The Taxman Always Rings Twice
In the past few years, I’ve worked on an unusually large number of matters requiring complex tax analysis in high-stakes situations. While I’ve always had a healthy respect for the importance of tax issues, these more recent engagements have left me in absolute awe of the risks associated with the tax code. Seemingly harmless transactions consummated years before can dramatically alter your tax position years after.
The notion I wanted to get across with this post’s hopefully catchy title is that there are always at least two occasions on which tax advice is critical for any transaction or business arrangement: first, at the time of entering into the transaction or arrangement; and second, at the time of exiting the transaction or arrangement.
A corporate and transactional lawyer is, by definition, at least half a tax lawyer — he or she must have enough knowledge and experience to spot issues, and then must have a full tax lawyer nearby. Obviously, tax advice should always be obtained in connection with any venture capital financing or merger & acquisition transaction. But, the tax code is full of other tricks and traps to catch the unwary. Some of the usual suspects in my practice include:
- complex rules regarding limited liability company (LLC) membership interests, including the use of profit interests for purposes of employee or consultant compensation — these issues seem particularly acute when a company wants to superimpose a corporate-style capital structure (e.g., common stock, preferred stock, options and warrants) on an LLC
- complex “change of ownership” rules that can dramatically limit the value of net operating loss (NOL) carryforwards — these rules are specific to ‘C’ corporations (as opposed to pass-through entities such as ’S’ corporations or LLCs) and can pose problems whenever there are meaningful share issuances or transfers; it is important to keep track of the ‘change of ownership’ test on the occasion of each such issuance or transfer
- complex rules governing the use of equity incentive compensation, such as non-qualified stock options (“NSOs” or “non-quals”), incentive stock options (ISOs), restricted stock, and stock appreciation rights (SARs) — the decisions on this topic impact the tax benefits available to the company and the after-tax income ultimately received by the recipient, and often have unintended or at least under-appreciated tax, accounting and financial consequences for both sides
- Section 409A rules that regulate details that must be included in any deferred compensation arrangement (which is quite broadly defined to include most compensation that is not paid in cash at the time it is earned)
- Section 280G rules that greatly complicate “golden parachutes” (i.e., substantial compensation payments due as a result of a change of control transaction)
- Section 83 rules that provide an optional election (under Section 83(b)) in connection with the receipt of restricted property (such as restricted stock or profit interests) that vests over time (while the election allows the recipient to eliminate the tax that would be due at each vesting date, it can result in a higher tax under some other circumstances)
- and others…
Effective tax planning can create substantial economic benefits for a company (or individual), while a lackadaisical approach can result in real tax costs. Although there is a fairly high upfront cost to good tax planning, in my experience it is a fraction of the cost later incurred in trying to fix a tax problem that otherwise could have been avoided. Unfortunately, since most people have not personally experienced a large unexpected tax bill, the risk of such a tax bill is often underestimated; nevertheless, it is quite distressing if and when it comes. Conversely, tax savings create dollar-for-dollar value that is available to fund working capital, growth or distributions to owners. Accordingly, my strategic advice to companies (and individuals) is to discuss tax issues with their legal counsel early and often, no less than on the ‘entry’ and ‘exit’ of every significant transaction.
Business Negotiations: When the Whole is Less than the Sum of the Parts
It’s an axiom of business that “the whole is greater than the sum of the parts.” Through the magic of synergy, a company can often create value by combining two or more things (e.g., businesses, products, marketing ideas) that interact positively and result in more than a purely additive outcome.
The same result can often be seen in business valuation. For example, two companies, each with $10 million in revenue and $2 million in earnings, might become more valuable simply by combining into a single company with $20 million in revenue and $4 million in earnings. (While there are a number of factors that make this true, a discussion of them will have to wait for a future post about business valuation.)
However, I believe that the way people handle business negotiations often results in “negative synergy,” where the whole becomes less than the sum of the parts. The problem that arises is something akin to the volume discount. When I represent a client that is selling (or licensing) something, I believe it is critical to analyze the elements of value in silos. Then, the negotiation is about the fair price to be paid for each silo. If you only think of them as a bundle, the total price may look good on the surface, but could well result in leaving significant value on the table.
