This week on “In Process: Conversations about Business in the 21st Century,” we continue our third annual series of podcast episodes dedicated to the topic of preparing to sell your business. In our final installment of our six-part podcast series, Managing Partner, Evelyn Ashley of Trusted Counsel and Partner, John Monahon, speak with Michael Levy, Partner-in-charge of Aprio’s Transaction Advisory Services practice and Yelena Epova, Partner-in-Charge of Aprio’s International Services Practice about financial and tax considerations. Aprio is Georgia’s largest full-service CPA-led advisory firm.
During the course of the podcast, entrepreneurs, business owners and C-level executives will learn about:
- Current state of the M&A market
- The CPA’s role in due diligence
- Importance of an audit and other financial reports
- Missed opportunities often made by sellers
- Tax implications of earn-out structure
This year has been another good year for a robust merger and acquisition (M&A) market. Interest rates continue to be low as is unemployment and there is abundant capital, both at private equity groups as well as strategic investors. In addition, if you take into account tax cuts, sellers are in a position to realize some significant net cash proceeds advantages – but you have to be prepared and plan ahead.
“From a financial due diligence aspect, it’s really about getting the house in order from an accounting perspective. Are your financial statements in accordance with generally accepted accounting principle (GAAP)?” said Michael. “Also, having two or three years of financial information audited or reviewed really gives the seller that much more credibility in the process and prospective buyers will feel more comfortable with the financial statements that are provided to them in the process.”
While invested companies are typically GAAP compliant, many private companies are not. Private company owners should seriously consider GAAP compliance when coming up to an exit. Most buyers in a transaction will expect that the seller for example, have reps and warranties and purchase agreements stating that the financial statements are in accordance with GAAP. Hence, in order for a financial statement to be read with certainty, having it audited gives the buyer that much more security on the financial performance of the business.
Being prepared and planning ahead for a transaction will not only get the seller increased value from a purchase price perspective, but also it will affect the time that you spend in the process which is rigorous. Preparation increases the likelihood of a successful sale transaction as well as credibility with the buyer.
“Receiving tax and legal advice no later than the letter of intent stage is strongly recommended, said Yelena.” “It’s great for us to be able to tell the client ahead of time how to structure their business so that they have more flexibility on how to sell it. In most cases, the buyers want to buy assets or buy stock and make an election to treat the sale as a sale of assets.”
Learn more about the executive steps involved with getting to the point of selling a business by streaming the conversation in its entirety in the player below or download it to your mobile device via iTunes. Don’t miss a single episode, subscribe to our show “In Process Podcast” on iTunes to receive this episode as well as future episodes to your smartphone.
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Is Your Business Ready to Sell: (Part VI of VI)
Trusted Counsel (Ashley) LLC. All Rights Reserved.
Speaker 1: It’s time for In Process. Conversations about business in the 21st century with Evelyn Ashley and John Monahon presented by Trusted Counsel, a corporate and intellectual property law firm. For more information, visit trusted-counsel.com and now with In Process, here are Evelyn Ashley and John Monahon.
John: Hello and welcome to In Process, we’re entering the fifth installment of our six part series of podcasts about what businesses and their chief executives should be thinking about in order to get their businesses to a point where they’re ready to be sold. We’d like to thank our sponsors who made this series possible, Growthpoint Partners Technologies, Wilmington Trust and Aprio who we actually have joining us in the studio today.
Yelena Epova is a partner in charge of Aprio’s international services practice. She specializes in advising domestic and the international companies on international tax issues and tax planning strategies regarding inbound and outbound operations. She also has experience providing tax consulting and structuring services on numerous domestic in the international M&A transactions.
Michael Levy is a partner in charge of Aprio’s transaction advisory services practice. Michael has over 20 years of audit and merger acquisition and divestiture due diligence and structuring experience. He has assisted both financial and strategic clients in domestic and international merger acquisition and divestiture transactions. In his capacity as the leader of transaction advisory services, Michael’s primary responsibilities include assisting clients with developing structures, performing accounting and tax buy-side and sell-side due diligence, closing assistance and post-transaction integration assistance. Michael and Yelena, welcome to the show.
Evelyn: Michael, Yelena, what’s the state of the M&A market?
