SHOWING YOUR WARTS
It’s much less expensive to remove financial warts before your company goes on the market than to have the buyer discover them during due diligence.
A CEO was delighted and surprised when the manufacturer of the equipment he distributed offered to buy part of his business. The offer was out of the blue and in his words: “Last year was our best year ever, and I didn’t have time to pretty things up for a buyer.” But after hiring a CVE to verify the value of his company and consulting with his lawyer, he accepted their generous offer.
What should have been a routine transaction took thirteen months to close. Inaccurate accounts receivable, accounts payable, and inventory records were issues in the asset sale. He hadn’t performed annual audits, and the buyer insisted that one be done before closing. After the audit, the price was reduced because his working capital was less than industry average and a substantial portion of the remaining price became earn-outs in the Asset Purchase Agreement. After celebrating the closing, the CEO lamented: “I had no idea how complex and frustrating financial negotiations could be. I would have gotten a boatload more money if I had gotten professional help years ago.”
A second CEO operated a lucrative business in a building that he owned. Unfortunately, a family matter forced him to sell the company and move out of the area. He found a buyer, but the bank wouldn’t grant a loan big enough to purchase the business and the building. The deal was salvaged through an asset sale. The CEO continued to own the building, and leased it to the new owner. However, the transaction had unfavorable tax consequences to the seller. The lesson learned is never put real estate into an operating company—better to put it in a holding company with a lease-back agreement that maximizes your selling options and provides flexibility in tax planning.
A third CEO could only sell her business to a publicly-traded firm as an asset sale because of liabilities and personal debt on the company’s books. For many years, her attorney and CPA had advised her to switch to an S-corporation but she ignored the advice and her company was still a C-corporation when it was sold. She was able to purchase Errors & Omissions (E&O) insurance against the liabilities. However, when proceeds of the sale were received in the shell company, they were taxed twice: first at the corporate rate and again as ordinary income when she got the cash. Had she converted to an S-corporation, the proceeds would have been taxed only once at the more favorable capital gains tax rate.
A fourth CEO offered his government services company for sale via a broker. A prospective buyer was selected using a limited auction. The business had a record of consistent growth and above-market profits, a portfolio of multi-year contracts, and a highly qualified technical staff. But it also had a huge wart that wasn’t revealed before signing the LOI: an unquantifiable, off-balance sheet liability caused by overbillings on government contracts. When the buyer found the issue in due diligence, he withdrew from the transaction.
A fifth company had the practice of recording a sale and creating an account receivable when a client submitted a purchase order. However, the actual price was usually discounted heavily when the merchandise was delivered, and the company used an allowance-for-bad-debt to reconcile the difference. When the company went on the market, buyers and banks walked away because of high bad debt expenses. By changing their accounting practices to recognize an account receivable when the purchase price was fixed, the company’s gross income was reduced, but net income remained the same and the bad debts disappeared. Two years later, the company was sold with a much improved balance sheet.
The common thread in these five mistakes is that once your business is on the market, financial warts can be very expensive in terms of price reductions, higher taxes, increased escrows, extended payments, higher legal fees, and inability of the buyer to secure financing at a reasonable interest rate. Financial warts kill more deals than any other single factor. And even when the deal goes through, the negotiations take longer and the deal usually closes at a lower price than specified in the LOI. That being said, if you can’t remove a wart before putting your business up for sale, it is essential that you “open the kimono” and cite the wart in the selling memorandum.
While not warts per se, some income tax elections may have adverse consequences in a sale transaction. It’s common for small and mid-size businesses to elect S-corporation status to eliminate double taxation on earnings. However, an S-election usually causes the owner to accelerate tax-deductible expenses in the last quarter of the fiscal year to minimize the income tax liability. This type of tax planning can negatively impact the buyer’s ability to finance the transaction because banks evaluate a company’s net income to determine the ability of the borrower to repay the loan. Therefore, the seller’s desire to reduce his current-year income tax liability can make it difficult for a buyer to finance a transaction. Also, an S-Corporation may not be able to take advantage of certain income tax benefits in an ESOP transaction.
A second income tax election that may affect the sale is whether your company is taxed on the cash or accrual basis of accounting. Cash basis accounting usually reduces the current income tax liabilities. However, most large companies are required to be on the accrual basis and, if they buy a company, that company also must be on the accrual basis. In such cases, the buyer will require the seller to bear the income tax liability associated with converting from cash to accrual. Depending on your accounts receivable, accounts payable, and other factors, the tax liability may be substantial. However, IRS allows companies four years to pay the income taxes associated with the conversion from cash to accrual. Generally, a buyer will require an escrow for payment of those taxes.
In closing, it is not unusual for the buyer’s team to discover things about your business during due diligence that you didn’t even know. If the buyer finds a significant wart during due diligence that you failed to identify, he may lose trust and spend more time looking deeper for other warts. In extreme cases, he may pull the plug on the deal. Anything that delays the transaction or extends the exclusionary period is an enemy of the seller because it increases the chances of the transaction unraveling.