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Accountant’s road map; business exits

Family businesses often trust (and expect) their accountant to guide them through every stage of the business life cycle, including significant one-off events such as a business exit.

Insights Scott McKenzie and Andrew Henshaw, Velocity Legal 08 October 2021
— 8 minute read

Complex or significant business exits can leave many advisers feeling out of their depth, particularly where a sophisticated buyer is involved (such as a private equity firm or a much larger competitor).

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Scott McKenzie is an accredited specialist in commercial law and Andrew Henshaw is a chartered tax adviser. Both regularly advise on M&A transactions and work closely with accountants to see deals through. Read on for their guide to business exits, including the industry knowledge crucial for any accountant.

Stage 1 – Preparing for sale

Before a potential sale is even negotiated, it is important to ensure that the business is sale-ready. In preparing a business for sale, think ahead and rectify issues that may cause a buyer to have second thoughts or seek a price reduction due to perceived risk. The necessary preparation will vary business to business, but might include ensuring:

  • Employment agreements are in line with best practice
  • Existing business contracts with suppliers are up to scratch
  • IT systems are protected against cyber risks
  • That any lingering disputes or litigation are resolved
  • Intellectual property owned by the business has been appropriately registered

By making sure the business is sale-ready, you can limit the risk of any surprises being uncovered in the due diligence process that might cause issues (including the transaction falling over).

Stage 2 - Initial discussions and transaction structure

Initial discussions

When a business sale is in the early discussion phase, business owners and their accountants should be careful not to make any representations about the business that might be misleading or deceptive.

Transaction structure

One of the first things to consider is what is for sale (e.g. shares in a company or “business assets” such as goodwill, land, intellectual property or other physical assets) and who is selling (an individual, discretionary trust, unit trust, partnership or company). Depending on your client’s circumstances, these differences are likely to shape the complexity of the deal and the ultimate take home sum (after tax).

From a seller’s perspective, a share sale will often result in a more advantageous tax position. However, this is not always the case – particularly where the seller has a multi-tiered corporate structure or where small business CGT concessions apply.

While a seller often desires a share sale, this approach usually results in significantly higher legal risk for the purchaser, as the underlying business might be burdened by any number of “skeletons in the closet”. For example, this may include historical tax compliance issues, employment arrangements, wage theft and superannuation non-compliance, intellectual property ownership concerns, key contracts and general litigation against the company. In contrast, the legal risk for a purchaser for an acquisition of business assets is much lower.

Stage 2 – Term sheet

Once the initial discussions are complete, the deal will enter into the next stage – sometimes referred to as the “Heads of Agreement” stage. A “Heads of Agreement” document, also known as a “Term Sheet” or a letter of intent (LOI) sets out the key terms of the deal and acts as a rough framework of the transaction. An LOI is also useful to:

  • Get the ball rolling on any necessary governmental approval processes
  • Establish a schedule for all necessary steps leading up to the completion of the transaction
  • Protect confidential and proprietary information disclosed during negotiations
  • Facilitate funding for the sale

Most LOIs are non-binding and do not contemplate the full legal detail of the sale. There are good reasons for this, such as deferring a CGT event until the formal contract is signed and that the necessary level of due diligence has not yet been performed.

Despite this, LOIs are an important negotiating tool. All too often, a client will approach us to assist with a transaction after they have already signed an LOI, thinking it is not important as it is non-binding.

In fact, an LOI is both an opportunity and a potential threat for the client. It can often be hard to move from the position adopted in the LOI, so it is important that the deal is fully considered prior to an LOI being signed.

At this stage, considerations include the overall tax position of the deal, particularly regarding items such as bonuses, incentive payments, salaries, scrip for scrip, earnouts, small business CGT Concessions and CGT.

Stage 3 - Due diligence

Most complex or significant business exits will be subject to due diligence. Known as “DD”, due diligence will often be separated into “accounting due diligence” and “legal due diligence”.

The exact due diligence process will depend on assets being sold, the seller entity and the commercial terms of the deal. Some things to be wary of in the legal due diligence process include:

  • Investigating the business’ most important assets, and any interests registered on the PPSR (Personal Property Securities Register)
  • The number of seller and guarantor entities
  • Any intellectual property held by the business
  • If the business has a physical presence, investigating the terms of any leases or titles
  • Any contracts the business is a party to
  • If the business has been engaged in any litigation
  • Whether the business’ employment contracts and enterprise agreements comply with best practice
  • A request for information – often shortened to RFIwhere the buyer prepares a “shopping list” of questions with varying levels of priority. The seller will then respond to the questions in turn, and the buyer may request later clarifications to those answers

Stage 4 – Negotiating, contract preparation and ‘deal fatigue’

Lawyers and accountants will be heavily involved in the negotiation and contract preparation phase of a business sale. For accountants, their involvement will mainly be needed for the financial aspects of the transaction.

