A version of this article appeared in Western Independent Bankers Directors Digest in September 2015.
Merger and acquisition (M&A) activity has definitely picked up during 2015, and M&A-related discussions are at the forefront of meetings among leaders of community banks.
Why the increase? It’s due to a number of factors, including improved profitability in the banking sector, accelerated loan growth, reduced ambiguity related to regulation, and the increasing talent gap associated with replacing retiring executives with qualified, seasoned bankers. Community bank management and directors are ultimately charged with maximizing shareholder value. While this is typically accomplished by building a fortress-like balance sheet and running a solid institution, some may determine that selling the bank is the best way to deliver maximum value to their shareholders.
In this article, we’ll explore some key considerations for potential sellers to improve deal value in an M&A transaction.
Review Your Change-in-Control (CIC) Agreements
CIC agreements protect executives in the event an institution’s ownership changes hands. They also protect shareholders by ensuring management’s objectivity in evaluating and implementing a proposed transaction.
While these agreements are an effective tool for attracting and retaining executive talent, they can significantly impact the overall cost of an M&A transaction and could impede a deal if they aren’t appropriately structured. As a result, it’s critical that potential sellers review and understand the impact of their CIC obligations by asking themselves:
- Are the agreements appropriate in today’s environment?
- What benefits are subject to accelerated vesting (supplemental executive retirement plans, unvested equity awards, etc.)?
- Are the payouts associated with single- or double-payment triggers?
- Have tax issues for individuals and the company been addressed?
An effective CIC agreement—that is, one that’s unlikely to adversely impact your M&A transaction—will:
- Incorporate a double-payment trigger that requires both a CIC and termination for the executive to receive payments
- Account for golden-parachute and deferred-compensation tax issues
- Reflect a cost of less than 5 percent of the total deal cost
Section 280G and 4999 of the tax code limit deductibility and impose an excise tax on executives that receive “excess” golden-parachute payments. Additionally, Section 409A establishes requirements for deferred-compensation payouts. This may impose additional taxes on the individuals and complicate payroll reporting and withholding for the acquirer. Understanding the tax implications and how they apply to each individual is important and may involve the inclusion of what’s often called a claw-back provision to avoid potentially adverse tax consequences.
Work with a specialist to evaluate any outstanding CIC agreements. You’ll want to be sure they reflect the intent of the parties involved and comply with representations required for the transaction. A proactive review of the agreements may create an opportunity for them to be modified, as necessary, so they aren’t impediments to an M&A transaction with unintended consequences for management.
Know the Value of Your Loan Portfolio
Loan volume and credit quality are key drivers of an institution’s value. Furthermore, the value of the loan portfolio is one of the most actively negotiated items in any M&A transaction due to the fact that its value is based on future loan performance, which is an unknown. To generate maximum value in an M&A transaction, take the following actions:
- Validate risk grades. An independent reviewer can validate internal risk grades and provide an unbiased assessment.
- Understand the valuation methodology. The acquired loan portfolio will initially be recorded by the buyer at fair value. Thus, it’s imperative that potential sellers understand how fair value is determined and what the ultimate fair value of the loan portfolio may be.
- Negotiate for contingent consideration. Contingent consideration bridges the gap between credit quality disagreements between buyers and sellers while providing additional consideration to the seller if actual performance of the portfolio is better than pro forma estimates.
Some additional areas where institutions should focus their attention:
- Understand how net operating losses (NOLs) and deferred tax assets may be used and valued under Internal Revenue Code Section 382 in advance of the diligence process, because they may be subject to limitations due to prior capital raises and equity shifts. The valuation of your NOLs may be discounted due to limitations on the amount or timing of use by an acquirer. There may be an opportunity to add value through tax planning, both before and after entering into a transaction.
- Sell less-profitable, smaller, or rural branches. Branches that are a drag on earnings or don’t have strategic significance will likely be closed after a transaction, resulting in post-transaction expenses for the acquirer. These costs will be considered when a buyer is determining the price it’s willing to pay.
- Renegotiate long-term leases. Leases with favorable terms (relative to the market) have value. By renegotiating these leases, you’ll increase the amount that can be derived from the transaction.
- Understand shareholder tax consequences. The differences between taxable and nontaxable transactions and how stock, cash, or a combination of stock and cash impacts shareholders can be important elements in structuring the transaction.
Preparation Is Key
M&A activity is expected to continue as economic conditions improve, deal prices increase, and smaller institutions struggle to generate critical mass and compete. In the spirit of increasing shareholder value, it’s incumbent on the leaders of community banks to consider all options and ultimately position the institution for success in whatever may lie ahead—whether that’s an M&A transaction or not.
To learn more about how your community bank can increase its value and its preparedness for a transaction, contact your Moss Adams professional.