Bank Board Letter September 2014 : Page 2

earnings for the bank. This applies to any seasonal or cyclical revenue source if the bank’s earnings are largely dependent upon a limited source of revenue. Another element of earnings in today’s market is interest rate risk. With the expectation of interest rates rising in the future, a good understanding of a bank’s deposit and other borrowing rates and maturities, along with the level of fixed rate or vari-able rate loans and their maturities, is essential to the valuation process. Cost of deposits, the type of deposits, large depositors and noncore or public funds can all impact valuation. Valuation cannot just look at current or historical earnings, but must con-sider future earnings as well. Another significant driver of valuation is location. The analysis of locations is similar to that of earnings. Are the locations sustainable over a long period of time? As men-tioned with earnings, the value of any investment is based on the economic return on that investment. While earnings are the principle component of an economic return, the length of time you will receive these earnings (the future earnings) is also a significant factor. As operating costs continue to rise and populations con-tinue to shift, the long-term viability of a bank’s locations becomes a greater factor in valuation. Is the bank located where there will be sufficient long-term loan demand? Banks located in sustainable, growing markets should be able to continue their core earnings indefinitely, which will typically result in a higher valuation than banks located in markets that are stagnant or decreasing in size that may not be able to continue to generate the same earnings over an extended period of time. Similar to the importance of location is the asset size of the bank. Normally, a larger bank is more economically sustainable over the long term than a smaller bank. This does not mean that smaller banks are not viable, just that they tend to have a lower valuation than larger institutions. Historically, statistics have shown that the larger asset size banks generate the higher multiple of equity and multiple of earnings in a sale. There are many more factors that impact valuation but, as with the ones mentioned above, it is the impact of these fac-tors on the current and future capital and earnings that directly impact the value of a bank. Put as simply as possible, a bank’s value is directly derived from its tangible capital and its earnings. However, as briefly outlined above, it is the earnings potential of an institution that can cause two very similar looking banks to have two very dif-ferent valuations, and why market statistics charts are not a very good indicator of value for an individual bank. Bob Wray is president/CEO of The Capital Corp., LLC in Overland Park, Kan. He can be contacted at bob@thecapitalcorporation.com. Is a Merger of equals rIght for Your organIzatIon? By Paul J. CamBridge and JosePh r. mantovani I n today’s complex regulatory and business environment, many community banks are considering either growing through acquisition or selling to a larger institution. As an alternative to these transactions, we are seeing an increase in community banks considering strategic mergers with simi-larly sized banks that would otherwise be competitors. These “mergers of equals” or “strategic mergers” are attractive be-cause they allow two institutions to combine resources and gain market share, with the goal of creating a larger, stronger organization that is still locally owned and managed. If the right partner can be identified and an agreement reached on post-consummation strategy and operations, the combined institution can be better positioned to maximize long-term value for the shareholders of each bank. accounting purposes. Generally, mergers of equals are stock transactions in which the surviving holding company issues shares to the shareholders of the non-survivor in exchange for their current shares. The ownership split in the surviving entity will typically be based upon the value that each party brings to the pro forma business. In addition to the issuance of stock by the surviving entity, the parties may specify amounts of cash for use by one or both parties to pay special dividends to shareholders prior to closing or for shareholder redemptions. With survivor stock as a large percentage of the merger consid-eration, desirable IRS tax-free reorganization treatment can be achieved for mergers of equals. Tax-free reorganizations include no corporate-level tax at the survivor or target level, and the shareholders exchanging their shares for stock are able to defer any taxable gains until a future disposition of their shares. TransacTIon sTrucTure In a merger of equals, one of the entities involved will need to be the “survivor” of the merger for legal, regulatory and BenefITs of a sTraTegIc Merger Strategic merger partners will benefit from leveraging their respective fixed costs over their larger, combined asset base. It should be noted, however, that because the combined bank typically continues the prior businesses of each party relatively unchanged, the economies of scale developed from mergers of equals are generally less than those established in traditional deals where the buyer is significantly larger than the seller. Banks engaging in a merger of equals may also benefit from increased market or product diversification. This arises when the two banks have different but complementary strengths, which Next moNth: the magic Formula to mainstream P2P Business operating models: evaluations & Assesments

IS A MERGER OF EQUALS RIGHT FOR YOUR ORGANIZATION?

