So-Crates, Inc. is at it again, this time pulling off a major M&A deal. The company’s GC, Bill S. Preston, Esquire and its CFO “Ted” Theodore Logan, call to tell you that the company will finance the acquisition with a shelf take-down. They want to know what financial statements will be required in the prospectus, and they are complaining about “needless complexity” that they say is “totally bogus, dude.”
The starting point for your analysis Rule 3-05 of Reg. S-X, which sets out the requirements for financial statements of acquired businesses in a registration statement.1 Rule 3-05 is a lot more complex than it looks at first glance, but thankfully there are some great resources out there, including the Corp Fin Staff Financial Reporting Manual.
As a general matter, financial statements for a significant acquisition of a “business” that has taken place 75 days or more before the offering are required to be included in registration statements. In the case of the most material acquisitions (i.e., those above the 50% significance levels discussed below), you also have to include financials for acquisitions that are probable but have not yet been consummated.
Bear in mind that “business,” “significant” and “probable” are terms of art under Rule 3-05, so let’s start by taking a look at what each of them means.
Definition of “Business”
First, the SEC considers the term “business” to mean an operating entity or business unit, but not to include machinery and other assets that do not generate a distinct profit or loss stream. See S-X Rule 11-01(d) (which presumes that a separate entity, a subsidiary or a division is a business).
A lesser component of an entity may also constitute a business, although it depends on the facts and circumstances. Some of the issues you should consider when figuring out whether an acquisition of a lesser component of an entity constitutes a business include:
- whether the nature of the revenue-producing activity of the component will remain generally the same as before the transaction; or
- whether any of the following attributes remain with the component after the transaction: (i) physical facilities, (ii) employee base, (iii) market distribution system, (iv) sales force, (v) customer base, (vi) operating rights, (vii) production techniques or (viii) trade names.
As a result, an acquisition that constitutes a “business” under US GAAP may not be one for SEC purposes, and vice versa.
Definition of “Significance” and Significance Tests
Whether financial statements for recent acquisitions must be included in the filing also depends on whether the acquisition is “significant” and, if it is significant, at what level. Significance is evaluated under S-X Rule 3-05 based on three tests derived from the definition of “significant subsidiary” in Rule 1-02(w):
- investment test—the amount of the issuer’s investment in the acquired business compared to the issuer’s total assets;
- total asset test—the total assets of the acquired business compared to the issuer’s total assets; and
- pre-tax income test—the acquired business’ income from continuing operations before income taxes, extraordinary items and cumulative effect of a change in accounting principle compared to that of the issuer (and if the acquired business had a net loss, then the test looks to the absolute value).
Each test is calculated based on a comparison between the issuer’s and the target’s most recent annual audited financial statements, subject to a few exceptions we will cover in a soon-to-be-released sequel.
The significance level will determine the extent of audited financial statements of the target to be included in the issuer’s registration statement:
- 20% significance level—if the acquired business exceeds 20% of any of the three significance criteria, one year of audited financial information is required;
- 40% significance level—if the acquired business exceeds 40% of any of the three criteria, two years of audited financial information are required; and
- 50% significance level—if the acquired business exceeds 50% (or if securities are being registered to be offered to the security holders of the acquired business), three years of audited financial information are required.
Bear in mind that that unaudited interim financial statements may also be required and that the target’s financials must satisfy the usual staleness deadlines.
The term “probable” is interpreted to mean “more likely than not.” The SEC Staff has taken the general view that an acquisition becomes probable at least upon the signing of a letter of intent. However, this is a facts-and-circumstances analysis, and a different conclusion may be reached depending upon the customary practice for an industry or a particular issuer. For example, an issuer may be submitting a letter of intent as one of many parties in a bidding process, or a roll-up entity may routinely sign letters of intent to further its due diligence investigations of multiple potential targets, but with the acquisition of only a minority of those companies becoming probable.
A 3-05 Cheat Sheet
Recalling that Bill and Ted were not always great about studying for their exams in their days back at San Dimas High, here’s a handy summary of when financial information is required for a recent or probable acquisition under Rule 3-05:
|Acquisition Scenario||Reporting Requirement|
|Individual acquisition at or below the 20% significance level.||No requirement to include audited or interim financial statements.|
|Individual acquisition (or multiple acquisitions of “related businesses,” as described above) in excess of the 20% significance level, but not above the 40% significance level.||Audited financial statements for the most recent fiscal year of the acquired business must be included. Unaudited interim financial statements may need to be included, depending on the time of year that the offering takes place.|
|Multiple acquisitions of unrelated businesses below the 20% significance level individually, but aggregating in excess of the 50% significance level.||Audited financial statements for the most recent fiscal year will be required for a substantial majority of the individually insignificant acquisitions. Unaudited interim financial statements may need to be included, depending on the time of year that the offering takes place.|
|Individual acquisition (or multiple acquisitions of “related businesses,” as described above) in excess of the 40 significance level, but not above the 50% significance level.||Audited financial statements for the two most recent fiscal years of the acquired business (including one balance sheet) must be included. Unaudited interim financial statements may need to be included, depending on the time of year that the offering takes place.|
|Individual acquisition above the 50% significance level.||Audited financial statements for the three most recent fiscal years of the acquired business (including two balance sheets) must be included. This requirement also applies to acquisitions of this size that have closed within the 75-day period prior to the offering or are “probable” at the time of the offering. However, audited financial statements for the earliest of the three fiscal years required may be omitted if net revenues reported by the acquired business in its most recent fiscal year are less than $50 million. Unaudited interim financial statements may need to be included, depending on the time of year that the offering takes place.|
|1 We are focusing only on historical financial statements of the target for now and will discuss pro forma financial statements in a future installment. We are also not tackling Form S-4 or F-4 financial statement requirements at this time.|