M&A in Agricultural Sector
Alexander I. Borodkin
Transactions for acquisition of agricultural companies and their assets have certain specifics as compared to other M&A transactions. These specifics come from the very nature of agricultural business. Understanding the peculiarities of agricultural business allows lawyers and other advisors to better structure the transaction in whole, choose proper contractual instruments and collaterals, and propose workable time and settlement schedules. The article provides an overview of some industry-specific factors to be taken into account in conducting M&A transactions in the agricultural sector.
Yearly-framed agricultural production cycle
First of all, agricultural production is cyclic and seasonal.
The yearly cycle starts late in autumn with preparation and early field works, late spring and early summer are the busiest planting and growing stages, while mid and late summer ends with harvesting. These business features are mostly observed in farming sector, however, they also affect cattle industry and processing businesses.
Most major transactions with agricultural assets take place during a short time of the lowest business activity at the end of the summer — beginning of autumn. This is the time after the crops have been already harvested but before cultivation works start to prepare the fields for the next production year.
In conducting transactions during any other period of the year the stage of business cycle should be taken into account. During early stages the purchaser would normally be requested to compensate the seller for the already performed field works, planted seeds, paid advance rents, etc. On the other hand, if the transaction consummates closer to the harvesting stage, the parties should discuss whether the agribusiness would be purchased with such harvest or whether the seller would be allowed to harvest before or after the control passes to the purchaser, and who should pay the land rents in such case. For those reasons conducting transactions in the middle of agricultural production cycle is rather untypical.
In case the transaction is not closed within a short inactive period of yearly production cycle, which is more typical because of complexity of most agricultural M&A, certain additional instruments are often introduced to smoothen the transition period. A right of the seller to collect its harvest may be formalized by specific harvesting agreements, under which the target company could transfer the title to the harvest to the seller’s affiliate together with the right to gather it and, sometimes even, to use the target’s machinery or warehouses for that purpose. The price of such harvest and relevant services, use of equipment and other assets may be considered within the transaction price.
When the transaction is delayed the purchaser would normally ask for a possibility to start field works before closing the transaction. Due diligence, merger clearance and negotiations could last for months, while weather conditions might worsen and the purchaser would not be able to prepare the fields for the next season after the acquisition. To allow the purchaser to start the field works before closing, the parties may chose to execute some specific transactional instruments such as cultivation agreements, joint tillage agreements, ploughing works or other agricultural services agreements, etc.
Despite the type of instrument the parties should agree on the mechanism of mutual settlements in case the transaction disrupts: compensation to the purchaser for provided services and performed works, including cost of seeds, chemicals, fuel and other materials used; compensation to the seller for any harm to the agricultural assets and any required restoration expenses; or, alternatively — the right of the purchaser to finalize the agricultural production cycle and to get the relevant benefits from it.
Personal attitudes to the seller
Agricultural business often deals with a vast number of local people, who either let the land to the business, or supply raw milk or other materials, or are employed with the company, or have other personal involvement in the business. Since the agricultural business is usually the most active and thus important factor in the local social climate, on one hand, and rather dependant on the attitude of the local population on the other hand, it is important to take into account this connection during negotiations with the seller.
In case local people identify the agricultural business by its commercial name, corporate acquisition would not influence their attitude much. Change of control over the company would go smoothly. Merger is not usually a good idea in such situation, unless the surviving company preserves the commercial name that the local people are used to. This situation is relevant for big agroholdings.
For smaller agricultural businesses a usual situation is when the local people identify the seller as an individual, and not the business itself. The seller often acts as both the owner and the chief manager simultaneously. In M&A transactions with such sellers the purchaser would likely propose the seller an office in the target’s board or the role of an external business advisor or some other kind of partnership to preserve the seller’s personal contacts with locals. Such office could last for a year or more — until new faces are introduced to local communities and earn their trust.
The main objective of such transitory partnership with the seller is to introduce the purchaser to local municipalities, help in calling general meetings and making presentations in communities, where the purchaser would normally announce its social programme and nearest business objectives.
In like situations it is less important what happens with the company as a legal entity: it could either join the purchaser’s group; or merge with the purchaser’s company or even be wound up after the purchaser acquires all its assets.
However, the most frequent is the situation when local people are fairly acquainted with both the seller and its business. In such case a set of introductory activities is discussed in the transactional documents relevant both to the target company and the seller personally. To accommodate all of them a typical M&A transaction in the agricultural sector would run for a year or more.
Acquiring land leases
Land is the main asset in agriculture. It is of the most importance for growing businesses, but also for animal husbandry and other branches of agribusiness. Historically, most land in Ukraine is not owned by agricultural producers. The law imposes restrictions for agricultural land turnover. Private individuals and the state preemptively own the land. Agricultural companies may only lease it from those landlords.
The land law is currently being actively reformed. The government declares the introduction of the land market soon. However, the latest proposed land market regulations do not allow legal entities to get the land in ownership. Moreover, they limit the volumes of land in lease within one district or region. Needless to say that this draft faces active resistance from the market and will hopefully be redrafted.
Until now, agribusiness remains in the position of having to deal with corrupted state and municipal authorities, often adopting arbitrary decisions and cancelling them on a whim, or with private individuals, who are often scared and unorganized. Medium and long-term leasing is the most common instrument in the land market now. Consequently, getting control of target land leases is the main objective of M&A transactions in the agricultural sector.
