Whether due to the Tax Cuts and Jobs Act or attrition, M&As are on the upswing
Mergers and acquisitions (M&As) have long played an important role in the life cycle of many chiropractic practices. An M&A transaction can help a practice expand, move into new areas of practice and become more efficient with one simple transaction. For many chiropractors 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 the 2017 Tax Cuts and Jobs Act, the cash it freed up, or the attrition of elderly practitioners or business owners, M&As are on the upswing — with a great deal of the action involving smaller deals. The use of warranty and indemnity insurance to remove all or a big part of the risk in M&A deals is yet another factor in that reported upsurge.
Breaking down terms
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 chiropractic practice does not emerge from an acquisition. Rather, the acquired practice, or “target,” is often consumed and ceases to exist, with its assets becoming part of the acquiring entity.
The general term “M&As” can include a number of other transactions, including:
Consolidation: A consolidation creates a new entity where shareholders or principals in both entities approve the consolidation, after which they receive equity shares in the new firm.
Tender Offer: In a tender offer, one business or incorporated practice offers to purchase the outstanding stock of the other entity for a specific price. The acquiring practice or business communicates the offer directly to the other practice’s principals, partners or shareholders, bypassing the management and board of directors. Obviously, this usually involves larger, often-publicly-traded businesses rather than professional practices.
Acquisition of Assets: In a purchase of assets, one practice acquires only the assets of another entity. Asset purchases are common during bankruptcy proceedings, where others bid for various assets of the bankrupt practice or business, which is liquidated after the final transfer of assets.
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 practice for shares in the selling practice. Paying with stock is 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 generally receive an equal amount of stock in the newly-formed operation, rather than simply receiving cash for their shares.
Paying with cash is the most obvious alternative. After all, cash transactions are instant, relatively mess-free and usually don’t require the same kind of complicated management as stocks. Unfortunately, smaller chiropractic practices without large cash reserves must usually seek alternative financing options to fund their transaction. One popular alternative to paying for an M&A with stock or cash involves agreeing to take on the debt owed by a seller.
For many professional practices and businesses, debt is the reason for the sale. Unfortunately, debt can reduce a seller’s value, often to the point of worthlessness. From a buyer’s point of view, this strategy can be 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 practice or simply take control of its assets.
Mezzanine financing is a hybrid of debt and equity financing involving senior debt, such as loans from banks secured by liens on specific assets of the chiropractic practice, or other sources. 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 U.S. Small Business Administration (SBA). But that’s not the only way the SBA can help in an M&A transaction.
U.S. Small Business Administration
Surprisingly, many M&As and owner buyouts qualify for SBA loan guarantees. Although there are a few restrictions, 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 practice or business. Even larger transactions are possible with mezzanine financing or when real estate is included.
The large component of goodwill 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 are 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 more than $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 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. 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 the cost of defense. With a buyer policy, if the seller commits fraud, the policy would still pay.
Because the buyer is the insured party and 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.
The tax bill
Despite the new, lower 21 percent corporate tax rate, many chiropractic practices are likely to continue pursuing tax-free M&A transactions. Tax-free M&A transactions are considered “reorganizations” and are similar to taxable deals — but in a reorganization, the buyer uses 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 Tax Cuts and Job Act, such as the full-expensing of asset costs, may cause many to weigh their effects on any transaction. The ability to perform a taxable-asset transaction and take advantage of front-loaded deductions may encourage many chiropractors to complete a taxable deal instead of a tax-free transaction.
Cash vs. tax-free acquisition
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 chiropractic practice to make a “qualified stock purchase” of another practice 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.
Do your due diligence
Recent trends involve more buyers that are cash-ready but have 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 regardless of their knowledge and experience, every chiropractor is well advised to perform their due diligence as well as seek professional advice.
Mark E. Battersby is a tax and financial adviser, freelance writer, lecturer and author located in Philadelphia. He can be reached at 610-789-2480.