Law Office of David S. Howard
David S. Howard, CPA

Mistakes Not To Make When Selling a Closely Held Company

The economic recovery has apparently started. The stage is setting up for industry consolidation, mergers and acquisitions. Company cash is hardly earning interest, stock prices are coming up, profits are returning. The feeding frenzy will be starting soon to gobble up closely held companies.

The buying companies will be offering cash deals, asset purchase deals, so-called tax-free deals, mergers, and many other variations. Here are some tax related ideas on how to get the closely held “target” in-shape to maximize valuation. The suggestions go against the grain of conventional tax planning wisdom. However, if they are implemented now with an anticipated sale within the next two years very costly mistakes may be avoided.

Biggest Tax Mistake of All: Not understanding the buyer’s valuation formula.

You may think the real value in your company may be the wonderful people who work for you or your great reputation or longevity in the market place. However, the bean counters who do the financial analysis will be looking at your EBITDA (pronounced ee-bit-dah) which is the acronym for Earnings Before Interest Taxes Depreciation and Amortization.

After they compute your EBITDA they will apply a multiplier factor they feel is appropriate for your industry with adjustments for what they might see as your growth potential or lack there of. Typical multipliers are from 4 to 9 times EBITDA.

Don’t let the formula get past you. Focus on it. The formula is very simple but pervasive.

EBITDA is not always the sole basis for the valuation. Sometimes the formula or rule of thumb might be a multiple of sales. Nevertheless, EBITDA is still taken into consideration by sophisticated buyers.

Note that income taxes are not deducted from earnings in the EBITDA approach. Tax planning strategies are designed to reduce earnings so fewer taxes are due. Beware, your careful tax planning may now become your worst enemy.

Example. Your company with current “tax planning” in place has EBITDA of $1 million per year. If we say the appropriate multiplier is 7 then the indicated value is $7 million. (This may be adjusted to deduct long-term debt and add back free cash.)

Now assume you took away your “tax planning” deductions and your taxable income went up by $500 thousand. Your EBITDA is before taxes and would go to $1.5 million and the valuation would jump to $10.5 million (1.5 times 7) or an increase of $3.5 million just by paying the additional income taxes on $500 thousand say about $200 thousand.

Following are tax planning mistakes that need to be avoided the year or two before the business is sold. Some of this can be done at the last minute with pro-forma financial statements. But the actual track record is more persuasive. The sooner you get started the better.

Mistake: Too much “family” compensation.

This may be a good time to take a big pay cut, take family members off the payroll or reduce their compensation. You might consider cutting their pay to minimum wages so they still get health insurance but loan the money to live on. Stop providing company assets for personal or family use even it you are properly charging that expense to them on their W-2 forms. Stop getting reimbursed for business expenses. Change your employment agreement so you are required to pay certain expenses as part of your job.

Note that if the acquiring company wants you to stay on as the manager be sure and ask for a big pay raise and increased fringe benefits. Do this after the valuation has been set. Sometimes sophisticated buyers will reduce the EBITDA by the additional compensation they figure they will have to pay to replace under-paid employees. But let them figure this out.

If you are getting paid $250 thousand a year salary and cut it to $100 thousand this will not only increase earnings there will be a great decrease in payroll taxes and fringe benefit expenses.

By reducing the compensation of other family members you might be able to increase EBITDA by say $500 thousand. This translates into an increase of $3.5 million in valuation. This is a lot more than the $200 thousand of additional income taxes the company may have to pay.

Mistake: Non-essential expenses.

Since every dollar of additional expense can reduce the valuation of the company by a factor they should be eliminated or deferred. A year or so before the sale is a good time to start scrubbing through your expenses. Take a look at consulting expenses, fees paid to outside service providers, research and development, maintenance and repairs, fringe benefits, etc. Consider all operating expenses such as utilities, shipping, etc. Cut, cut, cut.

Don’t overpay anyone but absolutely do not make the mistake of underpaying key employees or your sales department. You want happy customers and strong sales.

Some closely held companies may have been valuing ending inventory on a very conservative basis to avoid over stating taxable income. Now would be a good time to be more rigorous in counting inventory and making sure it is all on the books at full cost including the required allocation of overhead required by the tax code. The allocation of overhead to inventory increases taxable income and EBITDA.

Mistake: Not considering operating expenses versus capital expenses.

This is another reason to really understand EBITDA. Generally speaking capital expenditures funded by debt will not adversely affect EBITDA. Neither the interest on the debt nor the depreciation or amortization reduces EBITDA. On the other hand, operating expenses reduce EBITDA dollar for dollar.

A good example of how an operating expense could be converted to a capital expense is changing a rented asset into an owned asset. Rent is a current operating expense. If you buy the asset with borrowed money and then amortize or depreciate the cost and pay interest on the debt there is no reduction.

For example: If you need a $100 thousand piece of equipment and you can rent it for $25 thousand per year you will decrease the valuation of the company by $175 thousand (25 times 7). If you borrow $100 thousand and buy it and you have to pay $7,000 a year of interest and take $20,000 a year of depreciation you will have zero impact on EBITDA.

The formula might require a further reduction of equity value by the amount of additional debt. So while the value goes up $175 thousand it will be less the $100 thousand for a net increase of $75 thousand, still not an insignificant amount.

You may want to make the rent versus buy decision on a case-by-case basis to compute the net increase in value.

Note that acquiring another company is usually a capital expenditure that does not hurt EBITDA but may add substantial earnings.

Always remember that the debt related to a capital expenditure will not reduce the EBITDA but it may reduce the net value of the company equity depending on the formula used.

Mistake: Thinking a Tax-Free deal is better than a taxable deal.

A simple rule of thumb is that to the extent the buyer pays you cash or assumes your debts you will be taxable. For the transaction to be tax-free or partially tax free the buyer will be giving you shares of their company stock. But watch out for the strings attached to those shares. You may not be able to sell them for a long time. You may not have any downside protection.

Example: You might get stock worth $16 a share that by the time you can sell them is only worth $8 a share. On the other hand, the shares could go to $30 per share.

Mistake: Not asking for a last minute kicker.

These are things that add value to you and may be perceived as little additional cost to the buyer. Many of these kickers are tax deductible for the buyer and are taxable to you.

Ask for and out-of-the money warrant for the right to purchase shares in the buyer’s stock at some price above current market price. An out-of-the-money warrant may not be highly valued.

I participated in the negotiations for the sale of a closely held company where just before the close we asked for a warrant to purchase 500,000 shares of the acquiring company at $30 per share when the shares were currently selling for $25. The buyer did not consider this to be unreasonable and granted the warrant.

Within two years the stock was at $50 per share and the seller made $10 million.

Other kickers are employment contracts for you, covenant not to compete, seat on board of directors of the company, etc.

Most of the ideas presented here have significant income tax consequences and need to be considered within the context of the situation. You need competent professional advice.

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