By the numbers

As I gaze into my crystal ball, I see several likely developments that will shape the manner in which mergers and acquisitions are structured.

Most notably, I foresee an increase in tax rates, including an increase in the levy imposed on capital gains. Moreover, in order to avoid the criticism that stems from massive write-downs of acquisition-induced goodwill, managements will seek to structure deals in which a portion, perhaps a substantial portion, of the outlay is dependent upon the productivity, use or disposition of the acquired properties.

Therefore, the increase in tax rates should lead to the resurgence of deals that are structured to qualify as tax-free reorganizations.

Moreover, the desire to ensure that a portion of the outlay will be contingent upon the performance of the target's operations should foreshadow the increasing use of contingent value rights, escrowed stock and warrants as integral elements of the package of consideration an acquirer will offer to the target's shareholders.

Fortunately, these items can be received by the target's shareholders on a tax-advantaged basis, assuming certain rudimentary requirements are adhered to. Thus it is now well accepted that CVRs, when received in an otherwise tax-free reorganization, do not constitute "other property or money" and, therefore, are regarded as "stock." CVRs will be so characterized as long as they can give rise to nothing but stock upon their maturity, the CVRs will mature no later than five years from the date of the merger and the CVRs are not assignable and are not evidenced by negotiable certificates. In fact, the case law in this area is even more liberal than the Internal Revenue Service's guidelines. Such case law provides that a CVR that can ripen only into additional stock will still be treated as stock even if the right is negotiable and the term of the arrangement exceeds five years.

There is, however, one pitfall associated with CVRs. If the CVRs mature more than one year from the date of the merger, a portion of the shares issued will be taxed to the recipient as "imputed" interest income. The CVR, in this case, evidences a "deferred payment" of a portion of the selling price. The tax code provides that where, in these cases, adequate interest is not provided for, a portion of the sales price will be characterized as taxable interest income.

The imputed interest problem can be solved if the parties opt for an escrowed share arrangement. In the typical case, shares are deposited into escrow by the acquirer and will be returned to such acquirer if the target's performance does not clear the hurdles set forth in the agreement. The shares, in these cases, are issued in the names of the former target shareholders, and they are entitled to vote the shares and receive all dividends paid on the shares. The IRS has acknowledged that an escrow arrangement does not constitute a deferred sales contract, with the result that the imputed interest rules will not apply to the placement of the shares into escrow or to their subsequent release.

Historically, warrants received in connection with reorganizations were classified as "other property or money" rather than as stock or securities.

However, this unfavorable situation has been recently redressed. Thus warrants are now classified as "securities," and this variety of securities is deemed to have "no principal amount." Accordingly, warrants have been, in effect, upgraded to the status of CVRs in the sense that they can now be received on a tax-free basis in the course of an otherwise qualifying reorganization.

Thus it is clear that the most commonly encountered varieties of "contingent consideration" can be received by the target's shareholders on a tax-advantaged basis. The use of contingent consideration -- in the form of CVRs, escrowed shares and warrants -- will satisfy the target shareholders' desire for relief from the higher tax rates we are forecasting and will also enable the acquirer to ensure that a portion of the purchase price is dependent upon the target's postmerger performance. In short, a portion of the purchase price will be, in effect, withheld, to be released only upon the target's performing up to expectations.

Robert Willens is president of Robert Willens LLC. He is also an adjunct professor of finance at Columbia Business School.