Michael: It continues to be very robust in activity, though the first quarter of 2019 was slower than 2018’s first quarter. So, a little bit of a slower start, but activity has certainly ramped up as 2019 has progressed. It’s driven by continued low interest rates, low unemployment and certainly lots of money on the sidelines, both at private equity groups, as well as banks for leverage. I do anticipate that 2020 will be a great M&A year. Though, there is certainly some slowdown in various sectors that private equity is seeing, but they look at it as an opportunity for maybe multiples to decrease slightly from the rates that they are today.
John: What sectors are those that might be decreasing?
Michael: Definitely the real estate sector has seen a little bit of slow down, as well as manufacturing, and there is a little bit of surprise there with the current tariffs situation, there was hope that there would be increased M&A activity in the manufacturing and distribution industrial space, but there is some slight pull back as companies really do wait to see what tariffs ultimately end up at here in the US.
Evelyn: Talk to us a little bit about the difference between CPAs that provide advisory services, like diligence and structuring, versus CPAs that just provide audit and tax compliance.
Michael: Yes, the audit and tax compliance, it is compliance work. It’s fulfilling a compliance requirement in association with a regulatory or maybe an internal revenue source requirement. As it relates to more advisory services, which we at Aprio are very focused on in addition to our compliance services, is that the advisory services are meant to help clients understand various transaction structures, understand how financial due diligence, the cash flows associated with that financial due diligence, but also to think about where there are opportunities and risks that need to be considered when entering into a transaction.
Evelyn: So, really kind of stepping back and planning, if you’re a business owner or an executive team that is looking at selling or exiting a business, stepping back and helping them with the planning. How far in advance does that usually happen and what does that entail?
Michael: The planning should happen two to three years out. That’s where we see our clients get the most value when executing a transaction. But, it’s not only the planning piece of it, but it’s also the execution on understanding where buyers are really looking for value and how you, as a seller, can position yourself to get the most value out of that. Those initiatives that buyers will execute on in the future.
John: So let’s say someone comes to the office, what are some of the things that you might talk to them about? They come to you two, three years in advance as you all suggest, what are some line items that you might go through?
Michael: I’ll let Yelena talk about the tax aspects of it, but the financial due diligence aspects of it, it’s really getting the house in order from an accounting perspective. Are your financial statements in accordance with GAAP? Are you now seeing where you can get more profitability out of the business? That’s the most important thing from a financial perspective that you can do when preparing for sale.
Yelena: Just to add to this, on financial side also, very often, they would advise clients to start getting audited financials. If they’re not getting them already or, at least, review the financials because the buyer will probably look for two, three, probably three years of the financials to be done and the sooner they get in process, the better.
Michael: Yes and certainly, having the two or three years of financial information audited or reviewed, it really does give the seller that much more credibility in the process and prospective buyers feel that much more comfortable with the financial statements that are provided to them in a process.
Evelyn: Invested companies will typically be GAAP compliant, but lots of privately held businesses without external investors typically are not, from our experience. Talk a little bit about the difference. Why should a private company owner think about GAAP compliance when coming up to an exit?
Michael: Certainly. Most buyers in a transaction expect that the seller will have reps and warranties and purchase agreements saying that these financial statements are in accordance with GAAP and certainly there are exceptions to GAAP that may be identified and the seller will have an opportunity to list those out in a purchase agreement. But, in order for a financial statement to be read with certainty that this is the operations of the company, this is the financial position of a company at a point in time, having it stamped as audited gives that buyer that much more comfort on the financial performance of a business.
Evelyn: I know that we’ve actually seen companies that are not GAAP compliant come up to a purchase where a buyer actually will force them to comply with GAAP and will often get clipped on the price because they weren’t compliant.
Michael: That’s right and we do have lots of clients from a sell-side perspective that have not been audited. You can get by with unaudited financial statements, but typically you would have a professional service provider come in and do sell-side due diligence to quantify what the quality of earnings are, the normalized EBITDA of the businesses, which is adjusted for any one time, non-recurring items and having a third party diligence report does give a buyer and a seller that much more information for understanding what the normalized EBITDA, the true cash flows of a business, truly are.
John: On the quality of your earnings point, how long does something like that take to put together?
Michael: Great question. It varies from seller to seller, buyer to buyer, and certainly, if it’s multi-location, the complexity of the business. We find that most engagements that we work on from a normalized EBITDA perspective is probably about a three week timeframe to get to do the analysis and to put it into a diligence report, but certainly there are times where it can take longer, based on the complexity of the business itself.
