Now, in this final episode of the first week, we'll say a few words about taxes and the fact of taxes on M&A transaction. This is really a wide topic, so we would be providing an overview, but the general idea is very simple. So, if stock for stock transaction takes place, that is nontaxable. If cash or debt is involved, that's taxable transaction. Now, the question is why people use this approach. Well, in terms of plain common sense, it's clear. So, when you just exchange stock, then even if, let's say lethargic shareholders, they gain a lot, but unless they sold the stock, the new entity or the stock and the subsidiary then became part of the new corporation, they did not realize their gain. So, when we talk about nontaxable, strictly speaking, it's not nontaxable, it's deferred tax. Now, let's make some comparison here. So, this is the bidder and this is the target. So, let's say this is nontaxable. Well, to be consistent, I would use blue marker. Nontaxable, and this is taxable. So, in this small table, we'll mention certain things. For nontaxable stock, for stock transaction, there are a couple of things that are available by regulators for the bidder. Namely, this is a net operating loss carryover, then tax credit carry over, and also, well, this is not allowed, this is just the facts. This is asset base carryover. What is important for the target. Well, we can say that here, gains to shareholders are deferred. It's not, until they sold this stock, that they recognize this. Here, in the taxable thing, we can't have step-up asset basis, and no carryovers. And for the target shareholders, we can say that immediate gain recognition. Well, we cannot say which one is really better or worse. These are the standard rules that are used when people treat these tax factors. Now, let's say a few words about the comparison, when you can buy the stock of the target or you can buy the assets of the target. Now, what is the difference here? The main difference is when you buy the stock of a corporation. That means that when you buy it, you also accept all its liabilities. And although, some of these liabilities are clearly seen on its balance sheet, there are some other liabilities that are not seen on its balance sheet and that are sort of hidden. And it's not until you become the outright owner of this corporation and you start to delve deeper in what's going on, that you can actually uncover these liabilities. If you buy assets, however, then you clearly study that before the purchase and then you avoid surprises in some hidden liabilities. So, it seems to be that buying assets is less risky. But at the same time, it's more expensive. Why? Let me compare. So, this is stock purchase and this is asset purchase. And we now study only the tax factors here. Here, for the stock, you have capital gain and this is taxed. On the right side, it's worse. First of all, you have corporate tax. So, the proceeds to the shareholders or the target, in this case, these proceeds are lower. And then, you have also capital gain tax. So, in the asset purchase, we effectively deal with double taxation, which is always bad. Well, for smaller corporation, you can find some legal ways to avoid this. But for now and I will say a few words about that in just a moment, but the idea is that the main reason why people sometimes still go ahead on this path, is to, I will put it clearly, here is, to avoid facing unknown liabilities. Well now, having said all that, I also promised to mention why is that in smaller corporation, there are certain special ways, like limited liability corporation and others that allow you to avoid double taxation. The key story here is that when the company is rather small, then most of its shareholders happen to be founding executives. So, for these people, it's clearly very important to be able, when they sell the company, to avoid double taxation and there are special legal forms and legal ways to do so. But I would like, so wrapping up this week, to pose a bigger question, and that will be like, does tax system affect M&As? Namely, is there any empirical evidence that people engaged in M&A transactions with important motives of tax savings, and in sort of irregular M&A transactions, we can say that this has been observed only in about 10 percent of cases. But what do I mean by irregular? There are special transactions that we study in much greater detail for overall in this course, that deal will leverage buyouts or management buyouts. For now, the important thing for us is that leverage here, initial leverage after a transaction, maybe up to 90 percent. So, when you have so much debt, then your savings on interest tax shields, maybe these savings may be really high. And if indeed the idea of saving on taxes would be key in some of these cases, then we would observe that people would like to keep this high leverage for a long period of time. But the empirical observations of that, they support the opposite view. As soon as the company that was taken over by an LBO starts making cash, then immediately this cash is used to pay off this debt as fast as possible. Why is that so? Because when you pay- you started with leverage of 90 percent, but if you paid off a lot of debt and then your leverage goes down, then this company that is now private, can go ahead with a secondary public offering. And even then, the proceeds of this SPO, they are used to further retire debt. So, we can see that instead of taking advantage of this interest tax shield, people still prefer to have less debt, because having very high leverage is risky. And that does not attest to the fact that the team, who took the company over and made it private, has been doing a good job in turning that around. So, that is about what we see here. And for now, I would like to say just a few words to wrap this up. We devoted this first week of this course to the preparatory work, if you will. So, we said that we have to observe the interests of all stakeholders, and we have to see certain procedure of actions, that may, if they are all completed successfully, lead to a successful transaction, and by a successful transaction we mean the one that does result in value creation. But we already see that there are so many musts here, so many necessary things, and there is so little promise of success, that we may feel somewhat dissatisfied. Because you have to do very many things in the hope of creating value, but still, if you failed to succeed in any of them, then unfortunately you may result in the failure. Actually, a lot of empirical studies on M&A's, they show that the majority of transactions fail in creating value. Well, it depends upon clearly the samples, it depends upon what exactly that fail means, it depends upon the timing of these returns. All that we'll discuss in greater detail further on. But for now, we just said that the key story is that, indeed, because we have so many indirect stakeholders that involve the government, or the market, or the society, whatever, then that is one of the ideas why when you have so many people involved, then you have to do so many things. Otherwise, in these transactions, you are unlikely to create value because there maybe some stakeholders that are abused or that are not happy, and these people start to fight against you, these people sue you, and as a result, you might lose a lot of this value in further litigation negotiations with these people. So, from now on, we move to our second week, and in the second week, we will study the main strategies, reasons and motives for the M&A transactions. We will basically say that, if there is no idea behind that, it's almost positive to fail. So, we will take a broader look and see what motivates people to engage in these transactions, and what sends some messages that promise to result in value creation. So, I wish you all good luck with your assignments in the first week, and I'll see you next week.
