Mergers and Acquisitions in the Biodiesel Industry

During these tough economic times in the biodiesel industry, success-even survival-often comes down to finding M&A partners. The following are important aspects for biodiesel companies to consider throughout the scope of the M&A process.
By Dean R. Edstrom | July 13, 2010
The term mergers and acquisitions (M&A) refers to a variety of transactions involving the acquisition by one party, the acquirer, of one or more business entities or lines of business of another party, the acquiree or target. The term also includes the combination of two or more companies into a single company.

These days, success or even survival in the biodiesel industry often means finding an M&A partner or partners. The economics of the industry reward control of or the ability to leverage a position with respect to feedstocks, markets, financing, transportation and other revenue and cost drivers. An M&A transaction that aggregates production capacity, a horizontal transaction, is one way that leverage might be created. A vertical transaction that integrates production capacity with feedstock supplies (an upstream deal from the point of view of the producer) or with a biodiesel market player or end user (downstream) creates a different kind of market power. These types of horizontal and vertical transactions are often called strategic transactions because they focus on competitive strategies. When the acquirer is not in the biodiesel industry and is interested in the target principally as an investment opportunity, which may include making additional financing available to the target, the acquirer is often referred to as a financial buyer.

Selecting the Team

The process of planning, negotiating and completing an M&A transaction can be difficult, complicated and time-consuming. Each party must select a team composed of management and outside professional advisors for the purpose. For a small company, management may be represented by a few key officers and board members. In a large company, the management team may include inside counsel and members of the finance, accounting, development and human resources staffs. Each party will be supported by outside counsel, independent accountants and tax advisors. For transactions of any significance, investment bankers will assist in analyzing values, structuring the deal and negotiating terms, and they will be in a position to provide fairness opinions with respect to the financial terms of the transaction. If requested, they may also conduct the search or auction process to identify the most attractive M&A partner and best financial terms. In some cases, intellectual property counsel, professional engineers, environmental consultants and other experts will be required to deal with issues that are critical to the transaction or could be a roadblock to success.

Planning for the M&A Transaction

The first step in considering a possible M&A deal is self-analysis. What are the strengths and weaknesses of the company, what does it bring to the table that may be attractive to potential acquisition partners and what does it look for in those partners? This analysis will reveal the types of transaction-horizontal, vertical, strategic, financial or a combination thereof-that should be considered. Consideration of the relative strengths of the company and potential acquisition partners will give an indication of whether the company is an acquirer or is likely to be an acquisition target. Being a target, incidentally, is not necessarily bad; receiving cash in an exit transaction or retaining equity in a stronger enterprise may be far better than struggling alone.

M&A Transaction Structures

The planning process will include consideration of alternative structures for the transaction that will maximize the benefit to the company's equity holders while retaining the attractiveness of the deal for possible M&A partners. The three principal structural alternatives for an M&A transaction are the following:

Statutory merger
A statutory merger is completed in accordance with the laws governing the organization of the respective parties to the transaction. Whether the parties are corporations, limited liability companies, partnerships, cooperatives or other entity forms, most state laws are now flexible enough to allow two companies to combine into one by merger of one into the other or to allow a subsidiary of one to merge with a target. A merger of a target with a subsidiary, where the consideration is cash or securities of the parent, is often called a triangular merger. When the target merges into the acquirer or into a subsidiary of the acquirer, the merger is a direct or forward merger. Often, however, it is advantageous (at least from an economic standpoint) to structure the transaction as a reverse merger, where the acquiring company or subsidiary merge into the target.

Acquisition of assets
In an acquisition of assets, the acquiring company purchases some or all of the business and assets of the target and may assume specified liabilities of the target. The acquirer generally acquires only those liabilities of the target that it specifically agrees to assume, subject to some successor liability doctrines imposed by law and court decisions such as liability for pre-existing environmental issues. Following an acquisition of assets, the target may sell its remaining assets, satisfy its remaining liabilities and distribute the cash or securities received in the acquisition to its equity holders, or, it may continue business with the lines of business and assets not sold in the acquisition.

