A Summary of Current Trends in Mergers and Acquisitions of Government Contractors
March 15, 2004
William Mutryn- Northern Virginia
Middle market government contracting companies continue to be attractive acquisition targets for larger companies and investment funds seeking vehicles from which to fuel growth and/or create a larger enterprise. The relatively stable revenues of mid-size government contractors, and the commitment of the Bush Administration to outsource greater amounts of traditionally government work, are key reasons for increased buyer interest. For buyers and sellers alike, understanding the contractual structure of acquisitions, and some of the legal factors affecting a company’s valuation, is important to the successful completion of any merger or acquisition.
TRENDS IN DEAL STRUCTURE
Overview of Purchasers
There are generally two types of buyers of companies: strategic or financial. Strategic buyers purchase target companies to gain access to a certain customer base and to increase growth at a faster rate than through organic growth. These types of buyers typically purchase the target with mostly cash, but will also pay with publicly traded stock and with what are called “earn-outs,” which are discussed in more detail below.
Financial buyers usually purchase companies as all or part of a platform from which to build a company, make it profitable, and then execute a successful exit strategy. Financial buyers seek to purchase entities with less cash and more subordinated notes, earn-out payments, and stock that is usually not publicly traded and not liquid until a future sale or IPO of the platform company. Earn-outs are, in many cases, a significant part of the purchase price for the financial buyer.
Consideration
Consideration (the value a buyer is using to purchase a target) for the sale of a company typically comes in the form of cash, stock in the buyer’s company, notes, and earn-out payments. Because of the uncertainty over the renewal of certain government contracts that are based upon the size or type of a firm, earn-outs have become more prevalent as part of the deal structure. Earn-outs work by setting targets usually based upon revenue growth, cash flow growth or specific contract awards. If these targets are achieved by the seller’s operations within specified time intervals after closing, then the buyer will pay the selling stockholders all or a portion of the earn-out amount.
In most transactions, a portion of the purchase price is placed into escrow at closing to serve as a source for the payment of indemnity claims by the buyer, usually for breach of seller’s representations and warranties. The amount in escrow varies depending upon the buyer’s assessment of possible claims and business health of the target, but the indemnity escrow can be as low as a 3 percent and as high as 20 percent of the purchase price. The escrow typically will last between one and three years.
Types of Purchases
A buyer can purchase the target’s stock, the target’s assets or merge with the target company. Most government contracting buyers prefer to purchase a company’s stock to prevent the necessity of novating the government contracts of the target company to the buyer. Sellers, likewise, prefer stock purchase sales because they may treat any gain from the sale as a long-term capital gain. The advantage of an asset purchase is the avoidance of a transfer of significant liabilities to the buyer from the seller. If the buyer purchases only the assets of the selling company and not its corporate “person,” then it assumes only those seller’s liabilities that are specified.
Major Tax Issues
If a buyer pays income taxes on an accrual basis and purchases a target on a cash basis, the IRS requires that the seller be converted from a cash to accrual basis at closing. This usually results in a large tax payable on the difference between the target company’s accounts receivable and its accounts payable. The IRS allows this tax to be paid out over a four-year period. Should the sale result in the realization of such tax, the sellers will assert that the buyer should pay it. The seller will argue that the tax is only due because the buyer is on an accrual basis. Conversely, the buyer will seek to have the sellers pay the tax because the buyer benefited from the deferrals that were created by being on a cash basis. The parties to a transaction should discuss the tax implications of the deal as early as possible to avoid having the deal become jeopardized after considerable costs have been incurred.[1]
Representations and Warranties
Representations and warranties are heavily negotiated issues in most deals. A central point of contention with respect to representations and warranties is the definition of the word “knowledge.” Sellers seek to limit their representation regarding a particular issue to the actual knowledge of a certain core group of individuals in the company. Buyers seek a broader definition of knowledge to include things that certain people in the company actually knew, or should have known about.
Government contracting firms, however, should pay careful attention to the representations and warranties concerning their company’s compliance with the various government contracting rules and regulations, such as those found in the FAR or DFARS, the False Claims Act, and the numerous other rules governing government contracting.
The survival of the representations and warranties depends upon the particular subject matter. Matters that go to the heart of the deal, such as capitalization, the authority of the seller to sell, and title issues, are generally indefinite. Others, such as those dealing with tax matters or ERISA, usually expire after the expiration of the applicable statute of limitations. The general expiration of other representations and warranties in the purchase agreement is usually one-to-two years. Post-closing covenants are usually indefinite, and pre-closing covenants are either indefinite or expire when the general representations and warranties expire.