John: Are there any rules of thumb as to when a quality of earnings might get you the job done versus, in this case, you might need audited financials, as far as dollar amounts or type of sellers that you’re selling to or buyers that you’re selling to?
Michael: We get that question often. Should we do an audit or should we do a quality of earnings report? I often say that a quality of earnings report is a little bit more advantageous to you as a seller because we’re trying to identify those one-time, non-recurring items that may impact EBITDA both positively, as well as negatively. An audit typically does not lay out those one-time, non-recurring items. So, when you think about a business that’s being sold based on a multiple of EBITDA, you do want to know what EBITDA is on a normalized basis and use that as a negotiating starting point when speaking with a buyer.
Evelyn: Yelena, talk to us a little bit about the importance of getting tax and legal advice no later than the letter of intent stage.
Yelena: The sooner the better, of course. Definitely not later than the letter of intent stage. It’s going to be very hard to change the structure of the transaction after a certain period after the LOI. It’s very, very important to understand how the buyer wants to structure it so you understand your tax impact and you can understand how much money you can net after tax. Normally, we work with a legal team because there are certain things we do and obviously, certain things that lawyers do. Very often, we would get clients who have different representation from different firms before the transaction and they come to us just represent them in the sale transaction because we’ve done a lot of it and we are experts, but it’s super, super, super important.
I know some companies want to save money, obviously, and it’s natural, but in most cases, they will end up paying more if they don’t get the appropriate people involved.
Evelyn: Absolutely. We’ve definitely seen that, too.
John: What are some of the effects that a corporate structure might have on a business if it’s a C Corp or S Corporate Partnership? That’s a big question because there’s a ton of differences, but generally.
Yelena: It’s great for us to be able to tell the client ahead of time how to structure their business so they have more flexibility on how to sell it because, in most cases, the buyers would want to buy assets or buy stock and make an election to treat the sales as a sale of assets.
The main reason for that is to be able to markup the value book, goodwill, gets some tax benefits from amortization, instead of having carryover basis. If you are an S Corp or a Partnership, if you’re pass-through entity, it’s much easier for you to sell the assets because you have one level of tax and you definitely become more marketable from that standpoint. Very often, you can get a premium for being able to sell assets. You can get a higher price for the sale. In the C Corp scenario, unless you have deep, deep NOLs, net operating losses, it’s going to be very costly to sell assets because when you sell assets, you pay corporate level tax, and then you have to pay dividends to get money out, and so you pay taxes again.
Of course, in today’s environment, it’s not as bad as it used to be because the corporate rates went down, but you still pay more if you sell your assets through a C Corp. Definitely think about it ahead of time and you cannot just change the form of your entity right before the sale because the gain will be tainted in most cases. Or, if you convert to an LLC, for example, it can be taxable liquidation. That’s why it’s super, super important to think about exit, maybe as soon as you incorporate the company.
Evelyn: Start putting it together.
Yelena: I know a lot of the times, owners don’t think about it, CPAs don’t think about it and then it’s a big oops right before the sale.
John: I know the tax reform, as you mentioned, changed a lot of the conversations, but in your opinion, has it changed? What is the general advice that you’ve typically given in the past regarding structures of LLCs and C Corps?
Yelena: We receive a lot more questions from clients, definitely, when they know that the corporate tax rate, federal rate is 21%. They get super excited and a lot of clients ask nowadays, “Should we convert to a C Corp?” Again, the answer is, if you are not planning to take money out, if you’re continuing to re-invest, maybe it’s not a bad idea to be a C-corp. If you planning to take money out, which most people do at some point, probably not such a good idea because you will end up still paying more tax. Plus, like I said, the sale, you’re somewhat limited on how the sale can be structured. Of course, if you sell stock of a C Corp, you pay capital gain tax and it’s a good scenario, but like I said, in most cases, buyers will want to buy assets. There were changes in pass-through taxation, as well. Even that C Corp tax is still less at 21% with pass-through entities, depending on the industry. But in most industries, you can get to 29.6% taxation on profits from pass-through entities, which is definitely a huge change. Lawyers and CPAs do not qualify in most cases.
Evelyn: No one’s going to buy us, anyway.
John: How does that happen?