Paul J. Cambridge,Joseph R. Mantovani


In today’s complex regulatory and business environment, many community banks are considering either growing through acquisition or selling to a larger institution. As an alternative to these transactions, we are seeing an increase in community banks considering strategic mergers with similarly sized banks that would otherwise be competitors. These “mergers of equals” or “strategic mergers” are attractive because they allow two institutions to combine resources and gain market share, with the goal of creating a larger, stronger organization that is still locally owned and managed. If the right partner can be identified and an agreement reached on post-consummation strategy and operations, the combined institution can be better positioned to maximize long-term value for the shareholders of each bank.

TRANSACTION STRUCTURE
In a merger of equals, one of the entities involved will need to be the “survivor” of the merger for legal, regulatory and accounting purposes. Generally, mergers of equals are stock transactions in which the surviving holding company issues shares to the shareholders of the non-survivor in exchange for their current shares. The ownership split in the surviving entity will typically be based upon the value that each party brings to the pro forma business. In addition to the issuance of stock by the surviving entity, the parties may specify amounts of cash for use by one or both parties to pay special dividends to shareholders prior to closing or for shareholder redemptions. With survivor stock as a large percentage of the merger consideration, desirable IRS tax-free reorganization treatment can be achieved for mergers of equals. Tax-free reorganizations include no corporate-level tax at the survivor or target level, and the shareholders exchanging their shares for stock are able to defer any taxable gains until a future disposition of their shares.

BENEFITS OF A STRATEGIC MERGER
Strategic merger partners will benefit from leveraging their respective fixed costs over their larger, combined asset base. It should be noted, however, that because the combined bank typically continues the prior businesses of each party relatively unchanged, the economies of scale developed from mergers of equals are generally less than those established in traditional deals where the buyer is significantly larger than the seller.

Banks engaging in a merger of equals may also benefit from increased market or product diversification. This arises when the two banks have different but complementary strengths, which are often geographic in nature or are related to either bank’s success with various market segments or products. Merger partners are able to more quickly diversify than they could through organic growth, which can enhance profitability and limit risk.

A strategic merger is an opportunity for succession planning. By combining boards and management teams, each bank will have the opportunity to identify the most capable personnel to run the combined bank. Such a merger also removes much of the pressure associated with choosing successors within a bank’s current roster of employees or members of a controlling family.

Participating in a merger of equals may also allow privately owned banks to provide liquidity to shareholders. While strategic mergers are primarily stock deals, many contain an option for a limited number of shareholders to receive cash in exchange for their current shares. Even if there is no liquidity event built into the transaction, the increased number of shareholders and size of the combined organization can lead to future liquidity opportunities through private sales to other shareholders or redemptions.

MERGER OF EQUALS DEAL POINTS
Many of the legal, regulatory, shareholder approval and disclosure issues in a merger of equals are the same as those in a standard stock-for-stock acquisition. Despite the similarities, mergers of equals can be much more complicated to negotiate than a typical transaction in which the seller will not have a say in the post-closing business. A strategic merger involves many social issues that are key to the success of the combined institution.

These issues usually include the following:
• Who will be on the board of directors?
• Who will fill the key executive management positions?
• Where will the combined bank’s headquarters be located?
• Will any overlapping branches be closed?
• What name will be used by the combined bank?
• Will all employees be retained?
• What employee benefits will be offered?
• What will the charter documents and bylaws look like?
• Will the combined organization be a C corporation or S corporation?
• Who will be the combined organization’s regulators?
• What data processing and other key vendors will be used?

There are many potential areas for disagreement regarding these and other social issues, especially given that a merger of equals often involves direct competitors. It is therefore important to agree on the social issues most important to your bank upfront in a letter of intent or term sheet before spending time and money negotiating a definitive agreement. The parties should then work with legal counsel to ensure that decisions on key social issues are covered in the covenants of the definitive agreement so that the parties are contractually obligated to carry out the combination as proposed. In addition, major organizational issues like board composition should be included in the combined institution’s charter and bylaw documents so that any post-closing change requires input of representatives of both parties. A successful merger of equals is built on mutual trust that the survivor will carry out the parties’ combined vision.

Paul J. Cambridge and Joseph R. Mantovani are banking mergers and acquisition attorneys in the St. Louis office of Polsinelli PC. They can be contacted at 314-889-8000 and at pcambridge@polsinelli. com or jmantovani@polsinelli.com.

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