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By
Philip W. Peters
Thelen LLP
Acquisition
activity in the construction industry increases during tough
economic times. The acquirer often must evaluate the target's
projects, make risk assessments and determine structure
very quickly. How can the acquirer take advantage of these
fleeting opportunities and protect itself against contingent
losses after the closing?
Valuation of Contracts
The
most important issue in construction acquisitions is the
valuation of executory contracts and work in progress. Long-term
construction contracts involving material amounts frequently
are the most critical assets of a construction firm. The
deal must be structured so as to provide maximum protection
against contingent losses. Washington Group's acquisition
of Raytheon's engineering and construction business is a
potent recent example of the importance of risk allocation
in an acquisition context. Valuation is more art than science,
particularly given the flexibility inherent within GAAP
and the subjectivity inherent in evaluating contingent liabilities.
How can the acquiring construction firm (acquirer) protect
itself against potentially troublesome projects in the hands
of an otherwise attractive construction company (target)?
Exclusion of the Troubled Project
The
bright-line method for avoiding responsibility for a troubled
project is never to acquire it in the first place. Under
this approach, the transaction is structured as an acquisition
of specified assets and liabilities rather than an acquisition
of the whole of an operating concern. In an asset purchase,
specific contracts and risks may be excluded from the scope
of the transaction. In contrast, stock acquisitions or acquisitions
by merger necessarily involve an assumption of all liabilities,
whether known or unknown (unless a pre-closing spin-off
or other prophylactic steps are undertaken). Accordingly,
the asset acquisition structure permits the parties to identify
and exclude one or more troubled projects. Absent the equitable
considerations that may justify imposition of successor
liability under state law, the acquirer should be insulated
from responsibility under this approach.
Frequently,
however, the target will not be able (or willing) to retain
a troubled project after disposition of the healthy parts
of its enterprise. What are the basic alternatives available
to the acquirer that remains willing to proceed in this
situation?
Use of Liability Shield
An
acquirer should take steps to protect its existing business
from its new assumed liabilities. The use of a liability
shield should be considered to protect the acquirer's other
assets from the obligations of the target generally and
the liabilities of a troubled project specifically. The
liability shield is created by housing the target's operations
in a separate legal entity set up as a subsidiary of the
acquirer. A troubled project could be further separated
from both the acquirer's existing assets and other acquired
assets by using two acquisition vehicles. The basic liability
shield is a natural consequence of acquisitions of stock
or transactions structured as triangular mergers.
A
reverse triangular merger, in which the acquirer establishes
a subsidiary that is merged into the target, with the target
as the surviving entity, has the added benefit of continuing
the legal identity, name and reputation of the target. In
contrast, a direct merger of the target into the acquirer
would terminate the separate existence of the target and
defeat liability insulation by exposing the acquirer's valuable
assets to claims relating to any troubled projects.
In
addition to structural approaches, a proactive approach
to the project owner, jointly by the target and the acquirer,
may well be beneficial. For projects viewed as bearing a
high risk-to-return ratio, it simply may not make sense
to consummate an acquisition without certainty regarding
the availability of mutually agreed upon risk allocation
and management measures (e.g., establishment of an owner/contractor
panel). Obtaining contract modifications may well be expensive
because owners seldom can be expected to give without receiving.
But, reasoned anticipation and addressing of potentially
serious issues may be the type of prudent business practice
that provides a mutual benefit for the owner and contractor
on a difficult job.
Valuation of Contracts in Transactional Pricing
The
acquirer may, of course, address the impact of contingent
liabilities specifically and directly in pricing discussions.
While a target may argue that contingent liabilities need
not appear on the books unless they are "probable to
occur and reasonably estimated in amount," the acquirer
nevertheless may require treating any contingent liabilities
as actual liabilities for purposes of the deal. For example,
should a deduction be made for threatened litigation even
though the company is not required to record a liability?
Should guarantees, secondary liabilities or other potential
exposures be considered liabilities for purposes of determining
net worth? An acquirer can justifiably address contract
valuation concerns at the outset during pricing discussions.
Nevertheless, an agreement in principle on price might not
adequately address the interests of the parties in the context
of unknown future events.
Addressing Project Risks in Contract Provisions
In
most cases, the target will have provided business information
to the acquirer and the acquirer will have conducted its
own due diligence by the time a deal in principle is struck.
In the text of the definitive agreement, the risks of future
contingencies will be specifically allocated between the
parties. The acquirer will request representations, warranties
and detailed disclosures regarding construction contracts,
defaults, claims, notices and the like. The target will
seek to require the acquirer to rely on its own investigation.
The outcome of these discussions will be a set of contractual
provisions determined by the interests of the parties and
the underlying issues. A percentage of the purchase price
may be withheld in escrow as security for the acquirer's
indemnification claims against the target. A portion of
the purchase price may be structured as an earn-out payable
to the target's shareholders, based upon earnings actually
realized by the project. Indemnification provisions (including
appropriate claims thresholds, liability limitations and
survival periods) will be negotiated, and personal guarantees
may come into play.
Other Primary Risks
While
acquisition issues relating to executory contract valuation
and troubled projects have been the focus here, a variety
of equally critical issues will affect the analysis, pricing
and structuring of construction acquisitions. These issues
include the value of the name and reputation of the target;
the nature and extent of insurance coverage; bonding of
ongoing and future projects and bonding capacity; licensing;
pension and benefit plan liabilities; employee stock ownership
and other profit sharing agreements; union contracts; employment
contracts; environmental issues (e.g., asbestos and mold);
and terms and conditions of construction contracts, including
assignability. A due diligence investigation focused on
these and other items will greatly inform the decision of
whether to proceed and, if so, the optimal structure for
the transaction and the provisions of the definitive agreement.
Summary
When
considering the acquisition of any construction entity,
the acquirer should take steps to ensure that it has arrived
at reasonable, informed valuations of existing contracts
and that the value will continue to exist in its hands after
the closing. While attorneys properly avoid rendering formal
valuation opinions, a law firm with substantial claims expertise
can play an important role in any construction acquisition.
It will do so through an examination of the legal risks
associated with specific executory contracts and through
negotiation of appropriate protective representations, warranties,
covenants and indemnities in the definitive agreement. A
solid understanding of contract risks is a key foundation
for a realistic value determination. As the threshold risk
assessment and pricing evaluation is completed, the law
firm can advise on consummation of the transaction in a
manner designed to ensure the realization of benefits while
affording the maximum protection possible under the circumstances.
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For more information about the issues covered in this report, please contact Philip W. Peters in our San Francisco office at 415-369-7009 or at pwpeters@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction Department, click here.
©2003 Thelen LLP
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