issuance of shares. The BIR ruled that the
conversion of the company’s liability to its stockholder into equity without issuing shares shall not give rise
to taxable income and shall be considered as additional capital investment on the part of the stockholder.
Furthermore, the same shall not be subject to donor’s tax, there being no donative intent .

On the other hand, conversion of liability to equity through creation of APIC without issuance of shares,
prior to January 2006, used to involve the application for approval of the Securities and Exchange
Commission (SEC). However, the Commission recently resolved to delete from the SEC Schedule of
Fees and Charges the transaction “Application for Creation of APIC” (which includes conversion of
liabilities to APIC) and the corresponding fee therefor. As a result, the position initially was taken that the
FAAD will no longer accept applications for creation of APIC.

The Commission, however, subsequently clarified that what was removed was the mandatory character
of the application, i.e., SEC approval of conversion of liabilities to APIC is no longer mandatory.
However, application of APIC to wipe-out capital deficit still requires prior SEC approval.

Notwithstanding the new SEC policy and the existence of precedent BIR rulings, there may be cases
where securing formal SEC approval of conversion of liabilities to APIC without issuance of shares would
be prudent. For instance, where the conversion of liabilities to APIC and application thereof to the capital
deficit are undertaken preparatory to a buy-in (through pu rchase of shares) of an investor, the latter
would not want the company to have outstanding liabilities to the current stockholder-seller and may
prefer that the SEC formally approve the debt-to-equity conversion. This is particularly true where the
investor is publicly-listed or is a multinational company who may be required to present to their respective
regulators, as well as stockholders, formal and independent approvals granted by the Philippine SEC.

While capitalizing stockholder advances and loans through conversion to APIC is a relatively simple
means of improving the financial condition of a distressed company, it would be prudent to determine
whether under the circumstances there would be a need to secure formal government approval.
 REVENUE MEMORANDUM RULINGS 2001
RMR 2001 in PDF Format

No. of Issuance Subject Matter Date of Issue

RMR No. 1-2001 Consolidates, provides, clarifies and harmonizes the existing December 5, 2001
guidelines on the tax consequences of a non-recognition transaction
consisting of a tax-free exchange of property for shares of stock of a
controlled corporation Full Text
Quezon City
November 29, 2001
REVENUE MEMORANDUM RULING NO. 1-2001

SUBJECT : Tax Consequences of Tax-Free Exchange of Property for Shares of Stock of a Controlled
Corporation Pursuant to Section 40(C)(2) of the National Internal Revenue Code of 1997

TO : All Internal Revenue Officers and Others Concerned

___________________________________________________________________________________________

Pursuant to Section 4, in relation to Sections 40(C)(2), (4), (5), (6), 175, 176, and 196, and pertinent provisions of
Titles II, IV and VII of the National Internal Revenue Code of 1997 (Tax Code of 1997), this Revenue
Memorandum Ruling is issued to consolidate, provide, clarify and harmonize the existing guidelines on the tax
consequences of a non-recognition transaction consisting of a tax-free exchange of property for shares of stock
under Section 40(C)(2) of the Tax Code of 1997. This Revenue Memorandum Ruling shall apply solely and
exclusively to, and may be relied upon only in situations in which the facts are substantially similar to the facts
stated below, but subject to the principles of substance over form.

I FACTS

1. A domestic corporation (the "Transferor") owns certain property, consisting, for example, of the following:

1.1 Land encumbered by a real estate mortgage (REM);

1.2 Buildings;
1.3 100 shares of stock in G Corporation with a par value of P10 per share;
1.4 50 shares of stock in D Corporation without par value;
1.5 Unsecured receivables;
1.6 Loans to Q ("Borrower/Mortgagor"), secured by a real estate mortgage;
1.7 Cash.

2. X Corporation (the "Transferee") is a domestic corporation.

3. The Transferor transfers the property to the Transferee. In exchange, the Transferee issues shares to the
Transferor out of the unissued portion of its existing authorized capital stock, or, if such existing authorized
capital stock is insufficient, out of shares from an increase in the Transferee's authorized capital stock. The
Transferor does not receive any money or property other than the aforementioned shares of the transferee.

4. The property transferred by the Transferor-corporation constitutes less than 80% of the Transferor's assets,
including cash.

5. In addition to the transfer of the property, the Transferee assumes liabilities of the Transferor. However, the
sum total of the amount of liabilities assumed, plus the amount of the encumbrance or REM on the Land (as
stated in Section 40(C)(4) of the Tax Code of 1997 - "liabilities to which the property is subject") do not exceed
the basis of the property transferred.

6. The shares are neither issued in payment for services, nor for settlement of an outstanding liability that arises
from the performance of services rendered by the Transferor to the Transferee.

7. As a result of the above-mentioned transfer, the Transferor acquires at least 51% of the total outstanding
capital stock of the Transferee entitled to vote.

II TAX CONSEQUENCES

1. Income tax. The Transferor shall not recognize any gain or loss on the transfer of the property to the
Transferee. Consequently, the Transferor will not be subject to capital gains tax, income tax, or to creditable
withholding tax on the transfer of such property to the Transferee. Neither may the transferor recognize a loss, if
any, incurred on the transfer. The last paragraph of Section 40(C)(2) and (6)(c) of the Tax Code of 1997 state:

"No gain or loss shall also be recognized if property is transferred to a corporation by a person in exchange for
stock or unit of participation in such corporation of which as a result of such exchange said person, alone or
together with others, not exceeding four (4) persons, gains control of said corporation: Provided, That stocks
issued for services shall not be considered as issued in return for property."

"(c) The term 'control', when used in this Section, shall mean ownership of stocks in a corporation possessing at
least fifty-one percent (51%) of the total voting power of all classes of stocks entitled to vote."

In addition, the assumption of liabilities or the transfer of property that is subject to a liability does not affect the
non-recognition of gain or loss under Section 40(C)(2) of the Tax Code of 1997, since in this case, the total
amount of such liabilities does not exceed the basis of the property transferred. Section 40(C)(4) of the Tax Code
of 1997 states:

"(4) Assumption of liability. -

(a) If the taxpayer, in connection with the exchanges described in the foregoing exceptions, receives stock or
securities which would be permitted to be received without the recognition of the gain if it were the sole
consideration, and as a part of the consideration, another party to the exchange assumes a liability of the
taxpayer, or acquires from the taxpayer property, subject to a liability, then such assumption or acquisition
shall not be treated as money and/or other property, and shall not prevent the exchange from being within
the exceptions.

(b) If the amount of the liabilities assumed plus the amount of the liabilities to which the property is
subject exceed the total amount of the adjusted basis of the property transferred pursuant to such exchange, then
such excess shall be considered as a gain from the sale or exchange of a capital asset or of property which is not a
capital asset, as the case may be."

In addition, the Transferee is not subject to income tax on its receipt of the property as contribution to its capital,
even if the value of such property exceeds the par value or stated value of the shares issued to the Transferor.
Section 55 of Revenue Regulations No. 2 ("Income Tax Regulations") states:

"Section 55. Acquisition or disposition by a corporation of its own capital stock. - xxx xxx xxx. The receipt by a
corporation of the subscription price of shares of its capital stock upon their original issuance gives rise to neither
taxable gain nor deductible loss, whether the subscription or issue price be in excess of, or less than the par or
stated value of such stock.

xxx xxx xxx"

However, stocks shall not be issued for a consideration less than par or issued price thereof. (Section 62,
Corporation Code of the Philippines)

2. Donor's tax. The Transferor is not subject to donor's tax, regardless of whether the value of the property
transferred exceeds the par/stated value of the Transferee shares issued to the Transferor, there being no intent to
donate on the part of the Transferor.

3. Value-added tax. The Transferor is not subject to value-added tax ("VAT") on the transfer of the property if it
is not engaged in a business that is subject to the VAT under Title IV of the Tax Code of 1997. Even if the
Transferor is engaged in an activity that is subject to VAT, it is nonetheless not subject to VAT on the transfer of
the property to the Transferee, since the Transferor gains control of the Transferee. Section 4.100-5(b)(1) of
Revenue Regulations No. 7-95, as amended states:

"(b) Not subject to output tax. - The VAT shall not apply to goods or properties existing as of the occurrence of
the following:

1) Change of control of a corporation by the acquisition of the controlling interest of such corporation by another
stockholder or group of stockholders, Example: transfer of property to a corporation in exchange for its shares of
stock under Section 34(c)(2) and (6)(c) of the Code [now 40(C)(2) and (6)(c) of the Tax Code of 1997].