Acquisition of stock or other equity interests If the transaction is structured as an acquisition of equity interests, the transaction focuses on the owners of the target rather than the target itself. In the case of a closely held target, the acquirer might successfully negotiate the simultaneous purchase of all of the outstanding equity. Where the equity of the target is more broadly held, the transaction might be conducted as a friendly or hostile tender-offer, in which the acquirer offers to purchase the equity of willing sellers, usually subject to a controlling percentage of the equity being tendered for sale. If a minority interest remains after an initial equity purchase, the acquirer will often conduct a second-stage squeeze-out or freeze-out merger, subject to state law, by which it would eliminate the minority interest for cash.

Typical reasons for choosing one or another structure focus on the tax consequences of the transaction, the preservation of tax or accounting advantages, the ability to selectively acquire a portion of the business, assets and liabilities of the target and the avoidance of the necessity to secure consents from third parties that have existing contractual or business relationships with one of the parties to the transaction.

Transaction Consideration

The nature and amount of consideration to be paid or issued to the parties to an M&A transaction or to their equity holders will normally be the most important term in the transaction. The consideration will normally be cash, debt obligations or equity securities, or a combination of those forms. The amount or value of the consideration given will depend on negotiations between or among the parties which often will reflect differing perceptions of value. Particularly when equity securities are offered, the value equation will focus not just on the value of the target but also on the present value or expectations of the future value of the acquirer issuing the securities. When the transaction involves the equity securities of comparably sized parties, the perceived relative values of the parties and the ratios of equity to be shared in the combined enterprise may be more important than any specific dollar values attributed to the parties or their equity.

Where values may shift significantly between signing of the M&A agreement and closing, or even after closing, special provisions may be negotiated. Adjustments to the purchase price may be based on a closing date balance sheet, particularly where the amount of cash, inventory, receivables and payables may change significantly. The possibility of a significant increase or decrease in the market price of equity securities at closing may trigger an increase or decrease in the amount of equity issued as consideration. Where uncertainty or disagreement exists regarding the future potential of the business acquired, an earn-out arrangement can provide for additional consideration based on future sales or earnings of the acquired business.

Tax Consequences of M&A Transaction

The tax consequences to the parties to an M&A transaction and to their equity holders are major and often deciding factors in determining the structure and attractiveness of any deal. For entities taxed as corporations, Section 368 of the Internal Revenue Code allows an M&A transaction to be accomplished without an immediate recognition of gain by equity holders in certain carefully defined circumstances, all of which involve the continuation of an equity interest in the resulting enterprise. Often called a tax-free reorganization, such a transaction actually defers tax on any gain at the time of the transaction, typically allowing capital gains treatment of tax on the gain when the equity is ultimately sold. If the equity holders receive cash, or if the transaction fails to meet the specific requirements for tax-deferred treatment, tax on any gain to the date of closing may be due, regardless of whether the transaction results in any cash distribution to the equity holders. Thus, great care must be exercised in analyzing the tax consequences of the transaction, which will depend on the organizational form of the parties and the structure of the transaction as well as the consideration exchanged.

The ultimate tax impact on equity holders will, in large part, be determined by the tax basis of their investment in the parties to the M&A transaction. In the case of limited liability companies or partnerships, an M&A transaction may also result in the recapture of losses previously recognized for tax purposes by the equity holders, the impact of which may differ among the holders.

An acquirer is also interested in the tax aspects of the transaction, such as the ability to step-up the tax basis of assets in an asset purchase and the possibility of preserving net operating loss carry-forwards of the target.

