By Mark E. Battersby / Published September 2018
Mergers and acquisitions (M&As) have long played an important role in the life cycle of many in the pressure washing industry. An M&A transaction can help an operation expand, move into new areas, and become more efficient with one simple transaction. For many pressure washers an M&A is a proven strategy for cutting overhead costs, increasing efficiency, or battling a larger competitor.
Whether the recent spate of M&As is attributable to last December’s Tax Cuts and Jobs Act (TCJA), the cash it freed up, or the new lower corporate tax rate, M&As are on the upswing—with a great deal of the action involving smaller deals. The use of warranty and indemnity (W&I) insurance to remove all or a great deal of the risk in M&A deals is yet another factor in that reported upsurge.
While often synonymous, the terms “merger” and “acquisition” are two separate transactions. A merger occurs when two separate entities combine forces to create a new, joint organization in which both—theoretically—are equal partners.
An acquisition refers to the purchase of one entity by another. A new pressure cleaning business does not emerge from an acquisition; rather, the acquired business, or “target,” is often consumed and ceases to exist, with its assets becoming part of the acquiring business.
The general term “M&As” can in-clude a number of other transactions:
• Consolidation—A consolidation creates a new entity where share- holders in both entities approve the consolidation, after which they receive equity shares in the new firm.
• Tender Offer—In a tender offer, one business offers to purchase the outstanding stock of the other business for a specific price. The acquiring business communicates the offer directly to the other business’s shareholders, bypassing the management and board of directors. Obviously, this usually involves larger businesses, which are often publicly traded.
• Acquisition of Assets—In a purchase of assets, one business acquires only the assets of another business. Asset purchases are common during bankruptcy proceedings, where other businesses bid for various assets of the bankrupt business, which is liquidated after the final transfer of assets to the acquiring business.
Adequate funding is necessary since there is little doubt that M&As are expensive. Fortunately, financing an M&A transaction with stock is a relatively safe option for both parties since both share the risk.
In a typical share-exchange transaction, the buyer will exchange shares in their own business for shares in the selling business. Paying with stock is especially advantageous for a buyer, especially if their shares are overvalued.
In a merger, shareholders on both sides can reap long-term benefits of a stock swap, as they will generally receive an equal amount of stock in the newly-formed operation that results from the transaction rather than simply receiving cash for their shares.
Paying with cash is the most obvious alternative. After all, cash transactions are instant and relatively mess-free and usually don’t require the same kind of complicated management as stock would. Unfortunately, smaller pressure cleaning businesses, without large cash reserves, must usually seek alternative financing options in order to fund their transaction. One popular alternative to paying for a M&A with stock or cash involves agreeing to take on the debt owed by a seller.
For far too many pressure cleaning businesses, debt is the reason for the sale. Unfortunately, debt can often reduce a seller’s value, often to the point of worthlessness. From a buyer’s point of view, this strategy is often a cheap means of acquiring assets.
Being in control of a large quantity of an operation’s debt means increased control over management in the event of a liquidation since owners of debt have priority over shareholders. This can be another incentive for would-be creditors who may wish to restructure the new business or simply take control of assets.
Mezzanine financing is a hybrid of debt and equity financing involving senior debt such as
loans from sources such as banks, secured by liens on specific assets of the pressure cleaning business. Equity is usually in the form of preferred stock, but buyers aren’t usually required to give up as much control to lenders.
The size of the mezzanine finance industry has grown in recent years. In fact, quite a few mezzanine groups have been sponsored by the SBA, but that’s not the only way the SBA can help in an M&A transaction.
Surprisingly, many M&As and owner buyouts of private (rather than publicly traded) businesses qualify for SBA loan guarantees. The SBA’s 7(a) program is the most popular loan program, providing up to $5 million for refinancing, working capital, or to buy a business. Even larger transactions are possible with so-called “mezzanine” financing or when real estate is included.
The large component of good will along with the lack of tangible assets so common in smaller M&A transactions isn’t a deterrent. Fortunately, the SBA’s programs focus on lenders where minimal collateral is acceptable, especially when there is strong cash flow and mitigating factors such as management expertise involved.
SBA M&A financing is generally through the SBA Preferred Lender program, often with additional working capital loans and lines of credit for financing packages in excess of $5 million. Since the SBA has eliminated its personal resource limitations, borrowers and investor groups with high net worth and liquidity are now usually eligible.
Much of the risk in an M&A transaction can be eliminated with an often-overlooked type of insurance. Warranty and Indemnity (W&I) insurance has evolved from its introduction in the 1970s into a popular and sophisticated tool for protecting buyers and sellers from the financial losses in M&A transactions.
W&I insurance essentially removes the risk, in whole or in part, with the promise that underwriters will be standing behind the warranty claim. However, by offering more protection against downside risk, W&I insurance also negates the requirement for the use of escrow or indemnities, providing certainty and finality to both parties.
With a seller’s W&I policy, the seller gives warranties and indemnities as is customary but then insures its own risk of a claim. Sellers remain liable to the buyer, but they are indemnified by the insurance underwriter.
Thus, when a claim occurs, the buyer would usually claim against the seller for breach of warranty, but the seller would look to the insurance company to write a check for all or at least part of the damages being sought. A buyer’s W&I policy covers damages following breaches and/or fraud as well as defense costs. With a buyer policy, if the seller commits fraud, the policy would still pay out.
Because the buyer is the insured party and it has not been fraudulent, nor has it fallen afoul of its disclosure obligation to the insurers, W&I insurance provides an extra layer of protection for buyers they wouldn’t otherwise have.
Despite the new, lower 21-percent corporate tax rate, many pressure washers are likely to continue pursuing tax-free M&A transactions. Tax-free M&A transactions are considered “reorganizations” and similar to taxable deals, except that in a reorganization, the buyer uses its stock for a significant portion of the sale price rather than cash or debt.
Reorganizations, while not usually taxable at the entity level, are not completely tax-free to the seller. A reorganization is immediately taxable to the target’s shareholders for any “boot” received. Boot is any consideration received by shareholders in the target entity other than the buyer’s stock.
Other provisions of the TCJA, such as the full-expensing of asset costs, may cause many to weigh their effects on any transaction. In reality, the ability to do a taxable asset transaction and take advantage of front-loaded deductions may encourage pressure cleaning business owners to complete a taxable deal instead of a tax-free transaction.
Consider a situation where a seller really wants cash, while the buyer is pushing for a tax-free acquisition. The tax law’s Section 338 permits a pressure cleaning business to make a “qualified stock purchase” of another business and choose to treat the acquisition as an asset rather than a share acquisition for federal tax purposes. The stepped-up basis in the qualifying assets can be immediately expensed and written off, dramatically changing the bidding dynamic on the transaction.
On the downside, M&A deals are often difficult to accomplish. The interests and objectives of sellers and buyers are all-too-often discordant. Sellers want the highest price with little or no residual risk or liability. Buyers want the lowest price possible with maximum recovery options.
Recent trends involve more cash-ready buyers but with more aversion to risk. What’s more, buyers are generally unwilling to enter into transactions if the warranty package being offered is too limited, or there are concerns over enforceability of those warranties.
Obviously, these challenges are not insurmountable, and deals continue to emerge with and without tax breaks, alternative financing, and risk insurance. But, every pressure cleaning business owner and manager would be well advised to perform their “due diligence” and seek professional advice.