4. Documentary stamp tax. The documentary stamp tax consequences of the transfer are as follows:

4.1 Either the Transferor or the Transferee is subject to documentary stamp tax as follows:

4.1.1 On the transfer of real property (Section 196, Tax Code of 1997) - P15 on each P1,000 or fractional part
thereof, based on the higher of: (i) the consideration contracted to be paid for such real property, and (ii) the fair
market value as determined in accordance with Section 6(E) of the Tax Code of 1997.

4.1.1.1 The "consideration contracted to be paid for such real property" shall be computed in accordance with the
following rules. "Stock in a corporation is a valuable consideration for the transfer of real property." (Section
177, Revenue Regulations No. 26) Therefore, the consideration for the real property shall be computed as the
par/stated value of the Transferee shares issued to the Transferor in exchange for such property plus the value of
such property in excess of such par/stated value recognized in the books of the Transferee as premium, additional
capital contribution, or donated surplus, or the like. For instance, if the value of the property is P1,000,000, but
only shares with an aggregate par value of P250,000 are issued, there being a premium above par of P750,000,
which the Transferee records as additional capital contribution, donated surplus, or the like, the consideration is
P1,000,000 (that is, par value of P250,000 + premium of P750,000).

4.1.1.2 On the other hand, the fair market value of the property as determined in accordance with Section 6(E) of
the Tax Code of 1997 whichever is higher between (1) the fair market value as determined by the Commissioner
(that is, zonal value), and (2) the fair market value as shown in the schedule of values of the Provincial and City
Assessors.

4.1.1.3 The value of the improvements thereon shall be based on the formula provided under Revenue Audit
Memorandum Order (RAMO) No. 1-2001 but shall not be lower than the fair market value in the Tax
Declaration in the year of exchange.

According to the said RAMO, the value of the improvement shall be determined by deducting the zonal value of
the land from the total selling price/consideration per Deed of Exchange. Thus, if the total selling
price/consideration per Deed of Exchange is P1,000,000.00 and the zonal value of the land is P600,000.00, then
the value of the improvement is P400,000.00.
The fair market value of the improvement shall be determined per latest tax declaration at the time of its sale or
disposition (in this particular case, the exchange of such property). If the tax declaration was issued three (3) or
more years prior to the date of sale or disposition, the Transferor shall be required to submit a certification from
the city/municipal assessor as to the fact that such tax declaration is the latest tax declaration covering the real
property. Absent such certification, the Transferor must secure a copy of the latest tax declaration duly certified
by the assessor.

4.1.2 On the transfer of shares of stock held by the Transferor (Section 176, Tax Code of 1997) -

4.1.2.1 The transfer of the shares of G Corporation, which have a par value, is subject to documentary stamp tax
of P1.50 on each P200 or fractional part thereof of the par value of such shares.

4.1.2.2 The transfer of the shares of D Corporation, which are without par value, is subject to the documentary
stamp tax of 25% of the documentary stamp tax that was paid when those shares were originally issued.

4.1.3 Transfer of mortgage (Section 198, in relation to Section 195, Tax Code of 1997) - The transfer of the
real estate mortgage, as a consequence of the transfer of the loan to Q ("Borrower/Mortgagor"), is subject to
documentary stamp tax at the following rate:

(a) When the amount secured does not exceed five thousand pesos (P5,000) - twenty pesos (P20);

(b) On each five thousand pesos (P5,000), or fractional part thereof in excess of five thousand pesos (P5,000), an
additional tax of ten pesos (P10).

4.2 The Transferee is subject to documentary stamp tax on the original issuance of its shares (Section 175, Tax
Code of 1997), at the following rate, depending on whether such shares are par or no-par shares:

4.2.1 If the Transferee's shares are with par value, the documentary stamp tax is imposed at the rate of P2 on each
P200 or fractional part thereof of the par value of such shares, regardless of whether the shares are issued at par
value or for a premium (that is, for a consideration in excess of par value).

4.2.2 If the Transferee's shares are without par value, the documentary stamp tax is imposed at the rate of P2 on
each P200 or fractional part thereof of the actual consideration paid for such shares.

5. Time of payment of Taxes. The time for the payment of the documentary stamp tax liabilities, whether the
taxpayer is an e-filer or not, shall be as follows:

5.1 With respect to the transfer of property mentioned in 4.1, above, the documentary stamp tax shall be paid on
or before the fifth (5th) day after the close of the month when the deed of assignment/transfer transferring such
property was executed, made, signed, accepted, or transferred (Section 5, Revenue Regulations No. 6-2001).

5.2 With respect to the original issuance of shares mentioned in 4.2, above, the documentary stamp tax shall be
paid on or before the fifth (5th) day after the close of the month of -

5.2.1 Approval of SEC registration, in case of original incorporation;

5.2.2 Approval of the increase in authorized capital stock, in case the shares issued to the Transferee come from
the increase in authorized capital stock of the Transferee; or

5.2.3 Execution of the deed of assignment/transfer of the property for which the Transferee's shares are issued, in
case the shares issued to the Transferor come from the unissued portion of the Transferee's existing authorized
capital stock.

III ADDITIONAL FACTS AND VARIATIONS NOT AFFECTING TAX CONSEQUENCES

The following additional facts or variations will not affect the tax consequences of the transaction, as described
above:

1. In no. 1 of "I. Facts" stated above, if the total number of Transferors does not exceed five persons, whether
such persons are natural persons or juridical persons.

2. In no. 7 of "I. Facts" stated above, the tax consequences are not affected by whether the Transferor is/was a
shareholder prior to the transaction, or that, prior to the transaction, the Transferor already possessed control of
the Transferee by owning 51% or more of the total outstanding capital stock of the Transferee entitled to vote. In
such a case, the Transferor is deemed to have acquired "further control" of the Transferee, which places the
transaction within the purview of Section 40(C)(2) of the Tax Code of 1997.

However, a Transferor who, prior to the transaction was an existing shareholder of the Transferee, but who
owned less than 51% of the voting stocks of the Transferee (even if it, together with not more than four (4)
persons, owned more than 51% of all classes of stocks entitled to vote of the Transferee) cannot be deemed to
have gained control or further control of the Transferee if, after a transaction in which it is the sole transferor, it
still owned by itself less than 51% of the voting stocks of the Transferee. For instance, assume in the above facts
that, prior to the transfer, the Transferor, together with Stockholders E, B, M and R, owned 100% of the voting
stocks of the Transferee. However, by itself the Transferor owned only 32% of the voting stocks of the
Transferee (the balance of the 68% voting stocks being owned by Stockholders E, B, M and R). The Transferor
transfers property to the Transferee in exchange for shares of stock. After this exchange, the Transferor owned,
including the initial 32%, a total of 49% - or less than 51% - of the voting stocks of the Transferee. In this
situation, the Transferor is not deemed to have gained control or further control of the Transferee.

IV FURTHER CLARIFICATION OF FACTS AND TAX CONSEQUENCES

1. No. 1 of "I. Facts" mentions "property". For purposes of Section 40(C)(2) of the Tax Code of 1997, this term
excludes services, accounts receivable for services rendered by the Transferor for the Transferee, cash and the
conversion of debt into equity.

2. No. 3 of "I. Facts" mentions the issuance of the Transferee's shares from the "unissued portion of its existing
authorized capital stock, or, if such existing authorized capital stock is insufficient, out of shares from an increase
in the Transferee's authorized capital stock". This statement of fact excludes the following, which if present,
would give rise to a different tax consequence treated elsewhere other than in this Revenue Memorandum Ruling
-

2.1 The issuance of treasury shares, which have previously been issued but were subsequently re-acquired by the
Transferee and have not been retired.

2.2 Settlement of subscription receivables. Therefore, the tax consequences described above shall not apply to the
extent that the property is transferred in payment for the unpaid balance of the subscription to shares.