Consider a business owner trying to sell her business. If she focuses only on the value to be paid for the company as a whole, she might miss several elements of value that really should be discussed separately:
- Executive Compensation: If the owner has employed herself in the business at a salary of $100,000, does that salary really reflect fair market value for the owner’s services going forward? If the owner plans to remain with the new company for an extended period, the value of her compensation should be specifically negotiated (with recognition of the fact that she would not then be an equity owner, except to the extent of any future option or stock grants).
- Real Estate: If the business owns real estate that is not income-producing (and therefore not valued in a straight discounted cash flow or multiples analysis), that real estate may have appreciated significantly in value and the price to be paid for it in the sale can be negotiated separately.
- Divisions: If the business has two divisions, one of which is mature and profitable with slow growth, and the other young and unprofitable but growing quickly, it may be a mistake to value those two divisions together.
- Revenue Sources: Similarly, if the business (e.g., a software company) has three sources of revenue – software sales (high margin), hardware sales (low margin) and consulting, training or implementation services (medium margin) – it is important to consider the value of each source individually (recognizing, also, the fact that the three sources may be growing at different rates).
- Territories: Sometimes, territories should be analyzed separately, too. For example, if you have a product that is selling high volume in the U.S. but low volume in another market (such as the U.K.), in a simple analysis the sale price may be based on the U.S. business while the U.K. business is essentially thrown in for free. If the buyer is not willing to pay fair market value for the U.K. market (and, indeed, the rest of the world), it may make sense to retain rights to those other markets for which you are not receiving value. (Note that a similar problem arises in territory-based licensing arrangements, if you grant exclusive rights to a licensee for a geographic area that is significantly larger than the area that the licensee can effectively cover in the near term.)
The benefit of thinking of all of the elements of value in silos is that you will then know, with clarity, the “sum of the parts.” Moreover, you will be able to discuss each element of value with the potential buyer, which may have both marketing and price advantages.
Admittedly, careful analysis of each element of value does not guarantee that you will be paid the full value for each as determined by your analysis – but it does help to ensure that, if you must give a “volume discount,” both you and the buyer will have a reasonable sense of both the existence and size of the discount. In addition, if you have specifically identified extra value for the buyer that is not fully reflected in the purchase price, this extra value may be used as negotiating leverage in other areas of interest (e.g., indemnification baskets and caps).
How Early to Get Your Lawyer Involved
I sat in a conference session yesterday and heard the presenter say that you should negotiate all the “deal points” of a strategic alliance before getting your lawyer involved. Lawyers can be expensive and also might introduce complications and delays into a business arrangement, so I understand the temptation to feel that way. Nevertheless, I strongly recommend the opposite course — discuss your business strategy with your lawyer early in the strategic alliance process.
A business-minded lawyer will be sensitive to cost, complexity and timing issues. But he or she can also guide you on key structural issues arising out of a strategic alliance. In the simplest case, you might negotiate the “deal points” of a distribution arrangement by establishing the price and market area. Your lawyer might then be given those terms, discuss your overall objectives with you, and then recommend an altogether different structure that will serve you better (for example, perhaps you should ask for a long-term license agreement instead of a customary distribution agreement). If you knew that early, you might easily get your business partner to agree; however, after the deal points of an alternative structure are set, it might be tougher to change course.
Similarly, your list of “deal points” and the lawyer’s list might not be the same. There are often issues that a lawyer will identify for you that you might have omitted from the upfront deal point negotiation. Sometimes these issues are more easily solved during the initial negotiation instead of after all the points you thought of have been settled. A trite, but perhaps illustrative, example is that your lawyer might encourage you to negotiate the payment terms at the same time as the price; if you only negotiate the price upfront, and then learn that your partner intends to pay only 60 days after the end of each quarter, you might have wished you asked for a higher price (due to your higher working capital requirements resulting from the payment delay) or even advanced royalties or prepayments.
In short, I’ve found almost universally that early intervention by an attorney can both (1) save money and (2) yield better outcomes by helping clients design the right structure first and resolve the right issues early. Conversely, where I’ve been brought in late, clients often grew to regret that fact because we were severely hamstrung in our ability to structure and negotiate the deal. That led to sub-optimal results for the client.
In conclusion, I recommend talking with your lawyer as early as possible in the process. He or she might give you insights that are invaluable, but only practical if you get them early.
