Tag Archive for: SellSideAdvisory

How Tax Structure Shapes the Economics of a Business Sale

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A business sale involves more than negotiating the purchase price. The transaction structure significantly affects the economics for both buyer and seller. Accordingly, tax considerations in M&A should enter the discussion early. Decisions made during negotiations may directly influence each party’s after-tax outcome.

Buyers and sellers often approach these decisions from different perspectives. What creates a tax benefit for one party may create additional costs for the other. The choice between an asset sale and an equity sale illustrates this difference.

Buyers often prefer asset purchases because they can receive a new tax basis in the acquired assets. This basis may generate future depreciation and amortization deductions. Sellers may prefer an equity sale, particularly when proceeds qualify for capital gain treatment. The seller’s entity structure may also substantially affect this analysis. C corporations, S corporations, partnerships, and LLCs can produce different tax consequences. Therefore, the parties must evaluate structure within the specific circumstances of the transaction.

Once the parties determine the transaction structure, purchase price allocation becomes another consideration. In an asset sale, the allocation assigns value among the acquired assets. These allocations may affect the seller’s character of gain and the buyer’s future deductions. As a result, allocation often becomes an economic negotiating point rather than simply a tax exercise.

The form of consideration can create additional tax consequences. Cash, seller notes, rollover equity, and buyer stock may affect the timing and character of taxable income.

Other tax considerations in M&A may also influence the transaction. These can include:

  • Tax Elections: Sections 338(h)(10) and 754 may provide different tax treatment when applicable.
  • Tax Attributes: Net operating losses and tax credits may have value, although limitations may restrict their use.
  • Built-In Gains: Certain S corporations may face additional tax exposure following a prior conversion from C corporation status.
  • Transfer Taxes: Real estate, sales, and other transfer taxes may create additional transaction costs.

These issues demonstrate why headline purchase price tells only part of the story. A higher offer may produce lower after-tax proceeds depending on its structure. For this reason, sellers should evaluate competing offers on both a gross and after-tax basis. Buyers should likewise consider tax benefits when evaluating their total acquisition cost.

The M&A advisor should coordinate this analysis with experienced tax and legal professionals. The M&A team can evaluate structure, allocations, consideration, elections, and other material provisions before they become difficult to change.

Addressing tax considerations in M&A early gives both parties greater flexibility during negotiations. More significantly, thoughtful planning helps ensure the transaction structure supports the seller’s broader financial objectives.

Protecting Confidentiality During the Business Sale Process

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Selling a privately held business requires sharing sensitive information with prospective buyers. However, sellers should control when and how they disclose that information. Maintaining confidentiality in M&A protects the company while allowing qualified buyers to evaluate the acquisition opportunity.

Premature disclosure can create significant problems. Employees may become concerned about their jobs, while customers may question the company’s future. Competitors could also use confidential information to their advantage. Meanwhile, suppliers and other stakeholders may react before a transaction becomes certain.

For these reasons, an M&A advisor typically approaches prospective buyers without initially identifying the seller. The advisor may use a carefully prepared teaser or executive summary during the initial contact. This document provides enough information to determine whether a buyer has legitimate interest.

Generally, the teaser describes the business without revealing its identity. It may include:

  • Company Overview: A general description of the business and its capabilities.
  • Products and Services: The principal offerings and markets served.
  • Geographic Reach: General information about customers and sales territories.
  • Financial Highlights: Selected revenue, EBITDA, growth, and other relevant financial information.
  • Investment Highlights: Characteristics that may make the company attractive to prospective buyers.
  • Transaction Overview: General information regarding the contemplated sale.

Once a buyer expresses sufficient interest, the advisor typically requests a Non-Disclosure Agreement, or NDA. Some parties may also refer to this document as the Confidentiality Agreement, or CA. The agreement establishes rules governing the buyer’s use and disclosure of confidential information. It may also address permitted recipients, information security, return or destruction of materials, and other protections.

Certain provisions may require negotiation, particularly with private equity firms or strategic buyers. The M&A advisor and transaction attorney should manage these discussions without unnecessarily delaying the sale process. After executing the agreement, the seller may provide more detailed information. This information often begins with the Confidential Information Memorandum (“CIM”) and progresses through later stages of due diligence.

