Tax Services • Published 10/05/2021 What to Expect When Private Equity Comes Calling

If you’re involved in the business world these days, you’ve likely run across private equity firms directly or through exposure to private equity deals in your line of work. The private equity sector has been very active over the past several years in evaluating opportunities and executing transactions across the U.S. So, what might be some of your initial considerations if your business is targeted in a private equity deal? In this first part of a series of articles on mergers and acquisitions, we’ll touch on some common factors to keep in mind as you start to evaluate any private equity “courting.”

What am I selling and how?

The structure of a business sale can take many different forms depending on your entity tax structure, but ultimately, you’ll be considering whether to sell the company’s assets or sell your stock or equity interests in the company. From both a tax and legal perspective, those can have very different outcomes and implications.

• Typically, the buyer – the private equity investor (PE) – will have a strong preference to purchase the assets of your business in order to get a future deduction through depreciation and amortization for the price that they pay for the assets. This asset purchase also has the advantage of being a “fresh start” for the buyer in that they don’t generally inherit any potential prior exposure that may have arisen within the company related to performance obligations, litigation, etc.
• On the other hand, the seller may often – but not necessarily always – prefer to sell stock or equity interests of the business. Such a sale normally qualifies the resulting gain (or most of the gain) for treatment as a long-term capital gain. Under current tax law, long-term capital gains are taxed at lower income tax rates than other income, assuming the gain ultimately flows to an individual.

Therefore, the structure of the sale has many implications on both the seller side and buyer side. If one party is adamantly opposed to an asset sale vs. an equity sale, a compromise may lead to negotiations for a material change in the purchase price. For example, if the sale of your stock in the business saves you a significant income tax burden because of the difference in tax treatment compared to a sale of assets, but the buyer is insistent on an asset purchase, your acceptable purchase price may need to increase to compensate you for the increased tax burden.

Both the structure of your company and the structure of the PE buyer may also significantly impact the form of the transaction. For example, if your business is taxed as an S-corporation, pre-transaction restructuring may be needed or recommended to effect the sale. Most PE buyers are structured as partnerships or C corporations, which are not permitted to own an equity interest in an S-corporation. Under a stock/equity transaction, both parties may agree to a Section 338(h)(10) election, which allows a stock purchase to be treated as an asset sale and alleviates the issue of a C-corporation or partnership owning an S-corporation. While there are other potential restructuring options available in this situation, the Sec. 338(h)(10) election is a common planning tool that may avoid more complex restructuring.

While the income tax ramifications present a tangible difference in dollars realized on a sale, many other factors come into play as well during PE transactions, including:

Sales tax considerations

Typically, each state has an occasional sales exemption that will prohibit sales tax from applying to asset sales in connection with a sale of a business, but you should be aware of those potential taxes in the event a particular state does not respect such an exemption or such exemption is limited. If vehicles or certain other vehicle-related assets are involved, thought must be given to requirements of re-titling those assets which can lead to transfer taxes in the context of an asset sale. These concerns are not generally applicable in a stock/equity transaction.

Employees

While your employees are not listed as an asset on your balance sheet, they are often a significant business asset and a sale could have immediate impacts to their employment status. In a sale of stock, the company structure continues as before (absent any restructuring done as part of the deal) so your employees and any employment contracts remain in place largely uninterrupted. However, in an asset deal, a new company assumes ownership of the business and your employees must be re-hired by the new operating entity. Any employment contracts, employee benefits, and salary structure must be reinstituted.

Customer contracts and relationships

Similar to employees, your customer base is an important asset for your business that may be impacted. Again, under a stock transaction, very little changes for your customers in that they will continue to be serviced and invoiced by the same entity as before. However, in an asset deal, any customer agreements, such as master service agreements or service contracts, must be re-executed with the new owner.

Setting the stage to sell

If your business does become the target of a PE firm, you will also want to market your company as an attractive candidate for PE investment.

Financial statements

If you have not previously conducted an audit or review of your company’s financial statements, you will likely need to consider engaging a CPA firm to perform a financial statement audit or review. The PE buyer will likely require an independent certification that your financial statements are materially correct.

Quality of earnings study

Prior to entering substantive negotiations, many PE buyers request a quality of earnings study that examines various aspects of your company’s net earnings. The PE firm typically leads this engagement with an outside provider, but it will largely rely on your business to provide relevant information and insight into your earnings streams and customer concentrations as well as your company’s cost structure.

Business valuation

You may have some idea of what you believe your company to be worth, but a formal valuation exercise will likely be needed. Business valuation takes a formulaic approach to identifying a value range and can aid in negotiating a purchase price that is fair to both the seller and the purchaser. A certified valuation analyst can formally analyze your overall business from its earnings to its assets and liabilities, providing a valuation that accounts for the current economy, market conditions, and industry norms.

Entertaining a sale to a private equity buyer can be very exciting, but it comes with many potential considerations. In future articles, we’ll examine other merger and acquisition topics and considerations in more detail. If you have questions about the tax implications of selling your business, reach out to your P&N tax advisor or contact us.