Securities Law Compliance

The securities law consequences of any M&A transaction will be a significant item in planning and negotiating any transaction. If a portion of the consideration is equity or debt securities (including promissory notes), the Securities Act of 1933 will require registration of the securities offered unless an exemption to registration is available. Transactions involving a limited number of target equity holders or only holders who qualify as accredited investors may qualify as exempt private offerings, but great care must be taken in assuring that an exemption is available. If a vote of equity holders is required and the party is subject to the reporting requirements of the Securities Act of 1934, the transaction will be subject to the proxy or tender offer regulations of the Securities and Exchange Commission even if cash is the only form of consideration. The anti-fraud rules of the federal and state laws will apply to any transaction involving securities even if the registration and proxy rules do not apply. Compliance with the securities laws can add considerable delay and expense to a transaction, particularly in cases where a full registration of securities is required and meetings of equity holders subject to the proxy rules are held.

Other Considerations

A variety of other federal and state laws and regulations may apply to the M&A transaction. For instance, where the size of the transaction meets one of the tests under the Hart-Scott-Rodino Act, a filing with the Federal Trade Commission is required to allow the FTC to determine whether the transaction may be anti-competitive. If a layoff is likely, early notice may be required under the federal Worker Adjustment and Retraining Notification Act. In the biodiesel industry, depending on state law and the structure of the transaction, state environmental and other permits may require assignment or renewal. The regulatory conditions on which grants, subsidies, tax relief and other incentives may have been granted must be checked and assignments, waivers or renewals obtained. Again, these requirements can be delaying factors, especially if they are not identified and dealt with early in the process.

Third-Party Agreements

Early attention also needs to be given to third-party approvals and consents necessary for the transaction. If the transaction is structured as a sale of assets, all agreements will need to be reviewed to determine whether they can be freely assigned at closing or if a consent to assignment is necessary. Even in the case of a merger, where most agreements are automatically assumed by the surviving party, particular provisions, such as prohibitions on change of control, may necessitate consents. Special attention needs to be given to financing arrangements that may contain provisions that directly or indirectly trigger a default if a consent is not obtained. These issues may have a significant impact on the structure of the transaction.

Finding an M&A Partner

The process of identifying prospective M&A partners should be a disciplined endeavor based on the thought and planning that has gone before. Analysis should indicate which candidates might be interested in a transaction, what their capabilities are to finance and complete a deal, and what strengths they would add to a combined enterprise. The list would likely include players in the industry and potential financial buyers. In the biodiesel industry, many of the potential partners would be known to management. An investment banker could assist in expanding and refining the list. The strategy to approach prospects should be considered, such as whether to start with what appears to be the best prospect and work down the list, approach a limited number of parties or, particularly in the case of a selling target, commence an auction process.

Negotiating the Terms

The success or failure of an acquisition is often determined by the early negotiations for the deal. That is when key issues are typically discussed and become the premises upon which all other negotiations and terms are decided. Those issues include the structure of the transaction, the form and amount of consideration, tax consequences, post-closing control relationships, exit opportunities and the like. Your negotiating team must understand the issues and choices, be properly prepared and have competent legal and financial consultants to assist at this early stage.

Confidentiality Agreement

When initial contact with a prospective M&A partner is made, the parties should consider entering into a confidentiality or nondisclosure agreement, which will provide the parties some measure of assurance that any confidential information disclosed in the process will not be disclosed to others or used to the detriment of the parties.

Letter of Intent

A letter of intent, memorandum of understanding, heads of agreement, term sheet or whatever you call it, this document will summarize the principal terms of the deal. A key consideration is whether it is to be binding or nonbinding. Even if most or all of the terms are nonbinding, the document will have a powerful influence on the negotiations going forward and in most cases the ultimate merger or acquisition agreement will not vary greatly from the basic terms as set forth in the letter of intent. The letter of intent also frequently contains exclusivity provisions that prohibit contact with other potential suitors or provide for significant penalties if another deal is consummated. Thus, great care must be exercised in preparing the letter of intent.