3. No. 4 of "I. Facts" mentions the property transferred constituting "less than 80% of the Transferor's assets,
including cash". This requirement is necessary to distinguish this transaction from a de facto merger as described
in Section 40(C)(6)(b) of the Tax Code of 1997 in relation to BIR Circular No. V-253 dated July 16, 1957, the
tax consequences of which will be discussed in a different Revenue Memorandum Ruling.

4. No. 5 of "I. Facts" mentions the term "adjusted basis of the property", as well as the fact that such liabilities
assumed and to which the property is subject "do(es) not exceed the adjusted basis of the property transferred".
These terms are clarified as follows:

4.1 The basis or "original basis" of the property is its "historical cost". "Historical cost" is the value of the
property as determined pursuant to Section 40(B) of the Tax Code of 1997. The term "adjusted basis" is the value
of the property as determined pursuant to the said Section, modified by adjustments to the historical cost. For
example, the "adjusted basis" of a property acquired by purchase is the historical cost (acquisition cost) of such
property increased by, among others, the amount of improvements that materially add to the value of the property
or appreciably prolong its life and decreased by accumulated depreciation. "Adjusted basis" excludes re-appraisal
surplus, whether or not recorded in the books of the Transferor.

4.2 "Property" does not include services or accounts receivable for services rendered by the Transferor to the
Transferee, cash, or the conversion of debt into equity. Therefore, in determining whether liabilities assumed and
to which the property is subject "do(es) not exceed the adjusted basis of the property transferred", the value of
services rendered, cash and the conversion of debt into equity will be excluded from the computation of
"adjusted basis of the property transferred".

5. The term "adjusted basis" should be distinguished from the term "substituted basis", since they are not
necessarily synonymous. The terms "original basis" and "adjusted basis" are used in reference to the value of the
property before it was transferred by the Transferor; whereas, the term "substituted basis" is used in reference
to both the value of the property in the hands of the Transferee after its transfer and the shares received by the
Transferor from the Transferee. The term "substituted basis" is significant in determining the tax basis of the
aforementioned property or shares for purposes of computing the gain or loss on the subsequent disposition of
such property or shares. The following rules will apply in determining substituted basis:

5.1 In general, the substituted basis of the Transferee's shares received by the Transferor for purposes of
computing gain or loss on the subsequent disposition of such shares by the Transferor is equal to the Transferor's
basis in the property at the time of the transfer (that is, "historical cost/original basis" or "adjusted basis", as the
case may be) decreased by (1) the money received by the Transferor, and (2) the fair market value of the other
property received by the Transferor, and increased by (a) the amount treated as dividend of the shareholder and
(b) the amount of any gain that was recognized on the exchange. If, as in this case, the Transferee assumed
liabilities of the Transferor and/or acquired property of the Transferor that is subject to liabilities, the amount of
liabilities shall be treated as money for purposes of determining the substituted basis. In the particular facts
covered by this Revenue Memorandum Ruling, the substituted basis of the Transferee's shares acquired by the
Transferor is the historical cost/original basis or adjusted basis of the properties mentioned in no. 1 of "I. Facts"
(excluding cash), less the total of (a) the amount of liabilities assumed by the Transferee and (b) the amount of
real estate mortgage on the Land.

Section 40(C)(5)(a) of the Tax Code of 1997 states:

"(5) Basis. -

(a) The basis of the stock or securities received by the transferor upon the exchange specified in the above
exception shall be the same as the basis of the property, stock or securities exchanged, decreased by (1) the
money received, and (2) the fair market value of the other property received, and increased by (a) the amount
treated as dividend of the shareholder and (b) the amount of any gain that was recognized on the exchange;
Provided, That the property received as "boot" shall have as basis its fair market value; provided, further, that if
as part of the consideration to the transferor, the transferee of property assumes a liability of the transferor or
acquires from the latter property subject to a liability, such assumption or acquisition (in the amount of the
liability) shall, for purposes of this paragraph, be treated as money received by the transferor on the exchange;
provided, finally, that if the transferor receives several kinds of stock or securities, the Commissioner is hereby
authorized to allocate the basis among the several classes of stocks or securities."

5.2 On the other hand, the substituted basis of the property in the hands of the Transferee for purposes of
computing gain or loss on the subsequent disposition of such property by the Transferee is the Transferor's
original or adjusted basis in such property at the time of transfer plus the gain recognized to the transferor on the
exchange. Section 40(C)(5)(b) of the Tax Code of 1997 states:

"The basis of the property transferred in the hands of the transferee shall be same as it would be in the hands of
the transferor increased by the amount of the gain recognized to the transferor on the transfer."

In the particular facts of this Revenue Memorandum Ruling, there are no circumstances under which the
Transferor recognizes gain. Thus, in this case, the substituted basis of the property in the hands of the Transferee
is equal to the Transferor's original or adjusted basis in such property at the time of the transfer.

6. No. 7 of "I. Facts" mentions that the Transferor acquires "at least 51% of the total outstanding capital
stock of the Transferee entitled to vote". Shares of stock "entitled to vote" excludes those shares that have been
denied voting rights in the Transferee's Articles of Incorporation, in accordance with the provisions of Batas
Pambansa Blg. 68 ("The Corporation Code of the Philippines" or the "Corporation Code") (although the
Corporation Code may retain the right of holders of preferred shares to vote in certain instances specified in the
Code).

For instance, assume in the above Facts, that the Transferee has an authorized capital stock of P32,550,000.00
divided into 265,000 common shares and 2,990,000 preferred non-votingshares with a par value of P10.00 per
share. Only common shares have voting rights. The stockholders of the Transferee before the transfer are the
following:

Stockholders Common Preferred

Transferor 135,490 9
B 10 8
C 64,000 651,244
D 64,000 651,246
E 1,497 530,340
F 1 1
G 1 1
H 1 1
---------- ----------
TOTAL 265,000 1,832,850
====== ======

The Transferee increases its authorized capital stock by increasing only the number of its common shares. Out of
this increase, the Transferor subscribes to 298,450 common shares for a total subscription price of
P2,984,500.00, which subscription is paid in property.

As a result of the subscription, the Transferor gains control of the Transferee by owning 77.01%
(433,940/563,450 common shares) of the latter's outstanding shares of stock that are entitled to vote, to wit:

Stockholders Common Preferred

Transferor 433,940 9
B 10 8
C 64,000 651,244
D 64,000 651,246
 E 1,497 530,340
F 1 1
G 1 1
H 1 1
---------- ----------
TOTAL 563,450 1,832,850
====== ======

7. If the Transferor is a Philippine branch of a foreign corporation, and the branch is incorporated into the
Transferee corporation (such that the branch will no longer exist after the incorporation of the Transferee)
directly owned by the head office, in addition to the tax consequences described above, the branch will be subject
to the 15% branch profits remittance tax to the extent that there are unremitted branch profits at the time of
transfer (Section 28(A)(5), Tax Code of 1997), since the transaction will be considered a constructive remittance
of branch profits to the head office which is converted into equity of the Transferee corporation. The 15% rate
may be reduced under applicable provisions of the various tax treaties to which the Philippines is a signatory.

V COMPLIANCE

In addition to the foregoing, the Transferor/s and Transferee should comply with their obligations as provided in
Revenue Regulations No. 18-2001 dated November 13, 2001 and Revenue Memorandum Order No. dated
November , 2001.

VI REPEALING CLAUSE

All Rulings that are inconsistent with this Revenue Memorandum Ruling are hereby repealed accordingly.

VII EFFECTIVITY

Subject to the provisions of Section 246 of the Tax Code of 1997, this Revenue Memorandum Ruling shall take
effect immediately.