Yelena: I don’t know. I’m still trying to wrap my head around that one but…
Evelyn: We know who hates them.
Yelena: But most of our clients qualify.
Evelyn: We have actually had these questions too and I do think that it’s a really important point that buyers still are more interested in assets and business owners do not typically understand the whole idea of, “If I buy stock of the company, it’s sweeping all of the potential liability that goes along with that.” So, the agreements can be much more complex and the shift of that liability is going to go right back to the seller and assets are often just a cleaner way to actually close that deal. We actually have some clients right now that are legacy companies, C Corporations, which I still can’t believe they’re not flow-throughs that are trying to sell and it’s hard. It’s very hard. Very expensive.
What are the tax implications? Let’s talk a little bit about earnout structures. Basically, that could be an asset transaction where the company hasn’t actually, or maybe the seller hasn’t, realized full value of the business and the buyer may say, “Hey, we’ll pay you something on the other side if performance hits x, y, z.” What are the tax implications that go along with earnout structures?
Yelena: It’s kind of like an installment sale. You’re not taxed until you actually get paid. So, if it’s a three year earnout, you may end up paying taxes on your transaction for three years, but definitely not before you get something in your hands. There’s a lot of business owners, a little bit delusional, for lack of the better word. They think they sell and then they’re good to go. But, then they have to work for the company to get the money. If I would be a buyer, I would structure it just like that with earnout.
John: I’m not a fan of having to draft earnouts but, of course, earnouts are a good way of solving a valuation gap between a buyer and seller. Michael, I’m wondering, what are you seeing in the market as far as earnouts? The market’s been so good. Has that affected the nature of earnouts at this point?
Michael: A lot of times, I see earnouts come into play when there’s a renegotiation of an initial term sheet. They buyer has come in and found something in the business that questions the true value of the business. The buyer wants to substantiate value and they do it through the future operation of the business under their watch and maybe it’s with the existing management of the seller. Those things are good when they work real well and they’re structured real well. There’s a lot of questions that come into question with an earnout is how much cost is the buyer going to burden the seller with, how much revenue is going to come into the business that results from the sale and will the seller get credit for that? There are tons of questions that happen in an earnout scenario.
Michael: The best thing that a seller can do, as well as a buyer can do, is really make sure the definition of how that earnout is being measured, post-transaction, and that’s it’s really spelled out in detail in a purchase agreement. It’s common that we see examples of the calculation in those purchase agreements as a schedule to the purchase agreement. Earnouts are something that have been a tool used in buyers and sellers transactions for several years. I don’t see it going away. If I had to guess the future as the market shifts and changes over time and risk tolerance may increase, I think earnouts may be one of those ways that buyers try to mitigate their risk for overpaying higher than the multiples that are being paid today for overpaying for a transaction.
John: Yes. They fill a great role conceptually in the market and a great tool. But, as you’ve pointed out, challenges in the actual defining of them.
Michael: Yes, and unfortunately, you know if you look at transactional litigation that happens post-transaction, there is a dispute between buyer and seller that ends up in litigation and so there’s commonly settlements that have to occur with those types of arrangements.
John: What’s the CPA’s role in due diligence Because a lot of people will get that and they think, “Well, attorneys do due diligence,” but not all of it.
Michael: We, as financial due diligence folks, we really want to help our clients understand the historical cash flows that are generated in a business and for them to use that information to think about what happens in their financial model, as they project out years ahead, after the close. There are several other streams of due diligence that a buyer, as well as a seller, absolutely want to consider. We, as financial due diligence folks and tax due diligence folks, we provide information to a seller for their consideration in connection with the sale. Also, it’s very common that the buyer also has a financial and tax due diligence advisor come in and do due diligence on the behalf of the buyer, as well as the other streams. Whether it’s customer due diligence, operational due diligence, environmental, HR and certainly legal due diligence.
John: One of the things that we were discussing with what you’ve seen as a trend in diligence recently, on the privacy front, can you tell us a little bit about that?
Michael: Every day, you can pick up the paper and see an incident where there’s security and privacy breaches of an IT platform at a business. We are seeing that buyers are coming in to make sure that the business that they’re buying, that it is a secure IT environment, that security and privacy related matters are addressed, but also mitigated. So, you as a seller, need to make sure you’re prepared for that buyer to come in to look at that IT platform. We, at Aprio, are helping our clients think through security and privacy. It’s another advisory service, but we also have assurance related to IT advisory. I highly recommend that you, as a seller, not only if you’re just operating the business into perpetuity, but also if you’re going to sell the business, you really do need to look at security and privacy matters today.