Still, signing an NDA does not eliminate confidentiality risk. Sellers should continue controlling access to sensitive information throughout the transaction. For example, highly sensitive customer or employee information may remain restricted until later in the process. The seller may also redact certain documents or limit access within the Virtual Data Room.

Effective confidentiality in M&A therefore requires more than an NDA. It requires a disciplined process for identifying buyers, controlling disclosure, and releasing information as buyer interest becomes more serious. An experienced M&A advisor will manage this progression while protecting the sellers identity and sensitive information. This approach allows buyers to evaluate the opportunity without creating unnecessary exposure for the business.

Why Valuation and M&A Transaction Value May Differ

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Business owners often expect a business valuation to predict the price their company will receive in a sale. In practice, valuation and transaction value may differ. A business valuation in M&A provides an analytical framework for understanding value. The marketplace determines what an actual buyer will pay.

Both analysis begin with many of the same fundamentals,. Historical earnings, expected cash flows, growth, risk, and industry conditions all influence value. A valuation professional may apply income, market, and asset-based approaches. These approaches may include discounted cash flow analysis, capitalization methods, and comparable transaction multiples. However, valuation methodology represents only part of the analysis. The applicable standard of value also influences the conclusion.

Fair market value generally considers a hypothetical willing buyer and seller under defined assumptions. Neither party faces compulsion, and both possess reasonable knowledge of relevant facts. Fair value represents a different standard and depends heavily on the purpose and applicable legal or accounting framework. It frequently arises in shareholder disputes, financial reporting, and other specific circumstances.

Neither standard necessarily predicts the price available from a particular buyer in an M&A transaction. That distinction brings investment value into the analysis. Investment value reflects the value of a business to a specific buyer based on that buyer’s circumstances. Different buyers may therefore place different values on the same company.

A strategic buyer may identify cost savings, new customers, expanded geography, or complementary capabilities. A financial buyer may focus more heavily on growth, leverage, and expected investment returns. Buyer-specific opportunities may support a transaction value above other indications of value. However, the seller does not automatically receive that additional economic benefit.

The M&A process determines how much value the seller can capture. 

An experienced M&A advisor identifies buyers with compelling reasons to pursue the company. The advisor then communicates the company’s financial performance, value drivers, and strategic opportunities. From there, a competitive sale process allows multiple qualified buyers to evaluate the opportunity. Each buyer approaches the company with different motivations and economics. Competition can reveal values that a standalone valuation may not anticipate. It may also strengthen the seller’s negotiating position on price, structure, and other transaction terms.

For this reason, business valuation in M&A should provide a reference point rather than create an artificial ceiling. It helps establish expectations and provides context for evaluating offers. Business valuation also provides a reasoned indication of value under defined assumptions. A competitive M&A process tests those assumptions and determines what the marketplace will actually pay.

Protecting the Seller in an Earnout Agreement

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An earnout may help buyers and sellers overcome differences in their expectations about future business performance. However, agreeing on the earnout amount represents only the beginning. After closing, the seller typically gives the buyer control over the business. That changes creates significant risk for contingent consideration. For this reason, seller earnout protection should address both the payment formula and the buyer’s post-closing operation of the company.

Before accepting an earnout, sellers should first evaluate the buyer. Financial strength matters because an earnout has little value without the ability to pay. Operating capabilities deserve similar attention. A buyer that cannot successfully manage the acquired company may reduce the probability of achieving performance targets. Sellers should also understand the buyer’s plans for the business. Changes involving employees, customers, pricing, suppliers, or investments could materially affect future results. Once comfortable with the buyer, the seller should focus carefully on the earnout provisions. Several areas deserve particular attention:

  • Performance Measures: Define revenue, EBITDA, gross profit, or other measurements precisely.
  • Accounting Policies: Establish consistent accounting methods for calculating performance throughout the earnout period.
  • Operating Covenants: Address significant actions that could unfairly reduce or shift the company’s reported performance.
  • Information Rights: Give the seller appropriate access to financial information supporting earnout calculations.
  • Payment Terms: Clearly establish measurement dates, payment dates, and procedures for calculating amounts owed.
  • Dispute Resolution: Establish a practical process for resolving disagreements, including independent accounting review when appropriate.
  • Buyer Creditworthiness: Consider available protections when future payment depends materially on the buyer’s financial condition.