When I am engaged in a business sale transaction, my client and their accountant are often surprised by just how many times a sale contract needs to be redrafted. More often than not, deal fatigue creeps in, and you might find yourself agreeing to things you never would have at the start of negotiations.

My tip for avoiding deal fatigue is to deal with the major commercial issues upfront – this comes down to good planning and strategic prioritising of the most important aspects for your client. Every party to a transaction starts out with what I call “early-stage deal energy” – this energy shouldn’t be wasted on granular items that have no real significance. Instead, start negotiating on the big items first despite the temptation to leave them until later. By dealing with the big issues first, you are less likely to make late-stage concessions just to push the deal ahead.

Stage 5 – Completion

Every deal will have a number of deliverables that must be satisfied to complete the deal – Completion refers to the point in time when all the conditions for completion are satisfied, often subject to a long stop end date.

The required steps for completion to take place are known as the “Conditions Precedent”; once finalised, each party must work towards completing all the deliverables before the ownership of the business is officially transferred on completion.

Stage 6 – Post-completion

Post-completion, both parties will want to put the deal and its terms behind them – but most of the time, this is not entirely possible. Buyers and sellers are likely to be bound by restraints on their future conduct, as well as post-employment obligations to the other party.

If shares are sold to an entity that is part of a tax consolidated group, accountants will need to lodge stub returns, e.g. a tax return for part of a financial year only before the business is taken on by the group.

Straddle returns, e.g. a tax return for the full year the transaction occurs in, also needs to be lodged. Although these are typically prepared by the purchaser, the vendor will also have various obligations to prepare information for that return.  

Deal jargon dictionary

Data room

The data room refers to where all of the documents relating to the transaction are stored. In the past, the data room was literally a room dedicated to the transaction documents – but in modern times, data rooms tend to be stored online or on an electronic drive.

Warranties

A warranty is a contractual promise that one party makes to another. For example, a sale contract might include a warranty that the business holds all the necessary licences and permits to operate. From a buyer’s perspective, warranties are commonly sought to provide the buyer protection if things don’t stack up to expectations. A seller will want to limit their risk under any warranties given to the furthest extent possible to ensure they can walk away from the business with peace of mind. It’s not uncommon for warranties to span several pages and be heavily negotiated between the parties.

Indemnities

An indemnity is essentially a promise to compensate for losses that might arise, including those that occur after the business has changed hands. These are often conceptualised as a promise by one party to financially protect another party if certain events occur.

Restraints

Restraints are relatively self-explanatory: they restrain a party from doing certain things after the deal is signed for a specified period of time. Commonly, a buyer will want to restrain the seller from competing with the business that they have just purchased, understandably. However, the seller will be reluctant to agree to any restraints on their future conduct, wanting the cleanest, no-strings-attached business exit possible. This creates a natural tension.

Restraints can come in many forms and the legal frameworks that interpret restrains can vary wildly between state jurisdictions. Ultimately, it is important that the boundaries of the restraint are appropriately drawn to prevent unfair outcomes. Some deals effectively pay vendors not just for the purchase of their business, but also to sit on the sidelines and to not interfere with the business that has just changed hands to protect the business’ market position and competitive edge.

Earn-outs

With COVID-19 and its impact role in volatile and uncertain economic conditions, earn-outs play an increasingly important role in business exits. They are useful when the parties either cannot agree on an upfront price or want to make the price contingent on economic performance. They can also work in reverse – the buyer may be obligated to pay back some of the purchase price if certain conditions are not satisfied.

The tax consequences regarding earn-outs are complex, but in general it is desirable that an earn-out qualifies as a “look-through earnout right”, rather than as a separate draft asset under Taxation Ruling TR 2007/10. Complex questions also arise in considering how much an earn-out could be taken into consideration for the purposes of the $6 million net asset value test.

From a commercial perspective, earn-outs require a careful weighing up of the pros and cons, and can have unexpected tax consequences if not carefully considered. In particular, sellers should make sure there are appropriate parameters included in a contract of sale to prevent the buyers from artificially constraining performance to avoid triggering earn-out payments.

Scott McKenzie, director, and Andrew Henshaw, managing director, Velocity Legal

Accountant’s road map; business exits
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