RENÉ G. BAÑEZ
Commissioner of Internal Revenue
In-House Counsel’s Guide to the M&A Sale Process and Deal Terms

by SUBMITTED POST on DECEMBER 15, 2011

by John J. McDonald, Esq.
Kelley Drye & Warren LLP
This article provides in-house counsel with an overview of the process of selling a privately-held company
in an M&A transaction and some of the significant deal points typically negotiated by the parties. While
not a comprehensive review of all of the aspects and issues involved in doing an M&A transaction, it
should provide in-house counsel with a good idea of what to expect from the process and such deal points.
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TERMINOLOGY. Transactions in which a company is sold are referred to as “mergers and acquisitions”
or “M&A” transactions because such transactions typically involve either the merger of the company being
sold (the “Target”) into the Buyer (or a subsidiary of the Buyer) or the acquisition by the Buyer either of
shares comprising a controlling interest in the Target from the existing stockholders of the Target, or all
or substantially all of the assets of the Target. M&A transactions are different from equity “financing”
transactions, in which a company raises money by selling new shares of its equity securities to investors
(as opposed to existing stockholders selling their shares to the Buyer in an M&A transaction), even though
equity financing transactions also involve the sale of stock in the company and can sometimes result in a
change in control of the company.
THE M&A SALE PROCESS.
• Timeline. Although all deals are different, the M&A sale process for a privately-held company will
typically take from three to six months from beginning to end, assuming no significant delays due to, for
example, contractual consents, a “second request” in response to an “HSR” antitrust filing (discussed
below) or other governmental or regulatory approvals.
• Engaging an Investment Bank. Once the Target’s board has decided to proceed with a possible M&A
sale transaction, the next step is often engaging an investment bank to assist with the sale process. Of
course, a Target may proceed without an investment bank, particularly if it receives a “preclusive” offer at
a price that the board thinks is unlikely to be matched in the marketplace. Usually the Target will contact
a number of investment bank candidates, some of which will usually be known to the Target’s
management or controlling stockholders from prior deals. Each candidate investment bank will present
an engagement letter with its proposed terms and conditions, which will be negotiated with the Target or
its controlling stockholders. The negotiated terms of the engagement letter typically include: (1) whether
the investment bank will be paid a cash retainer, how much, and whether it is paid over time during the
engagement or in a lump sum upon signing; (2) the amount and structure of the “success fee” payable to
the investment bank upon closing of an M&A sale transaction (often calculated using a graduated scale
consisting of fees consisting of different percentages of the total purchase price amount applied to
different purchase price amounts), (3) the cap on the investment bank’s expenses that will be reimbursed
by the Target, (4) whether the investment bank will also receive a fee if one of the potential Buyers it
contacts decides to make a minority investment in the Target, rather than buying the Target, and the
terms of such fee, and (5) the term of the agreement, including the length of the “tail period” after the end
of the engagement during which the investment bank receives a fee if the Target does an M&A sale
transaction or (if applicable) accepts a minority investment from an investor brought to the Target by the
investment bank.
• Teaser/Confidential Information Memorandum. Once an investment bank is engaged by the
Target, it will work with the Target to prepare a brief, 2-3 page “teaser” summary of the Target’s business
(which won’t include any confidential information about the Target) and a comprehensive 10-20 page
“confidential information memorandum” (which will include confidential information about the Target).
The investment bank will supply the teaser summary to a group of potential Buyers that it has determined
may be interested in the Target, to enable them to do a preliminary evaluation without being required to
sign a non-disclosure agreement. The potential Buyers will include both “strategic” Buyers (i.e., other
operating companies) and “financial” Buyers (i.e., private equity firms and hedge funds). If a potential
Buyer is interested, it will sign a non-disclosure agreement supplied by the investment bank and receive
the confidential information memorandum.
• Management Presentations. If a potential Buyer continues to be interested after reviewing the
confidential information memorandum, it will usually arrange through the investment bank to receive an
in-person or telephonic presentation concerning the Target’s business from its management (typically
with accompanying Powerpoint slides).
• Due Diligence. The next step is for the Buyer to do legal, accounting/financial and business due
diligence on the Target.
Financial/Accounting – Buyers often hire an outside accounting firm to assist with due diligence of the
Target’s historical financial results and financial projections, but some Buyers will do their
accounting/financial due diligence internally.
Legal – For Targets with significant patents, trademarks and other intellectual property, the Buyer will
sometimes engage a specialist consultant to help with analysis of such intellectual property. For Targets
that are industrial companies, legal due diligence will often include the Buyer hiring an environmental
consultant to perform a “phase one” environmental analysis of the Target’s current and former facilities.
Business – Business due diligence will typically include calls and possibly meetings between the Buyer
and the Target’s key customers and suppliers, which will usually be arranged by the Target or its
investment bank.
Order – In terms of sequencing, to help control costs, Buyers will sometimes delay the environmental and
other legal due diligence to last in the process, to avoid incurring those expenses in case the
accounting/financial due diligence reveals issues that cause the Buyer to terminate the proposed
acquisition. Sellers will sometimes request that the Buyer defer the key customer/supplier meetings to
last in the process to minimize potential damage to those relationships if the Buyer elects to not proceed
with the proposed acquisition.
Process – The legal and accounting/financial due diligence processes are usually administered by the
Buyer’s attorneys and accountants providing “due diligence request lists”, to which the Target will
respond either by supplying copies of documents, inviting the Buyer’s attorneys and accountants to visit
the Target’s offices to review the documents on-site, or posting the documents on an online “virtual data
room”. Follow-up requests, either by way of calls or written “supplemental due diligence request lists” are
common. The Buyer’s due diligence process will typically continue after submission of its bid and
preparation of the transaction documents, right up to the moment of closing.
• Making an Offer. Sometimes the investment bank assisting the Target with its M&A sale process will
send out a “bid procedures” document specifying the manner in which potential Buyers should submit
their bids. The bid procedures document is sometimes accompanied by a “form” purchase agreement
(usually with extraordinarily Target-favorable terms), which each potential Buyer is required to mark-up
and submit along with a letter summarizing the terms of its bid. Otherwise, the Buyer will typically make
its offer by presenting to the investment bank an “offer letter”, “term sheet” or “letter of intent” with the
terms of its offer, which is not legally binding but will be heavily relied upon by the Target and its
controlling stockholders in deciding on a winner.
• Selecting the Winner. The Target and its controlling stockholders will evaluate the bids received with
the advice of the investment bank. The hope of the Target and its stockholders will be that a “bidding war”
will start and, if there is more than one offer (or even if there isn’t), the investment bank will try to get
each of the bidders to improve its offer, and a “winner” will then be selected by the Target or its
controlling stockholders. For venture-backed companies, the Target will typically create and circulate
“waterfall” calculations showing the amount of transaction proceeds receivable by preferred stockholders
(typically VCs) and common stockholders and optionholders (typically management) at different
purchase price levels, which the parties will use in analyzing the relative attractiveness of the bids
received. “Top line” purchase price amount is obviously a very significant factor, but other deal terms
(discussed below) will also be important factors in deciding the winning bidder, as they can significantly
affect the amount of proceeds that the Target stockholders ultimately receive in connection with the deal.
• Definitive Deal Documents. Once the winning bidder is selected, the Buyer and the Target will work
with their respective lawyers to prepare the purchase agreement and other definitive transaction
documents and proceed to closing the transaction. If a form purchase agreement was used as part of the
bid process (as described above), that document will be used by the parties, sometimes with further
revisions. Otherwise, the Buyer’s counsel will typically prepare the initial draft purchase agreement based
on the deal terms in the offer letter/term sheet/LOI, which will then be commented upon by the Target’s
counsel. Those comments will typically be conveyed in an “issues list” memo and/or a “blackline” of the
draft purchase agreement (showing the Target’s suggested changes to the initial draft document), which
will then be negotiated in a series of calls and/or meetings between the parties and their counsel. A
similar process will typically be followed for the other transaction documents (e.g., escrow agreement,
employment agreements (if applicable) and Buyer equity documents (for deals with Buyer stock as part or
all of the purchase consideration)).
THE TERMS OF THE DEAL.
• Deal Structure. M&A deals are usually structured as an “asset purchase,” a “stock purchase” or a
“merger.” The parties will sometimes “punt” on deal structure for purposes of the offer letter/term
sheet/LOI, but deal structure is very important as it can significantly affect the after-tax transaction
proceeds that the Target’s stockholders will receive in the deal, the Target’s value to the Buyer, and the
process for the transaction. The “default” deal structure is a stock purchase or a merger, with asset deals
being in the minority for acquisitions of healthy operating companies (as opposed to acquisitions of all or
parts of distressed businesses). Buyer concerns about assuming historical liabilities of the Target (which
mitigate in favor of an asset purchase structure) and the tax impact of the deal structure on the parties are
usually the main drivers for choosing a particular deal structure. Tax impact in M&A transactions is often
a “zero sum game”, where a deal structure that will be tax-beneficial to the Buyer will be tax-adverse to the
Target’s stockholders, and vice versa, but there are some exceptions, most notably doing a “tax-free”
merger as discussed below.
Asset Purchase Structure – Either the Buyer itself or a wholly-owned subsidiary of the Buyer purchases
specified assets of the Target’s business (usually comprising “substantially all” of those assets), resulting
in the Target business being housed in the buyer or its subsidiary and the Target entity becoming a “shell
company” whose only assets are cash (which is used to pay creditors and the remainder distributed to
stockholders) and any “excluded assets” that weren’t purchased by the Buyer. The asset purchase
structure offers some ability for the Buyer to leave behind with the Target shell company the pre-closing
liabilities of the Target’s business, which can be useful when buying Targets with outstanding litigation,
environmental issues or other known or suspected liabilities. However, the asset purchase structure will
trigger “anti-assignment” clauses in the Target’s customer and supplier contracts and governmental
permits/licenses, which can delay closing and make it more difficult to preserve the Target’s business
intact. Also, the “protection” for Buyers against the Target’s historical liabilities from using an asset