The measurement period also requires careful consideration. Longer periods increase uncertainty because business conditions and buyer strategies can change. Even strong contractual provisions will not eliminate every risk. Therefore, sellers should evaluate earnout consideration differently from cash received at closing. More fundamentally, the earnout should align the economic interests of both parties. A buyer should not benefit from preventing the seller from achieving reasonable performance objectives.

Effective seller earnout protection begins during negotiations, not after a disagreement develops. The M&A advisor should coordinate closely with legal, accounting, and tax professionals when evaluating the provisions. Earnouts may help bridge valuation gaps and complete transactions that might otherwise fail. However, their value depends on the seller’s ability to earn, verify, and collect the promised consideration.

Turning Business Weaknesses Into M&A Opportunities

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Every business has weaknesses. During an M&A transaction, the question is whether the seller addresses them before the buyer discovers them. Addressing business weaknesses before a sale allows the seller to explain potential concerns within the proper context. It also provides time to correct problems that could otherwise affect value.

Buyers will examine the company carefully during due diligence. Problems discovered unexpectedly may undermine confidence in management and raise questions about other undisclosed issues. For this reason, sellers should identify material weaknesses before entering the market. Common examples include:

  • Customer or supplier concentration
  • Uncollectible accounts receivable
  • Obsolete or slow-moving inventory
  • Expiring leases
  • Nontransferable contracts or licenses
  • Unprotected intellectual property
  • Pending litigation or contractual disputes
  • Unprofitable customer contracts
  • Unclear ownership of key assets
  • Significant dependence on the owner

Once identified, management should determine which weaknesses can be corrected before a sale. Some problems may require months or years to resolve. Other weaknesses may remain when the company enters the market. In those situations, thoughtful positioning becomes essential. The Confidential Information Memorandum (“CIM”) should present material issues accurately and within the broader business story. Appropriate disclosure allows buyers to evaluate both the risk and potential opportunity. For instance, customer concentration represents risk. Yet a buyer with broader customer relationships may see opportunities to diversify the acquired company’s revenue. Similarly, weak sales infrastructure may limit current growth. A strategic buyer with an established sales organization could identify meaningful expansion opportunities.

The seller should not disguise a weakness as an opportunity. Instead, the M&A advisor should explain the issue and demonstrate how a buyer could address it. This approach strengthens credibility while allowing buyers to consider opportunities unavailable to the current owner.

Timing also matters. Addressing business weaknesses before a sale gives sellers greater negotiating leverage while multiple prospective buyers remain interested. Before signing a Letter of Intent, competition may help sellers negotiate identified risks within the broader transaction economics. After exclusivity begins, that leverage generally decreases.

An experienced M&A advisor should identify likely buyer concerns before launching the sale process. The advisor may then determine what to correct, disclose, and position appropriately. Strong M&A positioning does not require a perfect company. It requires understanding the weaknesses, addressing them proactively, and presenting the opportunity with credibility.

Distressed

Navigating the Sale and Acquisition of a Distressed Business

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The current economic environment is creating acquisition opportunities involving troubled and financially distressed companies. Declining revenue, excessive debt, restricted credit, and liquidity problems are forcing some owners to consider alternatives. For buyers, distressed business transactions may provide access to assets, customers, employees, technology, products, or geographic markets. However, an attractive purchase price does not necessarily make a distressed company an attractive acquisition.

Understand the Seller’s Situation

A distressed seller rarely has the flexibility available in a traditional sale. Cash requirements may create significant time pressure. Lenders may also influence the company’s decisions and available transaction structures.

Under financial pressure, preserving value becomes increasingly difficult. Employees may leave, customers may become concerned, and suppliers may tighten credit terms. Owners should therefore evaluate alternatives before liquidity problems eliminate viable options. A sale, recapitalization, refinancing, restructuring, or Chapter 11 proceeding may provide different paths forward.

Evaluate More Than the Purchase Price

Buyers should determine why the business became distressed before pursuing an acquisition. Temporary financial problems differ significantly from a fundamentally broken business model. Diligence should examine operating performance, cash requirements, debt, customer relationships, contracts, employees, assets, and potential liabilities.

