March 1, 2010 | BUYOUTS

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GUEST ARTICLEBe Wary When Rolling OverManagement EquityByThomasKesoglouandKennethK.Yoon,McCarter&English,LLP

A fter searching high and low, you final-ly found that deal you’ve been look-ing for.

The target company has an excellentmanagement team and you have the particularindustry expertise to bring the company to thenext level. You are interested in acquiring thebusiness, butwould like the existing sharehold-ers andmanagement team to stay on board andown a piece of the business. You want themanagement team to have “skin in the game,”but you don’t want to take a pound of flesh ascollateral damage by not structuring it correctly.So, you offer up a proposal that allows the

existing shareholders andmanagement team toreinvest in the business by accomplishing atax-free rollover of a portion of their existingstock under Section 351 of the Internal RevenueCode. The existing shareholders and man-agement team, however, maintain that theywant to own the same type of security as yourfund (i.e. a strip of preferred stock withredemption features baked in a stockholdersagreement). You are reluctant since themanagement team would already have beenmade liquid with respect to as much as 80percent of their holdings in the target companyupon closing the deal. But, the deal would bepriced right if the management team receivedthe same security. So you agree. The deal finallycloses and everyone is off to the races.Twelve months later, the company is

performing fantastically and beyond everyone’sexpectations. But then, the IRS comes knockingat the management team’s door and declaresthat the rollover was, in fact, not a tax-freeexchange under Section 351 of the InternalRevenue Code, resulting in significant taxliabilities to the management team. Themanagement team is furious, to say the least,and has asked that you “fix” the problem sincethe deal was priced assuming a tax-freeexchange. This “fix” could certainly affect your

IRRs and the management team’s ongoingperformance, if not resolved appropriately.You call the lawyer who did the deal and ask,

“Howdid thishappen?Howcanthisbeavoided inthe future? Does this mean all of my deals werestructured incorrectly?”Unfortunately, thepreferredstock issued in the

transaction described above was deemed to be“nonqualified preferred stock” resulting in theloss of the tax-free status of the rollover. Althoughthe terms of the preferred stock in the charter ofthe issuing corporation did not include aredemptionfeature, thefactthatthepreferredstockwasredeemable (albeitbycontract inthestockhold-ersagreement) resulted in thetax-freestatusof therollover to be compromised.

Section351Generally, under the U.S. Internal Revenue

Code, transferring property to a corporation inexchangefor shares insuchcorporation is typicallyviewed as a “mere change in form” of aninvestmentasopposed toadispositionor“cashingout” of an investment. For the most part, such atransfer is generally regarded as an inopportunetime to recognizeanygainsand imposeany taxes.As a result, Section 351 and related InternalRevenueCodesectionspermit taxpayers to transferthebasis in theproperty exchanged to the sharesreceived ina transaction,deferring the impositionof taxes until and at such time the stock receivedis sold or disposed of.There are three principal requirements that

mustbemet inorder for a taxpayer to receive thetax deferment benefits under Section 351 of thecode:(1)...The transferor must transfer property (as

opposed to services);(2)...The shares issued in the tax-free exchange

must be common stock and certain preferredstock (other than“non-qualifiedpreferred stock”)and not other property such as cash or debtinstruments (or in tax terms, “boot”); and(3).gImmediately after theexchange, thegroup

transfering the property (e.g. the buyer and themanagement team)mustownstockpossessingatleast 80 percent of the total combined votingpower of all classes of voting stock and at least 80percent of the total number of shares of eachclass of stock immediately after the exchange.Eachof the three requirements set forth above

are necessary in order to achieve the non-recognition of gain (or loss) in connection with atax-free exchange. Although each requirementmust bemet independent of theothers, themostthorny requirement to meet is that the sharesissued in the tax-free exchange cannot be “non-qualifiedpreferred stock.”UnderSection351(g) ofthe Internal Revenue Code, “non-qualified

Thomas Kesoglou

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BUYOUTS | March 1, 2010 www.buyoutsnews.com

(#20484) Reprinted with permission from the March 1, 2010 issue of Reuters Buyouts. Copyright 2010 Thomson Reuters.To subscribe to Reuters Buyouts contact Greg Winterton at greg.winterton@thomsonreuters.com.

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GUEST ARTICLEpreferred stock” is preferred stock that: (i) theholderhastheright torequire the issuerorarelatedparty to redeem or purchase; (ii) the issuer orrelated party is required to redeem or purchase;(iii) the issuer or a related party has the right toredeemorpurchase, and, as of the issuedate, it ismore likely than not that such right will beexercised; or (iv) thedividend rate varies inwholeor in part with reference to interest rates,commodity prices, or other similar indices.Section 351(g) includes a few exceptions to the

definitionof“non-qualifiedpreferredstock” (aswellas exceptions to the exceptions), such as theput/call right cannotbeexercised for twentyyearsor that the rightmay only be exercised upon thedeath, disability or mental incompetence of theholder. Preferred stock, however, that enables ashareholder toparticipate in corporate growth toa significant extent avoids being classified aspreferred stock under Section 351, and thereforequalifies as stock for non-recognition purposes.UnderSection351suchpreferred stockwouldnotbe treated as participating in corporate growthunless there is a real andmeaningful likelihoodofthe shareholderparticipating in theearnings andgrowth of the corporation.