purchase structure can prove to be illusory where the Buyer will carry on the same business as the Target,
using the same corporate name and operated out of the same facilities, due to application of “successor
liability” theories. Finally, the asset purchase structure is often the least tax-advantageous of the three
deal structures to the Target’s stockholders, although often the most tax-advantageous to the Buyer.
Stock Purchase Structure – The Buyer purchases from the Target’s stockholders all of, or a controlling
interest in, the outstanding shares of the Target’s stock, resulting in the Target becoming a subsidiary of
the Buyer. Unlike an asset purchase, the stock purchase structure leaves the existing Target and its assets
in place, so it’s considered to be a “change of control” rather than an “assignment” and hence fewer
consents will be required under the Target’s customer and supplier contracts and governmental
permits/licenses. However, the Buyer essentially “becomes” the Target, assuming all of the Target’s
historical liabilities, with the only protection being indemnification from the Target’s stockholders under
the purchase agreement (discussed below). Also, if the Buyer wants to own 100% of the Target, all of the
Target stockholders will need to sign the purchase agreement, which can be difficult where there are a
significant number of minority stockholders, some of whom may not be getting much (if anything) in the
way of proceeds out of the transaction and, as a result, may not see the benefit in signing the purchase
agreement. Finally, unless the Target stockholders do a “Section 338(h)(10) election” (which is only
available if the Target is taxed as an “S-corp.”, among other requirements), a stock purchase structure will
usually be less tax-advantageous to the Buyer than an asset purchase structure.
Merger Structure – Either the Target is merged into the Buyer or the Buyer sets up a new wholly-owned
subsidiary with which the Target is merged. If a subsidiary is used, either the Buyer subsidiary or the
Target can be the surviving entity of the merger (this is referred to as a “forward” or “reverse” merger,
respectively). The merger is effected by the parties filing “certificates of merger” with the secretary of state
of each of the states in which the Target and the Buyer (or its subsidiary) are organized. The merger
structure is like a stock purchase structure in that it’s usually (but not always) considered to be a “change
of control” rather than an “assignment”, resulting in fewer consents being required under Target customer
and supplier contracts and governmental permits/licenses (a “reverse” merger, in which the Target is the
surviving entity of the merger, is the best type of merger in this regard). Like a stock purchase, the Buyer
essentially “becomes” the Target, assuming all of the seller’s historical liabilities, with its only protection
from the Target’s historical liabilities being indemnification from the seller stockholders under the
purchase agreement. One of the main advantages of a merger structure is that, if a sufficient amount of
Buyer stock is included in the purchase consideration (there are different percentages required by law
depending on whether the merger is a “forward” or “reverse” merger), the transaction can be “tax-free” to
the Target stockholders, which means that they can defer paying capital gains taxes on the appreciation of
their Target stock until they subsequently sell the Buyer stock that they receive in the deal (they will need
to pay taxes right away on any cash and other non-Buyer stock consideration received in the deal).
Another advantage to a merger structure is that, unlike a stock purchase structure, the parties don’t need
to get all of the Target stockholders to sign the purchase agreement (usually either a majority or two-
thirds in interest of the Target stockholders is sufficient).
• Purchase Consideration. The purchase consideration paid by the Buyer to the Target’s stockholders
can consist of cash, Buyer stock, “seller notes”, earnouts and other deferred or contingent payments. As in
most circumstances, “cash is king” in M&A transactions and, when evaluating acquisition offers, Target
stockholders typically rank “all cash” offers ahead of those involving other forms of purchase
consideration. However, Buyers will sometimes seek to “bridge the gap” between what they’re willing or
able to pay and the valuation being sought by the Target’s stockholders by using non-cash consideration,
particularly now that debt financing is much less readily available to fund acquisitions.
Buyer Stock – Buyer stock can be attractive as it can enable the parties to use the “tax-free” merger
structure as discussed above, especially where the Buyer is publicly-traded and the Buyer stock comes
with registration rights that enable the Target stockholders to obtain liquidity. Accepting Buyer stock
requires the Target’s stockholders to analyze the Buyer’s business and capitalization and evaluate the
likelihood that such Buyer stock will have value in the future. This analysis often includes: (1) the seniority
of the Buyer stock upon a liquidation or sale of the Buyer (e.g., common stock vs. preferred stock), (2)
voting rights of the Buyer stock (e.g., the ability to appoint directors or have “veto” rights on future equity
financings and other actions), (3) restrictions on transfer of the Buyer stock (e.g., a “right of first refusal”
requiring that the stock be offered back to the Buyer and/or its majority stockholders before it is
transferred to a third party and “drag along” provisions requiring the minority Buyer stockholders to go
along with a “sale of the company” transaction as long as they receive the same per-share consideration as
the majority stockholders), (4) redemption rights requiring the Buyer to “buy back” the Buyer stock in the
future, and (5) rights of holders of Buyer stock to receive Buyer financial statements and other
information about the Buyer. Buyers will sometimes request that Target stockholders who are also
members of Target management and will be continuing with the Buyer after the acquisition “keep some
skin in the game” by “rolling over” some of their purchase consideration into shares of Buyer stock.
Rollover stock differs from “incentive equity” like stock options and restrictive stock (which is issued to
management members “for free”) in that the rollover stock typically isn’t subject to vesting over time and
forfeiture upon termination of employment.
Seller Notes – “Seller notes” are promissory notes issued by the Buyer to the Target stockholders, under
which the Target stockholders essentially finance part of the purchase price being paid by the Buyer.
Using seller notes can be advantageous to the Target’s stockholders because, under certain circumstances,
doing so can enable them to defer into future tax years part of the purchase consideration that they
receive, which can reduce their overall tax burden from the transaction. Like Buyer stock, accepting seller
notes requires the Target stockholders to analyze the Buyer’s business prospects because seller notes are
usually “subordinated” to the Buyer’s existing senior debt facility, which means that they won’t be repaid
if the Buyer’s business operations don’t yield sufficient cash to be able to repay both the senior debt and
the seller notes. A negotiated point is often whether the Buyer is permitted to make principal and interest
payments on the seller notes as long as it isn’t in default under the Buyer’s senior debt facility (as opposed
to the Buyer being prohibited from making any payments on the seller notes as long as the senior debt is
outstanding) – this will be governed by an “intercreditor agreement” entered into by the Target
stockholders, the Buyer and its senior lender. Another negotiated point is whether the seller notes are
backed by a “second lien” pledge of the Buyer’s assets (which is subordinated to the senior lender’s lien
but senior to the Buyer’s trade debt and the claims of other junior creditors) or are unsecured. Finally,
Target stockholders will often seek “acceleration” of the Buyer’s obligation under the seller notes upon a
sale of the Buyer, arguing that it is not reasonable to expect the Target stockholders to assume credit risk
for an unknown-to-them purchaser of the Buyer’s business.
Earnouts and Other Contingent Consideration – Earnouts give Target stockholders the right to receive
additional purchase consideration if the “legacy” Target business meets specified financial performance or
other criteria over defined periods of time after the acquisition closes. Since the Buyer will control the
legacy Target business after the closing, a key negotiated point for Target stockholders, in addition to
whether the earnout criteria are realistic, is whether the Buyer is required to provide funding, personnel
and/or other operational support to enable the legacy Target business to achieve the earnout goals.
Another negotiated point is often whether credit is given for “near misses” of earnout goals, either
through “catch-up” provisions in subsequent periods or by breaking the goals into multiple segments that
reward partial performance, rather than being “all or nothing” tests. Finally, Target stockholders will
often seek “acceleration” of earnout benefits upon a sale of the Buyer, arguing, like in the seller notes
scenario described above, that it is not reasonable to expect the Target stockholders to assume credit risk
for an unknown-to-them purchaser of the Buyer’s business. In addition to earnouts, sometimes deals are
structured to give the Target stockholders the right to receive additional purchase consideration if
specified events occur post-closing (e.g., recovery of proceeds in a lawsuit being brought by the Target),
usually in situations where the Buyer and the Target stockholders disagree as to the likelihood of the event
occurring, the Target stockholders insist that the event will create additional value for the Buyer, and the
Buyer isn’t willing to assume the risk of it not occurring.
• Treatment of Stock Options and Other Target Incentive Equity. Target incentive equity like
stock options and stock appreciation rights (SARs) will typically either be “cashed-out” or “rolled-over” in
connection with an M&A transaction, with cash-out of Target incentive equity being somewhat more
common than rollover.
“Cash-out” of Target Incentive Equity – The parties will first determine the per-share amount of
transaction consideration that will be paid to holders of Target common stock in the deal, usually by doing
a “waterfall” calculation that applies the purchase price amount first to the Target’s outstanding debt,
then to its preferred stock liquidation preferences and finally the remainder (if any) to holders of its
common stock. If that per-share transaction consideration amount is more than the Target incentive
equity’s exercise price, the incentive equity will be “in the money” and its holders will receive the excess in
connection with closing of the acquisition, typically in cash (even if the transaction consideration consists,
in whole or in part, of Buyer stock or other non-cash consideration). If that per-share transaction
consideration amount is less than the exercise price of the incentive equity, the incentive equity will be
“out of the money” and, depending on the terms of the relevant Target equity incentive plan documents,
may be terminated in connection with closing of the acquisition.
“Rollover” of Target Incentive Equity – The Buyer exchanges the Target incentive equity for stock options
or other incentive equity in the Buyer, typically using an exchange ratio that is based on whether the
Target incentive equity is “in the money” (as described above) and the extent to which it is so, as well as
the comparative per-share value of Target stock and Buyer stock. The accrued vesting on the Target
incentive equity is sometimes carried over to the Buyer incentive equity received in the exchange.
Buyers will sometimes elect to cash-out (rather than rollover) Target incentive equity because rollover
would result in “legacy” Target employees having Buyer incentive equity amounts that aren’t consistent
with the Buyer incentive equity amounts held by their peers in the Buyer’s organization and they want
those legacy Target employees to have a “fresh start” with respect to their Buyer incentive equity,
sometimes including having restarted vesting schedules. If the Target’s incentive equity will be cashed-out
in connection with an M&A transaction, the Buyer will often plan to issue new incentive equity to legacy
Target employees under its equity incentive plans, either in connection with closing of the acquisition or
soon thereafter.