Beneath the financial distress, a buyer may find valuable operations or assets that fit its existing business. Strategic buyers may identify opportunities to consolidate facilities, eliminate duplicate expenses, or expand into new markets. Financial buyers may see opportunities to recapitalize viable businesses with unsustainable capital structures.

Structure the Transaction Around the Risks

Distressed acquisitions may involve asset purchases, equity purchases, bankruptcy sales, or negotiated transactions with creditors. The appropriate structure depends on the company’s circumstances. Buyers must consider secured debt, liens, working capital, cash requirements, transaction timing, and third-party consents (the bank). Lender cooperation may become essential when secured creditors control significant company assets. Given the compressed timeline, buyers must balance thorough diligence with the risk of losing the opportunity.

Find Opportunities Before They Become Obvious

Distressed opportunities may emerge through competitors, suppliers, lenders, attorneys, accountants, and other professional advisors. Sellers should also seek advice before financial conditions become critical.

An experienced M&A advisor can help evaluate alternatives, identify prospective buyers, and coordinate negotiations with other professionals. Buyers should involve experienced legal, financial, and restructuring advisors early. Distressed business transactions can create compelling opportunities, but financial distress changes the normal transaction process. The strongest outcomes occur when buyers and sellers recognize the problem early enough to preserve viable alternatives.

Pepperdine Private Capital Markets Project

Finding Growth Capital Beyond Traditional Bank Financing

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Many business owners are becoming increasingly optimistic about opportunities to grow their companies. However, access to capital remains a significant obstacle. The Pepperdine Private Capital Markets Project highlights this disconnect. Nearly half of surveyed business owners report insufficient financial resources to execute their growth strategies.

Meanwhile, the continuing effects of the financial crisis have changed the financing environment for privately held companies. Approximately 250 banks have failed since the financial crisis began in 2007. Additional failures and tighter lending standards may further restrict traditional credit. Against these conditions, business owners should understand the broader range of capital available to support growth.

Looking Beyond Traditional Bank Financing

Commercial banks remain an important source of financing for established businesses. However, conventional bank debt may not satisfy every company’s capital requirements. Owners may therefore need to consider alternative growth capital.

Potential sources include asset-based lenders, mezzanine funds, private equity firms, venture capital firms, angel investors, and factoring companies. Family and friends may also provide capital in certain circumstances. Each source presents different costs, risks, and requirements.

Debt financing may preserve ownership but creates repayment obligations. Equity financing may provide greater flexibility but requires owners to share ownership and future value.

Match the Financing to the Growth Strategy

Access to capital alone does not make a financing source appropriate. Owners should first determine why they need capital and how the investment will support growth. A manufacturer purchasing equipment may require a different structure than a company pursuing an acquisition. A rapidly growing company may need additional working capital to support increasing sales.

When evaluating alternatives, owners should consider interest rates, repayment terms, collateral requirements, covenants, and potential ownership dilution. Management should also understand how each financing alternative may affect future flexibility.

Use the Private Capital Markets

The Pepperdine Private Capital Markets Project provides valuable information about the changing private capital environment. The research examines banks, private equity firms, venture capital firms, angel investors, factors, and other capital providers. It also examines financing conditions, investment criteria, and the cost of capital across different market segments. For growing companies, this information may help owners evaluate financing sources beyond their traditional banking relationships.

Prepare Before Seeking Capital

Capital providers need a clear explanation of the opportunity before committing funds. Owners should prepare a business plan explaining the company’s strategy, financial performance, growth opportunities, and capital requirements. Financial projections should demonstrate how management intends to use the capital. They should also show the expected effect on revenue, earnings, and cash flow.

Alternative growth capital can provide additional options during a challenging credit environment. The objective is not simply to find available financing. The right financing should provide sufficient capital while supporting the company’s growth strategy, financial capacity, and long-term ownership objectives.

Allston Advisory Group is an experienced boutique M&A advisory firm providing a variety of services to lower middle market companies. See our footer for contact information.

Louisville, KY Office
(502) 742-2933
[email protected]
P.O. Box 70964
Louisville, KY 40270

Los Angeles, CA Office
(310) 905-4202
[email protected]
700 South Flower Street, Suite 1000
Los Angeles, CA 90017

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