Geneva

Topical Briefing
November 2003

MERGERS & ACQUISITIONS: DEAL STRUCTURE

Structure Plays Important Role for Sellers and Buyers

■ There is an old axiom that dictates that, while the seller determines the price of his or
her business, the buyer sets the terms.

■ While sellers tend to prefer all cash for their companies, such a structure may not
produce the highest overall value for the business and can limit the prospective buyer
universe.

■ Depending on the specifics of the deal, a seller can use structure to defer taxes,
participate in the future success of the business, and maximize the total proceeds
from the sale of the company.

■ Buyers use structure as a way to mitigate their risk, as an aid in the transition of an
owner-dependent business, as a means of bridging the gap between buyer and seller
value expectations, and as a means of financing the transaction.

■ Like price, deal structure is negotiable and can vary widely from one transaction to the
next. The individual needs of sellers and buyers are considered in structuring each
transaction in the most appealing manner to meet both parties’ objectives.

Deal Form

■ At the broadest level, deal structure is the fundamental decision of whether the deal
will be structured as a stock or an asset purchase.
■ Stock Purchase: In a stock purchase, the shares of the stock are transferred from
seller to buyer and thereby the buyer assumes all assets, liabilities, and operations of
the business, unless specifically excluded in the Stock Purchase Agreement.
■ Asset Purchase: Under this structure only the assets and liabilities specified in the
Purchase Agreement are transferred to the buyer, who must either create a new entity
or use an existing entity for the transaction.

■ Sellers generally prefer stock sales, which allow for an easier transition and usually
entitle them to pay taxes on the sale at the lower capital gains rate. Buyers often
prefer an asset purchase that identifies the exact assets acquired and liabilities
assumed, and which creates a barrier of liability through the new entity. In addition, an
asset purchase may offer tax benefits to the buyer through a step-up in asset basis.

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 MERGERS & ACQUISITIONS: DEAL STRUCTURE

Payment Methods

■ The term “deal structure” also refers to the methods of payment used to buy a business. M&A transactions often
employ a variety of payment methods, consisting of one or a combination of the following:
! Cash
! Stock
! Deferred fixed Payments
! Contingent Payments
! Other consideration
■ Cash: Cash and stock are the most common forms of payment. The cash portion of a deal includes both the
buyer’s equity as well as cash that the buyer borrows from banks and other financing sources by leveraging the
target’s assets and cash flow. Typically, a higher proportion of cash is used to fund transactions when interest
rates are low and buyers have ready access to cash at affordable rates, and when banks relax their lending ratios
(usually in an expanding economy).
■ Stock: Use of the acquiring company’s stock is common, and is even more prevalent when stock prices are high
and this currency will purchase more with fewer shares. Mergerstat reports that when the stock market was at its
peak in 2000, all-stock payments accounted for 32% of the transactions that disclosed their payment methods. In
comparison, in 2002, after the market corrected and prices dropped, all-stock deals accounted for only 22% of the
disclosing transactions.

■ If the buyer is a public company, sellers often view receipt of stock as equivalent to cash. However, deal terms
often limit the ability to liquidate the shares, subjecting the seller to the volatility (both positive and negative) of the
public markets.

■ Fixed Deferred Payments: These are payments for a fixed amount and made according to a specified payment
schedule. Such payments can be tied to secured or unsecured notes, and/or consulting, non-compete, or
employment agreements. In the case of notes, collateral might include a guarantee from the acquiring entity or a
lien against the acquired assets (in both cases subordinate to the claims of senior lenders). Consulting and non-
compete agreements are ways to provide the seller additional consideration that does not adjust based on the
performance of the business.

Payment Methods
1990-2003
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
*
90

91

92

93

94

95

96

97

98

99

00

01

02
03
19

19

19

19

19

19

19

19

19

19

20

20

20
20

All-Cash All-Stock Combination Other

*Through June 2003

Source: Mergerstat Review, 2003

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 MERGERS & ACQUISITIONS: DEAL STRUCTURE

■ Contingent Payments: Such structure is used when the company’s potential for future sales and profits is
substantially higher than its historical performance, to bridge a price gap between buyer and seller, or when the
buyer perceives a high risk in the ownership change. A buyer is likely to pay for a portion of the projected potential
now, and the rest as the business meets or exceeds the stated projections. Because these payments are subject
to the company’s performance, they offset some of the buyer’s risk in addition to spreading the payments over
time. Frequently, the seller remains involved with the business in some capacity during all or part of the
contingent payment period, thereby influencing the performance of the business and increasing the likelihood that
he/she will receive the contingent payments. Contingent payments include earnouts, royalties and licensing
agreements.

■ Using an earnout, the buyer pays the seller post-closing consideration based on the company’s future sales or
earnings. Realization of the earnout payment is dependent on the company achieving agreed-to sales or earnings
for a specified period after the sale.

■ Sales royalties call for the buyer to pay the seller an agreed-upon percentage of the company’s sales for a
specified period after the transaction has closed.

■ From the seller’s perspective, contingent payments can result in a significant increase in the total purchase price, if
the company meets or exceeds its projections.

■ Other Consideration: This category includes the buyer assuming the seller’s debt, the seller retaining company
assets, and the disposition (sale or retention/ leaseback) of the seller’s real estate.

■ The ultimate structure of a transaction depends on the price paid for the company, seller and buyer needs and
motivations, and the type of buyer. Public corporate buyers and financial buyers in particular have access to more
types of consideration (stock, financing, etc.) than do other buyers.