Incentive equity plans often provide that any Target incentive equity that is not “assumed” by the Buyer
(i.e., rolled-over) in connection with an M&A transaction will become fully-vested upon the acquisition
and, if not exercised before closing of the acquisition, will terminate upon closing of the acquisition. This
is the best type of provision for purposes of doing an M&A deal, as it provides the parties with certainty
concerning treatment of Target incentive equity in connection with the deal, especially any such incentive
equity that is “out of the money”. Buyers will often require the Target to “clean-up” any “out of the money”
incentive equity if the relevant Target equity incentive plan documents don’t clearly provide for automatic
termination by obtaining termination agreements from the holders as a condition to closing, which can be
a time consuming and potentially expensive process.

• Purchase Price Adjustments. M&A transactions involving privately-held Targets often adjust the
purchase price based on the difference (if any) between the amount of a specified financial measure of the
Target as of the closing, as compared to a “goal” amount of that financial measure. These provisions are
intended to compensate the parties based on changes to the Target’s business that occur between the time
at which the purchase price is negotiated (often based on a multiple of revenue or earnings) and closing of
the transaction. “Net working capital” (i.e., current asset minus current liabilities) is the most frequently
used financial measure but other measures are sometimes used such as “net worth” (i.e., assets minus
liabilities) and “cash at closing”. Adjustments based on “cash at closing” are intended to insure that the
Buyer won’t need to inject cash into the Target immediately after the closing to pay ordinary course
operating expenses. However, a fair number of M&A deals are done on a “cash-free, debt-free” basis,
which entails the Target stockholders delivering the Target to the Buyer at closing with no cash or
borrowed money debt, and consequently the Target’s cash at closing isn’t included in the purchase price
adjustment calculation.
Downward Only or Both Ways – Purchase price adjustments are either “downward only” (i.e., the
purchase price is reduced if the financial measure is less than the goal amount) or “two way” (i.e., the
purchase price is either reduced or increased, based on whether the financial measure is less or more than
the goal amount), with the latter approach being more favorable to the Target’s stockholders. Sometimes
purchase price adjustments include a “buffer” around the goal amount, within which no adjustment is
made.
Two Stage Process – Purchase price adjustments based on financial measures are often done in two
stages: an initial adjustment is done at closing based on the Target’s estimate of the financial measure and
a post-closing adjustment is done based on the Buyer’s calculation of the financial measure, with a dispute
resolution mechanism in which the parties appoint an independent accounting firm to resolve any
disputes that the Buyer and the Target’s stockholders cannot resolve through negotiation.
Accounts Receivable Purchase Price Adjustments – M&A deals in which the Target’s accounts receivable
are a significant part of its value sometimes include a purchase price adjustment in which the Target
stockholders compensate the Buyer for any amounts that it doesn’t collect on those accounts receivable
over a specified period after closing, despite it having used reasonable collection efforts, taking into
account the “bad accounts” reserve included in the Target financial statements. Sometimes the Buyer is
required to assign over to the Target stockholders any uncollected accounts receivable for which the
Target stockholders compensate the Buyer. Buyers sometimes resist doing so based on concern that the
Target stockholders will use collection methods that will damage the Buyer/Target’s relations with its
customers.
Satisfaction of Downward Purchase Price Adjustments – Sometimes, to secure the Target stockholders’
obligation to repay the Buyer for any downward purchase price adjustment amounts, part of the purchase
price is placed into a third party escrow until the post-closing purchase price adjustments occur.
Alternatively, sometimes the Buyer is entitled to deduct any such downward purchase price adjustment
from the escrow established for indemnification claims (discussed below) or to offset the downward
purchase price adjustment against its obligations under any seller notes, earnout payments and/or other
deferred or contingent purchase consideration.
• Representations and Warranties. The purchase agreement will usually include ten to twenty pages
of detailed statements about the Target’s business that are intended to cover all of the areas that could
potentially create liability for the Buyer or otherwise reduce the value of Target’s business. These
statements, which are called “representations and warranties”, are usually phrased to require the Target
to describe on “disclosure schedules” that it prepares and supplies to the Buyer any instances in which the
Target’s business deviates from a “perfect world” in which, for example, the Target doesn’t have any issues
with its financial statements, any environmental problems, any disputes with contract counterparties, or
any labor issues. In addition, there are usually “list” representations and warranties, which require the
Target to include in its disclosure schedules lists of, for example, all of its material contracts, all of its
governmental permits, and all of its employee benefit plans. Representations and warranties serve the
following important functions.
Due Diligence – First, because the representations and warranties (along with the disclosure schedules
that accompany them) highlight all of the ways that the Target’s business deviates from the “perfect
world” and provide lists of important business items, they are an important part of the Buyer’s due
diligence process and sometimes reveal issues that give the Buyer grounds to renegotiate the purchase
price or other deal terms, or cause the Buyer to rethink its desire to do the deal at all.
Certainty of Closing – Second, there is typically a “bring down” closing condition that entitles the Buyer
to walk away from the deal (rather than close) if the Target’s business changes between signing and
closing and, as a result, the representations and warranties (which are made as of signing of the purchase
agreement), don’t continue to be true and correct as of the closing. As a result, the representations and
warranties affect certainty of closing the acquisition (this is discussed in more detail below).
De Facto Purchase Price Adjustment – Third, in M&A transactions involving privately-held Targets, there
is usually an indemnification provision that requires the Target’s stockholders to compensate the Buyer
for any losses incurred by the Buyer if the Target misrepresents its business and the representations and
warranties aren’t true, for example by not disclosing a breached contract, a tax problem, an IP
infringement lawsuit or an environmental law violation, which effectively reduces the purchase price by
the amount of any such losses (this is discussed in more detail below).
Qualifiers and Carve-Outs – A negotiated point in most M&A transactions is the extent to which the
representations and warranties include “knowledge”, “materiality” and “Material Adverse Effect”
qualifiers or carve-outs. “Knowledge” qualifiers or carve-outs only hold the Target stockholders
responsible for misrepresentations that the Buyer can prove the Target (through its management) “knew”
about as of the time that the purchase agreement was signed or the transaction closed. Whether the
standard is actual knowledge or “constructive knowledge” (i.e., knew or should have known), as well as
which of the Target employees’ “knowledge” counts for this purpose, will be negotiated points.
“Materiality” and “Material Adverse Effect” qualifiers or carve-outs excuse the Target stockholders from
responsibility for not disclosing items that are not “material” to the Target or would not result in a
“Material Adverse Effect” on the Target. In certain instances, these types of qualifiers or carve-outs are
appropriate but the Target’s counsel will often try to include as many of them as possible in the
representations and warranties, in order to minimize the Target’s burden in preparing its disclosure
schedules, enhance certainty of closing, and limit the Target stockholders’ potential indemnification
exposure. As a result, those qualifiers and carve-outs will typically be a negotiated point.
• Closing Conditions. Most M&A transactions involve a sequence of events in which the parties
negotiate and sign the purchase agreement, there is a pre-closing time period in which the parties gather
all of the third party consents and other items necessary to close and, once those items have been
obtained, the “money changes hands” and the transaction closes. Other M&A transactions are
“simultaneous sign and close” deals, in which the parties negotiate the purchase agreement and other
transaction documents, gather all of the third party consents and other items necessary to close, and then