SameSecurityDilemmaMany existing shareholders andmanagement

teamsarewilling toentertain the ideaof a tax-freeexchangebutonly if theydonot recognizegain (orloss) with respect to the stock they receive in theexchange, andtheyreceive the identical securitiesas are received by the buyer (i.e. they are paripassu with the buyer in the transaction). Thereinlies thedilemma.Should theexistingshareholdersandmanagement teamhave identical rightsas theprivate equity fund, especially with respect toredemption rights? Private equity fundmanagersalmostalwaysreceivepreferredstockthat featuresa mandatory redemption right in order to createanother liquidity option. Since the existing share-holdersandmanagementteamshavealreadybeenmade liquidwithrespect toasmuchas80percentof their holdings in the target company, privateequity fundmanagers are not anxious to providethis redemptionright to theexistingshareholdersandmanagementteamsuntil thefundhasbecomeliquid with respect to its investment, and it hasachieved the IRR it is seeking.Accordingly, if the existing shareholders and

management teaminsistonbothnon-recognitionof gain (or loss) under Section 351 (other than onthecashreceived for80percentof target companyshares)andhavingthesamesecuritywiththesamerights as the private equity fund with respect toshares issued in the transaction, theprivateequityfund manager should determine whether toabandonthemandatoryredemptionfeature in thetransaction (by evaluating and determining theimportance, relevancyandvalueof themandatoryredemption and put and call rights) or to conjure

up a new type of preferred stock that includes aredemption feature but does not run afoul ofSection351. Inevaluatingwhether toabandontheredemption features, a private equity fundmanagerwouldneedtodeterminehowfrequentlythey have utilized the redemption rights in theirprior deals. Current market conditions shouldalsoweighinontheanalysis toexcluderedemptionrightssincemoreattractive liquidityevents (e.g. saleof the business or public offering) would beunavailable,which increases the importanceandvalue of the redemption rights. Also, a quickreview of the fund organizational documentsshould be conducted to determine if such rightsmust be included in the deal.At the end of the day, the most relevant

question is: Are these redemption rights worthgiving up in order to establish equivalencywiththe existing shareholders and managementteam in order to preserve the tax- free nature ofthe exchange to induce the existing sharehold-ers andmanagement team to sell? Or is there abetter way to structure the transaction so thateveryone can have their cake and eat it too?

WhatItLooksLikeIf abandoning the redemption feature isnot an

option foryour fund, thenanewtypeofpreferredstock that includes a redemption featurebutdoesnot run afoul of the tax-free exchange rules ofSection 351 should be considered. As describedabove, Section 351(g) only applies to “preferredstock” (i.e. stock that, by its terms, has nomeaningfulparticipation incorporategrowth). ForpurposesofSection351(g), aparticipatingpreferredstock (i.e. stock that shares inproceedsalongwith

the common stock upon a liquidity event) wouldnot be considered preferred stock and conse-quently, any redemption rights that the existingshareholders and themanagement team receivewould not jeopardize the tax-free exchange. As aresult, any preferred stock to be issued in atransaction should includeaparticipation featureto permit the inclusion of the redemption rights.AtypicalmethodofstructuringaSection351tax-

free exchange where the management teamobtains thesamesecurityas theprivateequity fundis to have the private equity fund capitalize anewly-formedcorporationwithcash inexchangefor shares of Series A Participating PreferredStock (which includes redemption rights) of thenewly-formed corporation. The newly-formedcorporationwould then pay cash (typically for atleast 80 percent) for the shares in the targetcompany, providing significant liquidity to theexisting shareholders andmanagement team. Atthe same time, the existing shareholders and themanagement team would contribute up to 20percentof the target company stock to thenewly-formed corporation in exchange for the sameshares of SeriesAParticipatingPreferredStockofthe newly-formed corporation purchased by theprivate equity fund.Whilewewon’t attempt toaddress,here, all the

issues and details concerning Section 351 androllover transactions, and this brief discussion isnot meant to be tax advice, we hope this smallexample illustrateshow important it is to consultwith your corporate and tax lawyers early on,before fixing,andbaking in, the termsofyourdeal.Often, choosing a good structure meansconsidering trade-offs, anddecidingonpriorities,based on your particular circumstances andobjectives.Sometimes, seeminglysmalldifferencescan make all the difference in changing theoutcome. Also, the laws are subject to change, asare typical market terms, so working with youradvisors earlyon, andconsidering the full picture,is key to a successful outcome.�

Thomas Kesoglou and Kenneth K. Yoon arepartners in McCarter & English, LLP’s NewYorkoffice. Kesoglou is a member of the firm’scorporate department and focuses his practiceon advising clients in connection with leveragedrecapitalizations, management buyouts, merg-ers and acquisitions, mezzanine financings,early and late stage private equity and venturecapital investments and secondary transac-tions.Yoon is a member of the firm’s tax depart-ment and focuses on tax law (including taxaspects of mergers and acquisitions, securitiesofferings, investment funds, and executivecompensation) as well as general representationof technology and emerging companies.Reach Kesoglou at 212-609-6821 ortkesoglou@mccarter.com, Yoon at 212-609-6827 or kyoon@mccarter.com.

Kenneth K. Yoon

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