Indemnification
Buyers seek to be indemnified by the sellers for breach of the seller’s representations and warranties, and buyers usually require the sellers to share jointly and severally in any liability to the buyer. Joint and several liability means that the buyer can pursue an action against any or all of the sellers for a breach of the purchase agreement. If there are a small number of sellers or a substantial escrow, the buyer may accept several liability, meaning the sellers would each have to pay their pro rata share of any losses. A ceiling or cap is usually put on the maximum amount of the indemnification liability of between 10 percent and 100 percent of the sales price. Some buyers ask to exclude losses arising from taxes, fraud, willful misconduct and ERISA issues from the cap.
Another trend is to create what is called a “basket,” a certain amount of money that a buyer will have to exhaust before it can recover from a breach of a representation or warranty, sometimes without regard to the qualifiers of knowledge and materiality. If, for example, a basket is set at $200,000, any breach must result in more than $200,000 in damages being incurred by the buyer before it can pursue the seller. Some baskets allow the buyer to recover the full amount of a claim if it reaches the basket level, while others deduct the basket from the amount of aggregate claims.
The Closing Balance Sheet
Most purchase agreements specify a required amount of working capital or net working capital that the target must have as of closing. At closing, the target usually prepares an estimated closing balance sheet that is subject to a true up based on a final balance sheet prepared after closing. The purchase price is usually adjusted upward or downward based on whether the final closing balance sheet reflects numbers that are higher or lower than the required amount. If the parties cannot agree on the adjustment of the price, they usually agree on a dispute resolution mechanism, such as a neutral accountant to settle the dispute.
VALUATION FACTORS
Currently, buyers have shown a willingness to pay greater than historic valuations for the relative long-term certainty and stability found in many government contracting firms. The highest valuations are given to companies with:
- Employees with highly technical skills
- Unique and protected intellectual property rights
- Customers who cannot easily move to different contractors
- Customers who have large operating budgets
- Professional management teams that will work for the buyer
- Contracts that are mostly won competitively, meaning that the contracts were not awarded through set-aside programs
While nearly every government contracting company needs and desires a highly skilled and trained workforce, companies can also increase their value through the ownership of strong intellectual property that enjoys either patent protection or protection under other government programs.[2] Companies with customers that require certain levels of security clearances and procedures, qualifications, or other expertise have less competition for their customers from other companies. The more that highly technical and skilled employees form relationships with certain government agencies or other contractors, the more dependent the customer becomes on its relationship with the company. Most companies seek customers with large and growing budgets such as the Departments of Defense and Homeland Security.
The presence of a professional management team that remains with the company will likely increase its value because a purchaser is essentially buying the contracts with the government and the employees who have the expertise to perform on those contracts. Many buyers will look for companies that have made an effort to retain its management team for at least one year after the time of the sale and many buyers encourage or require retention agreements with key employees as a condition of sale. Through an employment or retention agreement, a key employee is given a certain bonus upon the sale of the company and an additional bonus payable after six or 12 months of continued employment with the buyer.
The renewed interest by the Bush Administration in the annual recertification of small business status for Government Services Administration’s (GSA) Multiple Award Schedule (MAS) contractors may cause some large buyers to pass on certain companies that have most or all of their contracts through set-aside programs. Small businesses, for example, that enjoy 8(a) status and receive most of their contracts because of that status are less attractive to many buyers who will not be able to take advantage of being an 8(a) business after acquiring an 8(a) company.
CONCLUSION
The current legal trends in the deal structure of purchase agreements for middle market government contracting firms depends on the purchaser, the type of consideration, the type of sale and the relative bargaining positions of the parties. The treatment of the representations and warranties, tax issues, indemnity clauses and closing balance sheet issues are sources of negotiation between the parties. While the current market for the acquisition of mid-market government contracting companies remains favorable, buyers prefer companies with skilled employees, protected and sought after intellectual property, and contracts that were not awarded based on set-asides.
For more information, e-mail William J. Mutryn at william.mutryn@hklaw.com or Charles A. Neff at charles.neff@hklaw.com, or call toll free, 1-888-688-8500.
1. If the target company is an S-Corporation, then with the permission of the sellers, the buyer can make an election under § 338(h)(10) of the Internal Revenue Service Code. Such an election may allow the buyer to treat the transaction as an asset purchase and obtain a stepped-up basis in the target’s assets; however, this election results in a significant tax cost to the sellers.
2. For example, participation in the Small Business Innovative Research (SBIR) program allows any company, after what is called Phase II or the prototype phase of the program, to protect data rights in a product that may provide greater protection for a longer period of time than a patent.
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