sign the purchase agreement and other transaction documents and close the transaction. The latter
approach exposes the Target stockholders to some degree of risk, since the Target will need to “go public”
about the transaction by soliciting contractual consents from customers, suppliers and other third parties
without having a legally binding contract with the Buyer to acquire the Target in place. In some cases
(deals requiring an “HSR” antitrust filing and other regulatory approvals are prominent examples), doing
a “simultaneous sign and close” deal isn’t possible because a signed purchase agreement must be in place
before the third party approvals necessary for closing can be solicited by the parties.
What Target Stockholders Want – Because M&A deals that are signed but fail to close can stigmatize the
Target as being “damaged goods” and otherwise harm its business prospects, Target stockholders usually
highly value certainty of closing. This means that Target stockholders usually want as few closing
conditions as possible and want any such closing conditions to be relatively easy to satisfy.
What Buyers Want – Buyers, by contrast, often want to “lock in” the Target on the stated deal terms but
preserve as much flexibility as possible in case circumstances change and they want (or need) to get out of
the deal. Buyer also know that their leverage to get the Target to clean-up issues with its business
discovered during the Buyer’s due diligence process will evaporate once the deal closes, and so will often
condition closing on the Target cleaning up those issues.
Types of Closing Conditions – There are two types of closing conditions in M&A transactions: those that
are included in virtually all M&A transactions and, as a result, are relatively uncontroversial, and those
that are the subject of negotiation by the parties.
HSR Act Antitrust Closing Condition – If the transaction meets the applicable criteria under antitrust law
(which includes a minimum purchase price amount, among other factors), the Buyer and the Target will
each be required to make “HSR Act” antitrust filings with governmental authorities once the purchase
agreement is signed. The HSR Act filings provide a high-level description of the deal, which the
governmental authorities will use to determine whether to request additional information (a “second
request”) and possibly file suit to prevent the deal from closing. The parties will request “early
termination” of the “waiting period” under the HSR Act in which the governmental authorities must, if
they are going to do so, make a second request. For transactions in which HSR Act filings are made, early
termination of the HSR Act waiting period having occurred or expiration of the HSR Act waiting period
without a second request having been made will be a closing condition. Since HSR either applies or it
doesn’t and, if it applies, it will be a closing condition, its inclusion among the closing conditions is usually
not the subject of negotiation. What will be negotiated are the actions that the parties are required in the
“covenants” section of the purchase agreement to take to obtain HSR approval, which can include forced
divestiture of assets and restrictions on operation of the Target business by the Buyer after the closing
(which are often strongly resisted by Buyers), among other things.
Other Non-Controversial Closing Conditions – In addition to HSR, no governmental orders or
injunctions having been issued prohibiting consummation of the deal and repayment of the Target’s bank
debt and release of any associated liens on Target assets are usually among the non-controversial closing
conditions.
Negotiated Closing Conditions – As noted above, the Buyer’s obligation to close will usually be
conditioned on the representations and warranties made by the Target’s stockholders upon signing of the
purchase agreement continuing to be true and correct as of the closing, with it being a negotiated point
whether the standard for this “bring down” closing condition is “true and correct in all material respects”
(a relatively tight, pro-Buyer standard) or “true and correct, except as would not constitute a Material
Adverse Effect” (which is a looser, pro-seller standard). Additional closing conditions subject to
negotiation by the parties sometimes include: (1) the occurrence of a “Material Adverse Effect” to the
Target business, (2) the Buyer having received the financing necessary to be able to pay the purchase price
(a “financing contingency”), (3) the Target having received all consents triggered by the deal under its
contracts with customers, suppliers and other third parties, and (4) receipt by the parties of all
governmental approvals triggered by the deal. Financing contingencies are often vigorously resisted by
Target stockholders but, with the recent significant reduction in availability of acquisition debt financing,
have become more common. There is sometimes a “middle ground” on the “third party consents and
approvals” closing condition in which the Target is only required to obtain the “material” contractual
consents and governmental approvals listed on an agreed-upon schedule to the purchase agreement. It is
sometimes a closing condition for members of the Target’s management team to sign new employment
agreements on terms acceptable to the Buyer, but doing so can have the unintended consequence of giving
the individual management members undue leverage to request personal benefits under their new
employment agreements at the expense of the overall transaction.
“Clean-up” Closing Conditions – In addition to the “ordinary course” closing conditions listed above,
Buyers will sometimes require that the closing conditions include clean-up of issues discovered in their
due diligence of the Target. This sometimes includes “out of the money” Target stock options that don’t
automatically terminate in connection with the acquisition, as discussed above.
• Non-Compete, Non-Solicit and Other Post-Closing Covenants. In addition to covenants that
govern the parties’ conduct between signing and closing of the deal (most of which usually aren’t very
controversial), the purchase agreement will also typically include covenants that restrict the Target
stockholders’ conduct after the closing, which are frequently the subject of negotiation. These post-closing
covenants typically restrict the Target stockholders’ ability to disclose to third parties the Target’s
confidential information, as well as restrict their ability to enter into business in competition with the
Target, to solicit the Target’s employees and customers, or to make disparaging statements to third parties
about the Target’s business. The length of the non-competition and non-solicitation covenants are usually
negotiated by the parties and state law imposes some bounds on the length of covenants that will be
enforced by courts, but time periods of as short as one year after closing or as long as five years after
closing are not unusual. These covenants are premised on the idea that the Buyer is entitled to some
protection of the business that it purchased from the Target’s stockholders in exchange for the purchase
price that it paid. “Sale of the company” non-competition and non-solicitation covenants will sometimes
be in addition to non-competition and non-solicitation covenants to which Target management members
will become subject under employment agreements they enter into in connection with the deal. While
superficially similar, the two sets of restrictive covenants are different because the “sale of the company”
restrictive covenants in the purchase agreement are supported by the purchase price consideration paid
by the Buyer and are, as a result, less likely than restrictive covenants in employment agreements to be
struck down by a court as not supported by adequate consideration and therefore unenforceable.
Institutional investors such as venture capital and private equity funds will sometimes vigorously resist
being subject to non-competition and, less frequently, non-solicitation covenants, arguing that they are in
the business of making investments and the reward from sale of a particular portfolio company will not
adequately compensate them for being prohibited from entering into an entire area of business (either
directly or through their other portfolio companies).
• Indemnification (De Facto Purchase Price Adjustment). As mentioned above, M&A
transactions involving privately-held Targets typically include “indemnification” provisions requiring the
Target’s stockholders to compensate the Buyer and its affiliates for liabilities that they incur in connection
with specified matters relating to the Target and its stockholders. Because such indemnification payments
effectively reduce the purchase price paid by Buyer to the Target’s stockholders and, as a result, inject a
degree of uncertainty into the amount of proceeds that the Target’s stockholders will ultimately receive in
connection with the deal, indemnification provisions are usually one of the key negotiated points in M&A
transactions involving privately-held Targets. Indemnification provisions are very complex and include