Allocation of Purchase Price

■ Finally, the allocation of the purchase price across the various assets and liabilities of the business is an important
deal structure component and can affect the tax treatment of the transaction.

■ Generally speaking, an allocation of 100% of the purchase price to the purchase of stock will yield the lowest
possible tax consequence to the seller – at the long-term capital gains rate.

■ At the other end of the spectrum, an allocation of 100% of the purchase price to the purchase of assets from a C-
Corp will generally produce the highest combined corporate and individual taxes.

■ With the recent (2003) reduction in long-term capital gains rates, there is increased motivation for all forms of
payment (cash, notes, stock, earnout) received to be allocated towards the purchase of stock.

■ The sale of stock in most cases will yield a single level of long-term capital gains, while the sale of assets of C-
Corps (or S-Corps converted from a C-Corp in the last 10 years) generates the very unfavorable “double taxation” -
taxation at both corporate and shareholder levels.

■ Covenants not-to-compete, consulting agreements, and employment agreements are treated as ordinary income.
Earnouts and royalties can be treated as either ordinary income (as in the case of an employment bonus) or can
be allocated to the purchase of stock and thus taxed at the long-term capital gain rate.

■ Structuring a deal to balance price and risk between seller and buyer is critical and requires experience with
difficult and complex transactions.

■ Properly structuring a transaction may result in an increase in the total purchase price and may allow for deferred
tax liability for the seller. Sellers should consult a tax advisor when evaluating potential deal structures, as they
can greatly impact the after-tax value of the transaction.

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 MERGERS & ACQUISITIONS: DEAL STRUCTURE

Deal Structure Data

■ Mergerstat reports that the total number of deals that announced an all-cash structure increased from 45% of
transactions that disclosed structure in 2001 to 56% in 2002, the highest level since 1988 (also 56%).

■ Those transactions that announced an all-stock payment decreased from 27% in 2001 to 22% in 2002, and those
that announced a combination structure decreased from 27% in 2001 to 21% in 2002.

■ One reason for the more frequent use of cash is that private equity buyers are in a strong cash position. Another is
that interest rates are at a low. In addition, the value of the stock index has been volatile in recent years, pushing
buyers to use less stock – thus more cash in their structures.

■ Increased activity by corporate buyers using stock should materialize once buyers feel that their stock is valued
favorably.

Geneva Experience

■ A review of recently completed Geneva transactions (from January 2001 through June 2003) indicates that cash
and stock accounted for, on average, approximately three-quarters of the total consideration. However, there are
also numerous other components, which combined make up an average of nearly 25% of the consideration for
these transactions.

■ Further analysis of the data in two groups, those transactions smaller than $5 million and those equal to or larger
than $5 million, shows that while the cash and stock component remains fairly constant, the composition of the
remaining 25% has a statistically significant difference. Specifically, smaller deals have relied more on notes and
other fixed deferred payments, while larger deals have employed a higher proportion of contingent payments.

■ This specific difference between smaller and larger deals is reinforced when the frequency of different forms of
consideration are reviewed. The use of cash and stock is steady, found in 98% and 96% of small and large
transactions respectively. However, there is a nearly 20% difference in the occurrence of notes/fixed deferred
payments (more prevalent in the smaller transactions) and contingent payments (more prevalent in the larger
transactions).

■ These results are consistent with differences in the makeup of buyers. Purchasers of the smaller deals include
more small companies and individuals, who are likely to employ notes and deferred payments. Investment and

Geneva Transactions:
Forms of Payment

$5MM and above

Under $5MM

All Transactions

0% 20% 40% 60% 80% 100%

Cash and/or Stock Notes/Fixed Deferred Payments

Contingent Payments Real Estate/Assets/Debt
Other

Source: Geneva Proprietary Database, transactions completed January 2001-June 2003

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 MERGERS & ACQUISITIONS: DEAL STRUCTURE

private equity groups, who are more likely to use contingent payments in their non-cash consideration, purchased
a larger deal twice as frequently as a smaller deal in the Geneva sample.

Geneva Transactions:
Frequency of Payment Method

$5MM and Above

Under $5MM

All Transactions

0% 20% 40% 60% 80% 100%

Cash and/or Stock Notes/Fixed Deferred Payments

Contingent Payments Real Estate/Assets/Debt
Other

Source: Geneva Proprietary Database, transactions completed January 2001-June 2003

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Although the information in this sales literature has been obtained from and is based upon sources The Geneva Companies Inc. ("Geneva") believes to be reliable, we do not guarantee its
accuracy and it may be incomplete or condensed. All opinions and estimates constitute Geneva's judgment as of the date of the document and are subject to change without notice. Past
performance is no guarantee of future results. This sales literature is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. Geneva
shall not be liable for any actions taken in reliance upon this sales literature. The information herein does not take into account the investment or tax objectives or financial or legal situation of
any particular person or entity. You should obtain advice from your financial, tax or legal advisors based on your own individual circumstances before making an investment decision. Neither
Geneva nor any other person accepts liability whatsoever for any loss (howsoever arising and whether direct or consequential) from any use of the information contained herein or otherwise
arising in connection herewith. Geneva is an affiliate of Smith Barney, a division of Citigroup Global Markets Inc. Geneva may receive compensation for referrals of Geneva Clients or
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