Mergers, Merger Acquisitions, and Tax-Neutral Exchanges
Mergers, Merger Acquisitions, and Tax-Neutral Exchanges
In the past several years, mergers have gained even more popularity among financial advisors as a strategic approach. A merger involves combining two or more advisory practices into a single entity. This can be accomplished by forming a new organization to which all parties contribute or by one advisor integrating their practice and clients into another advisor's firm, with ownership based on the contributions to the overall combined value.
Advisor mergers usually extend beyond mere financial considerations, emphasizing strategic combinations that leverage complementary strengths and weaknesses. For financial advisors, they can offer substantial advantages, including increased scale, enhanced efficiency, diversification of client demographics, talent acquisition, improved client service, and a stronger market position. These partnerships can arise from two firms seeking to maximize synergies through a new partnership or as part of an acquisition or succession strategy.
The primary functional types of mergers are:
Lateral Mergers: Two complementary firms can form a new partnership and contribute their assets to the partnership.
Horizontal Mergers: Competing firms can merge by forming a new partnership and contributing their assets.
Vertical Mergers: A supplier or distribution partner can join a financial advisory firm through a partnership structure.
Geographic Expansion Mergers: Firms in different regions can form a partnership to expand their geographic reach.
Strategic Partnerships: A strategic partnership can often be structured as a tax-neutral exchange, where the partners contribute assets to a new entity.
Traditional statutory mergers often involve larger firms within our industry for more complex transactions or when specific regulatory requirements mandate their use. The vast majority of financial advisors however structure mergers through tax-neutral exchanges which is our focus here.
Tax-Neutral Exchanges: A tax-neutral exchange is considered a type of merger. While it doesn't involve the formal legal process of a statutory merger, it still results in the combination of two or more businesses into a single entity. The key difference lies in the tax treatment. A tax-neutral exchange allows for the transfer of assets without triggering immediate tax liabilities, making it a more attractive option for many financial advisors. In essence, a tax-neutral exchange is a less formal but equally effective way to achieve the goals of a traditional merger.
Equity Valuation: The allocation of equity in a tax-neutral exchange is typically based on the relative value of the assets contributed by each party. This means that partners who contribute more valuable assets or have greater expertise may receive a larger equity stake. The value of each can be done through market-based valuations or an agreed upon multiple. If one parter values at $1 million and the other partner's practice values at $2 million, then the split would be 33% and 66%, respectively. Other factors that can influence equity allocation also include the quality of the book, the financial contributions, expertise and experience , future growth potential, and more as each merger is unique.
Equity Equalization: Equity equalization is used when the goal is for the new partners to have an equal share in the newly merged entity. This is handled through the minority shareholder paying the difference to the majority shareholder so that they are equalized and both have the same amount of equity after. So in the above 33% and 66% ownership scenario the 33% partner would buy 17% equity from the 66% partner as part of the merger resulting in a 50/50 partnership.
Merger Acquisition: A tax-neutral exchange can be an effective tool for acquiring a financial advisory practice while allowing the seller to maintain involvement and potentially avoid significant tax liabilities. While tax-neutral exchanges are primarily designed to avoid immediate tax liabilities, it's possible to include a cash component in the transaction. This can be beneficial for sellers who want to receive some immediate liquidity in addition to their equity stake in the new partnership.
For example, if a seller's practice is valued at $1 million, there can be a cash payment of $200,000 with the remaining $800,000 being allocated to the seller's equity interest in the new partnership. The seller would be subject to tax on the $200,000 cash payment, while the remaining stock portion would be treated as a tax-deferred exchange.
Here's how it typically works at a high-level:
Partnership: The acquiring party and the seller form a new partnership entity or one advisor will join the other's practice and exchange clients/assets for shares.
Asset Contributions: The seller contributes their practice's assets (clients, revenue, goodwill) to the partnership in exchange for a partnership interest. The acquiring advisor can make a cash down payment to the seller as part of the transaction.
Equity Allocation: The equity interests in the partnership are allocated based on the value of the contributed assets.
Ongoing Involvement: The seller can retain an ownership stake in the partnership, allowing them to continue to participate in the management and decision-making of the combined business.
Tax-Free Treatment: Under IRC §721, the seller can generally avoid recognizing immediate tax liabilities on the exchange of assets for a partnership interest (but the cash payment would be taxable).
Agreement Considerations:
Partnership Agreement: Should outline the terms of the arrangement, including ownership interests, profit-sharing, and governance.
Contribution Agreement: Specifically addresses the contributions of assets to the partnership, including valuation, allocation of equity, and representations and warranties.
Buy-Sell Agreement: Consider including a buy-sell agreement to address potential future scenarios, such as the seller's retirement or untimely departure.
Lending for Mergers & Merger Acquisitions
Bank financing is available for mergers and merger acquisitions scenarios involving tax-neutral exchanges. Financing might be desired or required as part of an expansion or other project necessitating a loan and financing is also available for the cash down payment portion of a merger acquisition. However, any 20% owner of the newly merged entity gets drug into a bank loan in one way or the other.
Conventional Loans: Loans for both equity equalization and from a cash portion payment are eligible for conventional loans. While conventional lenders can require personal guaranties of 20% partners they will usually require a grantor agreement instead in these scenarios.
SBA Loans: SBA on the other hand is more heavy handed on guarantors. Any 20% owner of the newly merged firm will have to be a personal guarantor and are subject to all of the SBA's guarantor requirements. This includes their personal property collateral requirements which is required if you have 25% equity and the loan is $500,000 or more.
The other drawback with SBA loans for mergers is they are ineligible to be considered expansion loans by SBA's definition which means the borrower is subject to the equity injection rule. This is 10% equity injection of the total deal not just the loan amount. However, the selling partner can instead seller finance the 10% on a two year standby note and then get paid out over time after that. If the selling partner does the standby financing for 10% then no cash down payment has to come out of pocket from the buying partner.
This article is authored by Darin Manis, founder of AdvisorBox, LoanBox & AdvisorLoans.