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Minimizing the Escrow: Preparing a Business For Sale

July 12, 2021, 8:01 AM

After spending years—or more likely decades—building businesses, many owners this year will finally decide to hang it up and cash-out.

Between the stress and uncertainty wrought by the Covid-19 pandemic and a deal-hungry private equity space, many expect that 2021 will continue to be robust for middle-market deal-making as both the U.S. and global economies emerge from 2020 fueled by unprecedented central-bank stimulus. Furthermore, with the promise of large infrastructure legislation on the horizon, the manufacturing and industrial space has already seen a record pace for mergers and acquisitions.

While the decision to sell is never made easily, for an ownership group that has already made up their mind, there are even more important decisions that lie ahead. Although it may seem counterintuitive, pre-sale self-diligence, evaluation of a preferred transaction structure, and the retention of your transaction team are critical steps that must be undertaken before anyone ever signs a letter of intent. Any miscues or oversights have the potential to directly affect the cash in a seller’s pocket as escrows, earn-outs, and equity rolls are frequently employed to mitigate potential risk to a buyer while drastically reducing the cash component for a seller.

Self-Evaluation: Identifying Tax Risk

The process of negotiating a transaction is much closer to art than it is a science. Being able to control the dissemination of information and understand precisely how a disclosure may be interpreted by a buyer are critical tools for any seller and their team. The last thing a seller needs is an overlooked tax liability providing buyer’s counsel the ammunition they need to win an unrelated argument. It is always the unforced error which is most difficult to recover from.

While most management teams may believe they know where every last wart resides, it frequently takes an impartial observer asking the right questions to gain an understanding of the full scope of institutional risk. This, in effect, is sell-side tax due diligence. It is the process of self-evaluation to identify potential sticking points before there are dollars at stake. The scope of a tax due-diligence project can vary widely but can cover the spectrum between big-ticket items such as federal and state tax compliance to the far more obscure areas such as unclaimed property.

Now, more so than ever before, tax compliance has become riddled with traps for the unwary amid an ever-shifting legislative landscape. From the federal perspective, the last 15 months witnessed four different legislative packages, each affecting federal tax compliance to a varying degree. Items such as net operating losses and deductibility of business interest expenses, which were previously altered by the TCJA, were suddenly delayed or temporarily reversed.

Stimulus provisions introduced to buttress the economy such as the Paycheck Protection Program and employee retention tax credit, despite providing crucial benefits to businesses, introduce uncertainty in the acquisition context and can potentially present tail exposure to an acquirer if a business was aggressive in seeking such stimulus.

Shifting from the federal, tax compliance at the state level has seen a marked increase in complexity since the Wayfair decision in 2018. As states have broadened revenue collection bases through the expansion of sales tax regimes, the operation of a company across multiple state lines has become more fraught with significant exposure in states for which nexus characteristics have been recently changed. The use of transaction thresholds by state legislatures—either by amount of sales or by aggregate dollar value—complicates compliance decisions for executives and internal tax departments as deciding to remit and report can be a moving target.

Moreover, as a result of anticipated budget shortfalls caused by the Covid-19 pandemic, some expect state audits to be used as a tool to uncover liabilities and plug gaps. One such area prime for examination concerns our new virtual workforce. The work-from-anywhere culture, which has been embraced as a necessity due to the pandemic, will assuredly cause many companies to be considered “doing business” in new jurisdictions as a result of remote workers residing well-beyond the traditional headquarters.

Despite the laundry list above seeming like a collection of worst-case scenarios, in reality it is just scratching the surface of potential areas of exposure which will be discoverable by a buyer’s team in the diligence process and provide fodder for the proverbial horse trading on a counsel’s issue list. While mitigation and resolution of some of the aforementioned risks vary, being able to proactively identify an issue and outline measures already taken to curtail exposure provides a seller with a position of power when disclosing details in response to a buyer’s request. Simply being able to understand and quantify exposure can represent the difference of a buyer’s requirement for a significant holdback or escrow.

Understanding Your Preferred Transaction Structure

Although the discovery of lurking liabilities and exposures is always the prime objective of any tax due diligence project, a beneficial bi-product of such an examination is the identification of a preferred transaction structure. Prior to ever soliciting a bid, a seller must understand not only the value of their business but also the value of historic tax attributes and the structure which provides the optimal post-tax result for all stakeholders.

While no two businesses are alike, there are some common scenarios which can drive structural considerations depending upon the existing entity setup. For instance, as the threat of a capital gains tax increase on the highest earners looms, the utility of the qualified small business stock tax exemption becomes even more valuable for businesses and shareholders meeting the eligibility requirements—albeit a fairly narrow profile of eligibility.

Additionally, in the context of a closely-held business in which a founder is still actively involved, an evaluation of whether there is inherent personal goodwill—a capital asset—owned by a seller can be a fruitful exercise. Similar to the qualified small business stock exemption, the identification and valuation of personal goodwill is an important quality to fully understand before engaging a buyer as there are considerations that must be included in a letter of intent to validate such a carve-out.

Furthermore, merely understanding the post-tax value of a stock vs. asset sale can provide sellers the information necessary to sort through competing bids should a brokered auction sale be utilized. In the corporate context, quantifying the value of historic net operating losses—especially as impacted by the CARES Act—can drive considerations in a consolidated group situation. In all of the above fact patterns, these considerations must be understood and quantified on the front-end, as suggesting a tax-driven deal change too late in the negotiation process can frustrate buyers along with potentially tainting the business purpose of any pre-transaction reorganization.

Selecting Your Team

On top of all of the considerations above, a seller must understand that all attorneys and accountants are not created equally. This seemingly obvious statement may not be groundbreaking to some; however, many small and lower-middle market businesses utilize the same service professionals that aided in getting things off the ground. While loyalty is an important characteristic, understanding that not every lawyer is suited to negotiate a transaction document is an important realization. Moreover, the difference between the accountant who has filed your tax return for years and one equipped with dedicated modeling and planning resources can be stark.

Despite it being a difficult conversation to have, it is best to address such a concern in the nascent stages of a sale process as unwinding decisions, disclosures, and negotiation postures from an ill-equipped advisor can be next to impossible. Regardless of who resides across the table, either strategic or financial, the sale process is saturated with sophisticated buyers employing advisors who specialize in the M&A process. Recognizing such a shortcoming within your team can directly impact your cash consideration.

When it comes to selling a business—especially a closely-held one—the choice is never easy. The decision and subsequent sale process likely represents a once-in-a-lifetime event for those involved—increasing both the stakes and stress. With that being the case, it is important to maximize the process and ensure that each and every seller leaves with the most amount of cash they possibly can.

While equity-rolls and earn-outs can be used to boost overall purchase price consideration—especially in the private equity context—it is necessary to understand those amounts are not guaranteed. As such, sellers cannot afford to overlook risks and liabilities that a buyer’s team will assuredly identify. Thus, it is imperative to be able to identify and mitigate issues prior to a buyer’s discovery—otherwise your well-deserved payday may be escrowed for months or more likely years.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Christopher Hanewald is a strategic tax advisor with CBIZ & Mayer Hoffman McCann P.C. Christopher is a Strategic Tax Advisor based in the Memphis office with significant experience in mergers & acquisitions, investment fund structuring, and tax-advantaged real estate development.
Josh Littlejohn is a managing director with CBIZ and has more than 13 years of experience in public accounting, providing tax compliance, planning, and consulting to his clients, specifically large corporate entities in the public and private sector.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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