In case the target company is pure enough and there are no other impediments to its acquisition, the transaction may easily be closed at the corporate level. Sometimes this option is not appropriate due to companies’ history, or when the arrangement covers only part of the land bank, or in some other cases. Structuring this kind of transaction requires a rather creative approach on advisor’s part. We have experienced several options as to how the parties proceeded in a situations like this.
For example, the target company may be split into two companies by means of corporate restructuring. The land leases may be distributed between the companies according to an arrangement with the purchaser on target lands. Formally, the land leases survive reorganization of the company. Please note that lease agreements might provide otherwise, therefore they should be carefully reviewed before such restructuring. Practically, it could be recommended to also re-register the leases separated into another company to avoid any misunderstanding in the future.
The above option may not be applied when the seller’s company has some historical risks. Such risks could be inherited by the newly split company by operation of law. To avoid that, the parties may choose to re-execute the leases for a new SPV, owned either by the seller or by the purchaser or jointly by them. If the seller preserves any corporate interest in such SPV the transaction price may be paid at corporate level. The compensation issue arises when the new leases are perfected by a company fully controlled by the purchaser.
The parties in such case have no contractual instruments to pay consideration for land leases transferred to the purchaser.
Optionally, the consideration may be paid under the other transactional documents — for purchase of equipment and machinery, buildings, which are sometimes rather overvalued in the seller’s books, etc. However, such an option does not take into account the quantity and quality of leases actually acquired by the purchaser — which might differ from the quantity the seller has refused. Another issue may arise with the timing of the transactions: perfection of leases physically requires time — up to several months sometimes, while the sale of other assets may be finalized within a couple of days.
Another option is when the parties enter into a kind of agency agreement, where the seller as an agent undertakes to find and formalize land leases for the purchaser. The seller would receive all the powers to negotiate new leases on the purchaser’s behalf and sometimes even a right to sign the land lease agreements as per proforma approved by the purchaser. The purchaser would pay to the seller as its agent a consideration, which is calculated, based on the amount of lease agreements actually perfected and registered by the seller, or area of land so acquired. The payments may be structured on a monthly or other agreed regular basis — by scope of land acquired; number of finalized land parcels of agreed area (fields), etc.
In all of the above options the tax consequences are different from the tax regime of a corporate deal and so should be well considered. The parties should find ways to avoid or minimize the additional tax burden of an asset deal as compared to the share deal. Sometimes one party should agree to take the tax risks and relevant expenses.
When the leases are formalized to a joint SPV the parties should discuss and agree on the procedure of its transfer to the purchaser — either in stages alongside the lease re-execution process or at once with some mutual corporate and financial guarantees of closure.
The expenses for lease re-execution should also be monitored and their burden shared between the parties as per their agreement.
For this kind of assets transactions we usually recommended the signing of a kind of framework agreement first, which covers the whole process. The parties could then enter into specific agreements for implementation of the transaction on the basis of the framework agreement.
Fixed agricultural tax
An asset deal in the agricultural sector may sometimes be hindered by a specific status of the seller as payer of the fixed agricultural tax (FAT). In order to preserve such status a FAT-payer should earn at least 75% of its annual income from agricultural production activities. Evidently, mediation services in re-execution of lease agreements or sale of tractors or combine machines will not constitute an income from agricultural production activities for the tax authority. Getting major income from the sale of agricultural assets through asset deals within one tax year might deprive the seller of beneficial tax status for the whole of the subsequent year.
In order not to lose the FAT-status some sellers chose to stretch the transaction in time in order to get part of the price in one tax year and the remainder — in the next one. Non-agricultural incomes should be well planned.
Meanwhile, the right to use target assets should be somehow provided to the purchaser on another contractual basis. Lease, service, use and other like agreements are often explored for such purposes. Relevant payments under them and expenses for maintenance of equipment and buildings should be considered in overall transaction price.
Other specifics
M&A transactions in agricultural sector do have many other peculiarities. Specific warranties and indemnities are requested to cover the land bank, which cannot usually be properly checked in the course of due diligence because of its volume. Competition advisors argue in qualifying the asset deals as acquisitions of businesses or merely particular assets and, consequently, whether or not the law requires merger clearance. Treating tax assets like VAT credit as a pricing factor varies depending on the possibilities to recover them by the purchaser with the seller’s assistance. Getting financing for the transaction and choosing proper collateral may be a headache if the main assets of the business are land leases or the transaction is structured as a series of asset deals stretched out in time. Even a non-competition clause may become a deal breaker if the purchaser requires too strict limitations for the seller in closely related business, like whole-milk products and hard cheese, which actually have overlapping raw milk collection areas.
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Therefore, the above brief review shows that the very nature of agricultural business in Ukraine determines certain peculiarities of M&A transactions in this sector. The key factors to be considered are the cyclical, seasonal business process on one hand, and taxation along with other regulatory environment specifics in Ukraine, on the other.
The peculiarities, mentioned above often shape the very structure of a transaction, a set of contractual and other instruments involved, timing, pricing and settlement procedures. Only identifying the features of a particular agricultural business or company would allow appropriate planning of the M&A transaction from both legal and organizational perspectives.
