Many technology companies pursue M&A opportunities to increase value and drive growth. However, they’re often unprepared for the scrutiny of due diligence — resulting in negative consequences, such as a reduced valuation, tax exposure, or fines.
Conventional wisdom is that economics should drive transactions and taxes should be considered only after the economics. However, it’s important to understand how and why tax considerations impact transaction value as well.
Here are some common pitfalls to keep in mind before due diligence begins.
State income tax
Due-diligence teams often start off by determining if a target company is filing returns in all appropriate states. Almost always, they conclude it isn’t, creating some level of exposure to state income taxes.
Even development-stage companies are often very active in several states because of efforts to expand or develop markets. Each state has different rules for determining whether a company’s activities cause it to have nexus, resulting in unanticipated tax exposure.
Constantly changing state rules make it difficult to stay current and avoid significant exposure without a professional’s assistance. In this regard, companies are well served — especially if an acquisition, and subsequently a due-diligence review, are on the horizon — by taking the following steps:
- Limiting their tax exposure.
- Arbitraging disparities in a state’s inconsistencies.
- Maintaining their preparedness to answer a buyer’s questions — including how their state tax exposure is quantified and contained.
The rise of technology has altered the sales tax landscape. Complex rules now exist to address new questions, such as whether sales tax applies to various types of software services.
Even companies with limited sales can reach many jurisdictions online, triggering significant sales-tax obligations. It’s often uncovered during due diligence that a company hasn’t thoroughly assessed its exposure and, as a result, has significant unreported liability, which in turn decreases the company’s value.
Most companies have cross-border transactions with customers, vendors, development partners, or employees. To prevent tax evasion or manipulation, authorities are requiring more transparency into foreign-held assets and operations as well as imposing penalties for noncompliance and inaccuracy.
If a company doesn’t comply with international tax complexities, potential buyers may identify these areas during due diligence and request a lower purchase price or require additional escrow holdbacks for potential exposure.
R&D tax credits
Because development-stage technology companies often don’t expect to immediately monetize credits, they commonly don’t prioritize maintaining contemporaneous documentation to support R&D claims.
This oversight often creates an opportunity for a buyer to substantially discount the value of the federal and state research credits, denying the selling shareholders the full benefit of the research credits they paid to create.
Identifying transaction costs
Companies involved in a transaction often incur significant costs, such as legal fees. The tax treatment of transaction costs is challenging, and the rules are often misapplied.
Quantifying these benefits, understanding whether they can be carried back or forward, and projecting when they can be realized is a significant hurdle in transactions. To receive a fair price, however, a company must be able to answer these questions.
Technology companies consider various accounting elections and methods to help mitigate tax risks and capitalize on opportunities — often in the first year of business or at the outset of a new category of transactions. Any failure to make elections or adopt proper accounting methods in a timely fashion can create significant future tax exposures.
A due-diligence review often uncovers a seller’s inadvertent adoption of improper accounting methods. Sellers can benefit from understanding their estimated tax position through the date of close and whether they have the appropriate level of reserves to cover any known exposure.
Limitations on tax-attribute carryovers
Development-stage technology companies often generate significant tax attributes that can’t be monetized and must be carried forward. The tax attributes include net operating losses (NOLs) and tax credits, such as the research tax credit.
These attributes can be highly valuable and should be included in the determination of an enterprise’s value, however, there are limitations on the use of these carryovers if there have been enough owner shifts to trigger an ownership change. Determining if a change occurred is a complex calculation — an analysis that many early-stage companies defer performing.
When a seller hasn’t performed this analysis, the buyer may either do their own using buyer-favorable assumptions or presume any tax attributes don’t have value.
Before participating in M&A activities, proactive planning could help your technology company reduce exposure, avoid common pitfalls, and sustain a higher valuation.
Contributors: Rich Croghan, Ken Harvey, John Hauser, Arnie McClellan, and Adam Cline, Moss Adams This article is an excerpt. Read the full version and other articles from our Successful Exits series at mossadams.com.
Richard Croghan, CPA, can be reached at (415) 677-8282 or email@example.com.
Ken Harvey, CPA, can be reached at (415) 677-8272 or firstname.lastname@example.org.
John Hauser, CPA, can be reached at (408) 558-3211 or email@example.com.
Arnie McClellan, CPA, can be reached at (415) 613-1307 or firstname.lastname@example.org.
Adam Cline, CPA, can be reached at (206) 302-6786 or email@example.com.
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