Key Takeaways

  • A cash out merger involves buying out shareholders—often minority holders—for cash, eliminating their interest in the resulting entity.
  • It can serve as a legal tool for resolving internal disputes or removing dissenting minority owners.
  • Cash out mergers are common in both LLC and corporate settings and may be structured as short-form or long-form mergers.
  • These transactions are usually taxable events and require adherence to state-specific laws and fair dealing principles.
  • Disputes can arise if minority shareholders feel undervalued or coerced, which may result in litigation.
  • Business owners can protect themselves by incorporating merger and appraisal clauses in their operating agreements.

Cash Out Merger

A cash out merger (sometimes also referred to as a freeze out merger or a squeeze out merger) results from a merger of two entities in which the shareholders (or stockholders) of the target company (the company being taken over) do not want to be involved with the new company. In the case of a freeze out or squeeze out merger, the shareholders of the target company are often forced to sell their shares as part of the acquisition or merger deal.

Other points to consider include:

  • In a freeze out merger, the shareholders of the acquiring company attempt to “freeze out” the shareholders of the target company (typically minority shareholders) as it pertains to decision-making. This essentially renders the minority shareholders useless in times of voting on issues affecting the company.
  • In some cases, the actions of the majority shareholders may come under review in court, although it is often an effective tool for the majority shareholders to deal with problems or issues that they are having with minority shareholders.
  • Every state has different guidelines in place regarding what actions are and are not permissible during a freeze out merger.

Legal and Tax Implications of a Cash Out Merger

A cash out merger is not only a corporate restructuring tool but also a taxable event under the Internal Revenue Code. When shareholders are paid cash instead of stock, it typically triggers capital gains tax based on the difference between the merger consideration and the tax basis of their shares.

Additionally, legal implications often revolve around fiduciary duties. Majority owners or directors initiating a cash out merger must demonstrate that the transaction serves a legitimate business purpose and that the price paid to minority shareholders is fair. In some states, courts apply the "entire fairness" standard, requiring both fair dealing and fair price. This judicial scrutiny seeks to protect minority shareholders from abusive tactics cloaked as legitimate business decisions.

More on Freeze Out Mergers

Freeze out mergers can be tricky, and considered by some, unethical. Some additional details of a freeze out merger are:

  • The majority shareholders (also known as the controlling shareholders who are generally from the company doing the acquiring, or heading up the merger) can establish a totally new company, which they own and control.
  • Hoping that the minority shareholders will sell their equity, the new corporation may submit a tender offer.
  • If the aforementioned tender offer is accepted, then the acquiring company can decide to merge their assets into the new company. When this occurs, the minority shareholders would lose their shares and the previous company would essentially no longer exist. However, they generally do receive some sort of monetary compensation for the shares they owned in the previous company.
  • Some corporate charters may include a freeze out provision, which ensures that should they ever merge with, or be acquired by another company, the shareholders will be fairly compensated for their shares in the event of a freeze out.

Cash Out Mergers in LLCs

Cash out mergers are not exclusive to corporations—they also apply to limited liability companies (LLCs). In an LLC context, a cash out merger may be used to legally remove a problematic or uncooperative minority member when voluntary buyouts fail.

This process typically involves merging the existing LLC into a new entity controlled by the majority members. The old LLC ceases to exist, and minority members receive a fair market value payout for their interest, losing all management or ownership rights. While legal, this approach can be contentious and may lead to litigation if the minority member claims the payout was unfair or the process was conducted in bad faith.

To reduce the risk of conflict, LLC operating agreements should include provisions regarding mergers, member buyouts, and valuation procedures.

The Differences Between Cash and Stock Mergers

When a merger occurs, the shareholders can be paid out in one of two ways: cash or stock. Regarding a stock merger:

  • When two businesses are merging, shareholders of the target company may offer top dollar to convert their shares into merged equity. “Top dollar” in the context of a stock merger would mean that the shareholders will be offered a high number of shares in the new company in exchange for their shares in the former one.
  • While often seen when the company being acquired is of significantly lesser value than the company facilitating the acquisition, it is not uncommon to see this even when the two corporations are of similar or equal value.

Whereas, in a cash merger:

  • Shareholders are offered a cash payout in exchange for their shares. This type of merger then means that the shareholders of the company being acquired will no longer be shareholders in the new company, unless they then choose to buy shares on their own.
  • The company doing the acquiring buys out the target company’s shares or stocks with cash, rather than with stock options (or shares) in the new company.
  • This type of merger is often considered to be a buyout.
  • The shareholders of the target company still have to approve the offer being made by the acquiring company and approve the sale of the company.

Common Reasons for Using a Cash Out Merger

Cash out mergers are often employed for practical or strategic reasons, including:

  • Resolving deadlocks: Especially in closely held companies or LLCs where decision-making has stalled.
  • Removing minority owners: When their continued presence is detrimental to operations or future business plans.
  • Simplifying the ownership structure: Particularly ahead of a sale, restructuring, or acquisition.
  • Transitioning ownership: For estate planning or preparing for new investors.

The key advantage lies in simplifying governance by eliminating dissenting or inactive members through a legally structured, one-time cash transaction.

Short Form vs. Long Form Mergers

Additionally, there exist short form mergers and long form mergers. A short form merger pertains to situations in which a subsidiary is merged into a parent company who already owned the majority of the shares. This is a fairly easy and inexpensive way in which a merger can be conducted, as it is generally achieved by the parent company sending a letter to the shareholders of the subsidiary, called a merger resolution, and then files an executed articles of merger with the Secretary of State in which the company is located.

Shareholder Rights and Appraisal Remedies

In a cash out merger, minority shareholders who are compelled to sell their shares may have the right to contest the valuation. Most states provide a statutory appraisal process that allows these shareholders to seek a judicial determination of "fair value" for their shares.

This process often involves:

  • Dissent notice: The shareholder must formally dissent from the merger.
  • Demand for appraisal: A written demand must be submitted within a statutory period.
  • Court valuation: If no agreement is reached, a court assesses the fair market value, considering factors such as earnings, asset value, and market conditions.

While appraisal rights offer protection, they can also lead to prolonged litigation. Companies should consult legal counsel to ensure proper documentation and transparency throughout the merger process.

Frequently Asked Questions

  1. What is a cash out merger?
    A cash out merger is a type of merger where shareholders of the target company receive cash for their shares, effectively removing them from the ownership structure of the new entity.
  2. Is a cash out merger legal in an LLC?
    Yes, cash out mergers are legal in LLCs if conducted in accordance with the operating agreement and state laws. However, they must be carried out in good faith with fair compensation to minority members.
  3. Do shareholders have to approve a cash out merger?
    In most cases, shareholder or member approval is required. The exact threshold varies by state and entity type, with some jurisdictions allowing short-form mergers if ownership thresholds are met.
  4. Can minority shareholders fight a cash out merger?
    Yes, minority shareholders can challenge a merger if they believe the process was unfair or the price was inadequate. Many states provide appraisal rights or allow lawsuits for breach of fiduciary duty.
  5. Is a cash out merger taxable?
    Yes, cash out mergers are generally considered taxable events. Shareholders must report any gain from the sale of their shares, which may be subject to capital gains tax.

If you need help with understanding cash out merger, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.