An uneventful merger or acquisition is hard to come by.
M&A claims – and their costs – are on the rise. In 2018, almost 26 percent of deals ended in a claim. And, the severity of claims greater than $10M has doubled, with an average cost of $19M.1
Today, businesses considering a merger or acquisition must understand that the largest and most frequent claims often come from three areas: labor issues like employee misclassification, tax issues like S-corp status and international deals in which U.S. businesses acquire like organizations abroad.
Tax matters in M&A deals
One of the most common tax breaches in recent transactions include: corporate income tax, sales and use tax, and validity of the target company’s S-corp status.
To avoid falling prey to any one of these claims, hire a third party CPA firm or tax advisor to assess your target company’s tax profile. Do a historical analysis that goes back years highlighting these three areas of common tax breaches.
Underwriters are very knowledgeable of relevant tax issues. Make sure you choose a tax advisor that can properly communicate a message to the underwriter that the exposure is minimal or non-existent, if that happens to be the case. Ask them to do a state-by-state-level analysis that examines local tax law as well to see if there’s a premise for taxation and what those penalties and fees are. When the exposure approaches a material portion deductible, that’s when the carrier knows they’re potentially on the hook for liability.
Labor and Employment in M&A deals
Across industries from trucking to franchises, service-oriented firms and customer service businesses, employee misclassification is a hot claims issue. And it’s about to escalate. With the passage of AB 5, a California law limiting the classification of workers as independent contractors rather than employees, employee contract status is getting a lot more attention as states like Illinois and New York are considering similar legislation as well.
When exempt and non-exempt employees are not classified correctly, there’s a great potential for claims litigation, both individual and class action suits to be brought against a company. These claims have significant long-term ramifications that can lead to hefty fines and back-pay and benefits to workers.
Due diligence on a company’s worker classification history is imperative. Find out if the target has had previous claims. Engage a labor and employment attorney during discovery to do so.
Underwriters are more savvy on issues of employee misclassification than ever before and therefore, they are more likely to ask granular questions about the target business. Make sure your counsel is prepared to answer them.
International M&A deals
A crowded and expensive U.S. M&A market has led domestic businesses and private equity firms to look beyond the border for both logical add-on acquisitions and new platform investments. One of the most important things businesses exploring this route need to know: Don’t try to take your U.S-centric playbook and apply it internationally. Instead, each foreign market will have its own rules, regulations, processes and risks.
While this is similarly unchartered territory for underwriters, many of them have also been burned on foreign market deals. As a result, they’re getting smarter on international market issues and will only consider applications in which the buyer has done thorough due diligence – and can prove it. Underwriters are looking for third-party documents that specify due diligence, including reports on the target company’s legal, tax, financial, environmental, operations and insurance/benefits standings.
Finally, seek out an attorney that specializes in international M&A and can provide local representation abroad. This will be important to the underwriter, as they’ll need to rely on your designated local representatives and advisor who understands local risks and can boil down the issues into U.S. lingo. An investment banker with significant cross-border expertise is also highly desirable.
It's never been more important to explore the potential value of Representations & Warranties (R&W) Insurance and its sister products including but limited to Tax Indemnity and Litigation Containment policies. R&W coverage protects both the buyer and seller from financial loss resulting in the seller’s representations. Contact your HUB expert for more information on Representations & Warranties Insurance and M&A due diligence.