Acquisition Agreement

The acquisition agreement will set forth all of the details of the transaction. In addition to the terms previously negotiated and specified in the letter of intent, the acquisition agreement will contain numerous representations regarding the parties, their businesses, properties, employee relationships and benefits, environmental matters, and a myriad of other items. Warranties that define conduct of the parties between the signing of the agreement and closing of the transaction will also be included. Representations and warranties are important both because they are typically conditions to closing favoring one party or the other or can give rise to breaches of the agreement and damages. Other closing conditions, such as government approvals, consents of third parties, legal opinions and the like will be included. Remedies for breach will be specified. As in the case of the letter of intent, limitations on the right of the parties to negotiate with other potential suitors or terminate the agreement are likely to be included, with a "break-up" fee payable if a competing offer is accepted. Exhibits or schedules to the agreement will ususally provide extremely detailed information in support of representations made in the agreement itself.

Due Diligence Process

Due diligence has grown from a term known only to securities and M&A specialists to a concept generally understood by the public at large, an indication of the importance of the process. An acquirer needs to be sure that the target's value attributes are present, and that risks either do not exist or are acceptable. If the target or its equity holders are receiving equity in the acquirer, the target needs to investigate the same things. Due diligence will normally include a comprehensive review of the other party's organization, finances, key assets, intellectual property, material contracts, management, benefit arrangements, litigation, environmental and other special risks, and the like. It will involve the request for and review of documents on all of these subjects, followed up by requests for clarification of issues identified and interviews with management, accountants and others. The process frequently begins as early as the execution of a confidentiality agreement even before a letter of intent is signed, usually is very active between the signing of the letter of intent and execution of a definitive agreement for the transaction, and is completed within a stated period after the date of the agreement. The subjects of due diligence will, to a large extent, mirror the representations made by the parties in the definitive agreement and the agreement will state what impact that the failure of any representations may have on the obligations of the parties to close and their post-closing liabilities. Much of the diligence process is now conducted electronically through password controlled datarooms maintained by the parties, their counsel or outside providers such as financial printers.

Other Pre-Closing Activities

Most M&A agreements provide that the parties will conduct their respective businesses in the ordinary course and limitations are placed on their ability to engage in other transactions or activities that might detract from the value or other assumptions underlying the transaction. The parties typically agree that they will cooperate in the diligence process, support negotiations with lenders, assist in obtaining required consents, and make all securities and other regulatory filings necessary to the transaction. The target is frequently restrained from contacts with other potential suitors, and may accept a competing offer only subject to a "break-up" fee payable to the acquirer. If the transaction involves a registration of securities and solicitation of proxies, the parties will expend considerable effort to complete the registration and obtain the SEC's order of effectiveness so the proxy statement/prospectus can be mailed to equity holders. Meetings of equity holders typically are held about 30 days after mailing of the proxy statement/prospectus.

The Closing

The closing of the M&A transaction normally occurs as promptly as possible after approval by equity holders, and often occurs the same day. Verification of the correctness and satisfaction of representations and warranties, or waivers thereof, delivery of consents, assignments, legal opinions and other documents and execution of instruments necessary to effect the transaction are completed. In the case of a statutory merger, filings of articles of merger are made with the secretary of state of the states where the parties are organized. Asset transactions are typically completed by the execution of assignments and bills of sale, together with filings necessary to transfer real estate. The cash and/or securities forming the consideration for the transaction are delivered to the target or equity holders of the target, depending on the transaction structure.

Board Fiduciary Duties and Protection

The law of the state of organization of each party to an acquisition will impose fiduciary duties on the board of directors and management to negotiate a transaction that is fair to equity holders. This requires that the directors conduct themselves in a careful and prudent manner. Special protections may be necessary when the acquirer has a pre-existing equity interest in a target or where members of the board or management have conflicts of interest. In transactions of any significance, directors normally request the assistance of an investment banker and obtain an opinion regarding the fairness of the transaction from a financial point of view. Directors also should have in place a directors' and officers' liability insurance policy to provide additional protection against liability.

Dean R. Edstrom is a partner at Lindquist & Vennum PLLP. He has completed a wide variety of M&A transactions with clients ranging from private companies to Fortune 500 companies, including transactions in the biodiesel industry. Reach him at (612) 371-3955 or [email protected].
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