Evelyn: We had a client about a year ago who had released their chief operating officer and they were checking the network to see what documents he had downloaded and they found out that they were the subject of a ransomware attack as part of that, that was botched by the group that tried to get the ransomware, but it was only because they were there looking for other things that they found this. This is a company that is located in a small area where there was no reason for them to even believe that they might be subject to that.
I think that’s what happens. Small businesses will sit there saying, “It’s not going to be me. Why does anyone care about me?” But, they care about everybody because your files are valuable to you. Of course, as more privacy laws are adopted now state by state, who knows if we’ll ever have federal policy on that, but we definitely have seen buyers looking at that and being concerned.
Michael: No question about it.
John: I think it’s one of the ones where people really push for this uncapped liability a lot of times too, just like they do on IP and something that can hang over your head for quite some time after a sale. What are some of the things that some of the mistakes that people make on the financial side, as far as that you see? Sorry, there’s a lot of mistakes I’m sure you see on the financial side. But, let me limit this a little bit.
Evelyn: Like the letter of intent is signed when they call.
John: When the buyers are going through the financial statements, what are some major no-nos that just have to be cleaned up before someone comes to look at your company?
Michael: Two to three years out, it’s good to start thinking about how to become prepared and work with your advisor on what it means to actually go through the process. Your question related about financials, it really goes back to do you have reviewed and or audited financial statements that you can hand to a prospective buyer? That is the biggest thing that we would recommend our clients to do from a financial perspective. It’s to understand what the revenue recognition criteria is, expense recognition criteria is and putting an internal control structure around that, based on the benefits that you can get from those types of internal control structures.
That is the biggest thing that we would recommend to our clients today is, as you think about getting prepared for a sale, to go ahead and get your financial statements reviewed or audited. Also, while those things are happening from a third party, that you as a seller continue to operate that business and continue growth is always very, very important. If you have a slipping growth and the hockey stick goes the other way, that’s when you lose a lot of credibility and value in a transaction.
Evelyn: I think the other thing that’s really important with planning, certainly, is even outside of the idea of selling the business, are the tax law changes. As your business grows, there might be other opportunities for you to do R&D credits for development. It just seems so reasonable that there needs to at least be an annual meeting to discuss, “Well, what’s going on?” I think still business owners don’t necessarily do that.
Yelena: There are a lot of opportunities that are missed. A lot. Tax credits, but even with the law changes, this 29.6% tax rate for pass-through entities, there are ways to get that rate, and how to maximize the benefit. It’s amazing that-
Evelyn: People don’t take advantage.
Yelena: There are so many people who don’t pay attention. CPAs don’t pay attention, either. With every law change, there are some opportunities and there are some things, obviously, that cannot be changed, but there are some things with careful planning that can be really, really improved upon.
Evelyn: So is there anything that we’ve missed?
Michael: I would say this is a great time to be a seller. It is a sellers’ market out there. When you look at the amount of capital that’s out there, there are private equity groups and strategics that are eager, eager to grow their business and it’s more expensive for them to grow it internally or green field it. It’s cheaper for them and quicker for them to just go out and buy it. It’s a great time to be a seller and sellers that get the most value are those that are most prepared for the process.
Use your advisors to help you drive value and the cost of an advisor may look a little bit daunting at times, but at the end of the day, don’t look at it as a cost, but it really is an investment in value creation in a transaction. We see that all the time with those clients that are selling. When they’re most prepared, they get the highest value while being able to execute on a transaction that is much more efficient.
Evelyn: That makes perfect sense.
John: Michael, Yelena, thank you for joining us. This has been great.
John: If you would like to learn more about Aprio and their services, please visit their website at aprio.com. That’s A-P-R-I-O.com. Thank you for joining us.
Speaker 1: This has been In Process. Conversations about business in the 21st century with Evelyn Ashley and John Monahon presented by Trusted Counsel, a corporate and intellectual property law firm. Are you interested in being a guest on our show? Email our show producers at firstname.lastname@example.org. For more information on Trusted Counsel, please visit trusted-counsel.com.