For those who haven’t read the book or seen the movie, Moneyball is a story of a baseball team seeking to compete by finding and exploiting market distortions in the valuation of players. Specifically, players producing high on-base percentages were underappreciated by the established baseball market in terms of their contributions to team wins. This under appreciation was reflected in lower compensation levels for these players, which allowed a more savvy team to produce more wins at a lower cost by collecting these players at a bargain price.
This same concept is applicable to all areas of business, including M&A. One area of market distortion which is not always adequately appreciated by buyers and sellers is the differing tax treatment experienced by buyers who purchase companies via asset purchase structures vis-à-vis those who do so via stock purchase or merger structures. Like many market distortions, this one has been created by the US government (any government is, by definition, a source of market distortion), in this case, by virtue of the tax code.
Specifically, the IRS allows a step-up in tax basis for acquired assets only in asset purchase transactions (including deemed asset purchases for tax purposes). A step-up allows the new owner to book the acquired assets at full market value and, for those assets that may be depreciated or amortized, realize future tax deductions on the step-up in value. For consultancies, which typically have very little in depreciable or amortizable assets, the biggest impact of a step-up is that intangible assets such as goodwill, which is the difference between the purchase price and the value of identified assets such as accounts receivable and prepaid expenses, are created and may be written off on future tax returns. For example, in a $20 million transaction where $15 million of goodwill is created, the buyer can write-off $1 million of the goodwill per year over 15 years. At a 40% marginal tax rate, this results in $6 million less in future taxes paid. On a present value basis, using a simple 8% discount rate, these future tax savings are worth $3.5 million. Thus, for the same purchase price of the same business, the buyer who structures the example deal as an asset purchase effectively pays 18% less than if he structures it as a stock purchase or a merger. Alternatively, from the seller’s perspective, his business is potentially worth significantly more to an asset purchase buyer and therefore the purchase price could be negotiated higher to reflect this.
Given the significant value differential presented by this particular market distortion, one might think all deals would be asset purchases. Unfortunately, as a practical matter, asset purchases are only realistic alternatives when the to-be-acquired firm is structured as a flow-through entity for tax purposes (i.e., S-corporation, LLC or partnership). For C-corporations, an asset purchase would result in two levels of tax (i.e. the entity would pay tax on the sale of its net assets and the owners of the entity would pay tax on the dividend distribution of sale proceeds) and this negative impact on the seller greatly exceeds the step-up tax benefits to the buyer.
Given this, one would think that virtually all privately-owned firms would be structured as flow-through entities, so that they could extract maximum value from buyers in eventual M&A transactions. While there are some cases where a C-corporation is required (e.g., where the entity desires to have more than one type of ownership position, such as both preferred and common stock), I see many C-corp. firms with no requirement to be so but whose founders simply did not get good advice when the business was formed. While it might seem simple enough for these firms to just convert to LLC or S-corp. status before a transaction closes, the IRS thought of this first and effectively forces the seller to treat some-to-all of the purchase price as though received by a C-corp. (and therefore subject to double-taxation) if the deal is done within 10 years of the conversion.
Obviously, the purpose of this post is not to provide an exhaustive, detailed and academic discussion of these issues and I’ve significantly simplified things (e.g. ignoring the potential liability impact of asset vs. stock purchases and mergers) to illustrate the general principles. Every firm should consult with its legal and tax advisors to understand its optimal approach. However, for buyers, it’s important to keep in mind the potential net value benefits in comparing relative deal opportunities involving flow-through entities and C-corporations. And for potential sellers, it’s important to consider structuring the business to allow for optimum value to the buyer and to be aware of this buyer value benefit when negotiating the purchase price. Looking for and exploiting market distortions is not just for baseball teams but can pay off in a big way in the M&A market as well.