many points that are negotiated by the parties, but some of the most significant negotiated points are as
follows.
Scope of Indemnification – The Buyer is typically indemnified for losses incurred after the closing
resulting from breaches of the representations and warranties and covenants of the Target and its
stockholders contained in the purchase agreement. Sometimes the Target stockholders also provide a
“flat” indemnity to the Buyer for losses relating to the Target’s pre-closing tax and environmental
liabilities, which is in addition to indemnification for losses relating to misrepresentations in the tax and
environmental representations and warranties in the purchase agreement (which essentially make a stock
purchase or merger deal somewhat equivalent to an asset purchase deal with respect to these liabilities).
In asset purchase deals, the Target (or its stockholders) is also usually required indemnify the Buyer for
any losses associated with “Excluded Liabilities”, which is typically defined as any liabilities associated
with the pre-closing operations of the Target. In addition, potential issues are sometimes discovered
during the Buyer’s due diligence process that may or may not ultimately result in actual liability and,
rather than reduce the purchase price or put additional purchase consideration into escrow, the Target’s
stockholders will agree to provide a special indemnity to the Buyer for any liability that results from the
issue.
Who is “On the Hook” – In stock purchase and merger transactions, the Target’s stockholders will
typically be responsible for providing indemnity to the Buyer. In asset purchase transactions, sometimes
the Target stockholders will provide the indemnity directly and sometimes the Target entity itself will
provide the indemnity (with its obligation to do so guaranteed or otherwise backed by the Target’s
stockholders). Each Target stockholder is usually responsible for its pro rata portion of liability resulting
from breaches of representations and warranties concerning the Target and the Target’s covenants in the
purchase agreement (which are sometimes referred to as the “company” representations, warranties and
covenants), determined based on each Target stockholder’s percentage ownership of the Target. Each
Target stockholder is usually solely responsible for liability resulting from breaches of its own
representations and warranties and covenants. However, sometimes Buyers are able to negotiate making
the Target’s majority stockholders “jointly and severally liable” for all such liabilities (i.e., the Buyer can
collect the full amount from any Target majority stockholder), with each majority Target stockholder
entitled to seek “contribution” from the other Target stockholders for any payments it makes to the Buyer
in excess of its pro rata share of the liability. This is often the case where there are a few significant
majority stockholders (such as venture capital firms and significant founding stockholders) and many
minority stockholders with relatively small percentage interests (such as non-management stockholders
and “angel round” investors who have since been diluted), based on the Buyer’s argument that the
majority stockholders are receiving the vast majority of the transaction proceeds and it shouldn’t be
required to “chase around” the minority stockholders.
Duration of Indemnification Obligations – The Target stockholders’ indemnification obligations for
breaches of “fundamental” representations and warranties such as the ability of the Target and its
stockholders to enter into the deal, the Target having clear title to its assets, and the Target stockholders
having clear title to their shares of Target stock, as well as for “Excluded Liabilities” in asset purchase
deals and breaches of the covenants of the Target and its stockholders contained in the purchase
agreement, typically extend indefinitely after closing. The Target stockholders’ indemnification
obligations for breaches of representations and warranties concerning tax, environmental, and employee
benefit plans matters typically extend until expiration of the statute of limitations of the matters described
in the representations and warranties. The duration of the Target stockholders’ indemnification
obligations for breaches of other representations and warranties is subject to negotiation by the parties,
with periods of 1-2 years after closing being typical, sometimes based on the Buyer’s argument that it
needs to complete a “full audit cycle” including the Target’s operations after the closing, although longer
periods are sometimes negotiated.
Thresholds, Deductibles and Caps – The indemnification obligations of the Target stockholders are
usually subject to either a “threshold” (i.e., the Buyer must wait to make an indemnification claim until it
has indemnifiable losses at least equal to the threshold amount, but then receives full compensation for all
losses “back to the first dollar”) or a “deductible” (i.e., the Buyer is forced to absorb the first “X dollars” in
otherwise indemnifiable losses and is only compensated for indemnifiable losses in excess of that
amount). Deductibles are more favorable to Target stockholders than thresholds and the decision as to
whether a threshold or deductible will apply in a given transaction will be the subject of negotiation by the
parties. Threshold and deductible amounts can vary significantly based on the size of the transaction but
amounts of 0.5%-2% of the purchase price amount are not unusual. In addition to the “overall” indemnity
threshold or deductible, sometimes there is a “noise level” concept in which any individual indemnity
claim must have losses exceeding a specified amount to be able to be brought by the Buyer. The Target
stockholders’ total possible indemnification liability is typically subject to a “cap”, the amount of which
will be negotiated by the parties but can be as low as 10-20% of the purchase price amount or as high as
the full purchase price amount. Sometimes, there is also an indemnity cap for each individual Target
stockholder in which that stockholder cannot be subject to indemnification obligations is excess of the
amount of transaction proceeds received by it in connection with the deal. There is a somewhat recent
trend towards making the indemnification escrow fund (discussed below) the “sole remedy” of the Buyer
for indemnification, which effectively acts as a cap on the potential indemnification liability of the Target
stockholders. This is particularly the case for M&A transactions in which the Target stockholders are
venture capital and private equity funds that would like to be able to draw definite bounds around their
potential indemnification liability and distribute the remainder of their transaction proceeds to their
limited partners. Both the indemnity threshold/deductible and the indemnity cap are usually subject to
“carve-outs” for losses relating to breaches of “fundamental” representations and warranties, covenant
breaches, fraud and willful misconduct by the Target and its stockholders and “Excluded Liabilities” in
asset purchase deals, although the matters carved-out from the indemnity threshold/deductible and cap
are often heavily negotiated by the parties.
Indemnification Escrows and Other Indemnification Payment Methods – In order to secure the Target
stockholders’ indemnification obligations, part of the purchase consideration is sometimes placed into a
third party escrow account (typically with a bank) for a specified time period after closing, which usually
corresponds to the negotiated date on which the Target stockholders’ indemnification obligation
concerning “general” representations and warranties ends, as discussed above. A more Buyer-favorable
approach is for the Buyer to simply “hold back” in its possession part of the purchase consideration for
such time period. The percentage of the total purchase consideration that is placed into escrow or held
back by the Buyer will be a negotiated point but 10-20% is typical. As noted above, a somewhat recent
trend is for the indemnification escrow fund to be the Buyer’s sole remedy for indemnification losses but
more often that escrow fund is merely the Buyer’s initial remedy, which the Buyer must exhaust before
going against the Target stockholders individually for any additional amounts owed. If the purchase
consideration includes non-cash consideration (i.e., Buyer stock, seller notes, earnout payments and other
deferred or contingent consideration), which types of consideration (cash vs. non-cash) are placed into
escrow or held back by the Buyer, the order in which such consideration is forfeited to satisfy Buyer
indemnification claims (e.g., first Buyer stock, then seller notes, then earnout), and whether or not all of
such non-cash consideration must be forfeited before the Buyer can go against the Target stockholders
individually will be negotiated points. The valuation of Buyer stock for purposes of forfeiture to satisfy
indemnification claims will also be a negotiated point – the alternatives consist of “pegging” the valuation
at the price at which the Buyer stock was issued in the M&A transaction or allowing it to “float” by valuing
the Buyer stock for such purpose at its fair market value at the time of the claim.