Episode 17: Legal, Tax and Accounting Panel
on an Essential Guide To Preparing for a Successful Founder Exit

Episode Transcript

Shiv: All right, everybody. Welcome to today's episode. I'm super excited for our panel. It's a little bit unusual because normally we do one guest at a time, but the topic today is so interesting that we happened to get some really powerful and interesting guests together. So we have Hanny Akl from Warren Averett. We have David LeGrand from Warren Averett as well. And we have Zach Crowe from Morris, Manning and Martin. So guys, welcome to the show. And why don't we start by giving the audience just a brief background about yourselves and your respective firms.

Zach: Shiv, thanks for having us and great to be here. As mentioned, my name is Zach. I'm a partner in the corporate technology group at Morris Manning and Martin. We're a full service law firm based out of Atlanta, Georgia - mid-size law firm, a little over 200 attorneys with the main practice being in Atlanta. We focus on representing companies in the technology space from startup all the way through exit and then growth equity, private equity, and VC investors that invest in those tech companies.

Hanny: All right, great. And Shiv, thanks for inviting us on this podcast as well. So I'm a partner within Warren Averett and lead our transaction advisory practice. Warren Averett is a regional firm, about 800 people, 15 offices across the southeast. We've got clients across the country and in Canada, and of course, a few around the world. We focus very heavily on the technology space as well as manufacturing, health care and a few others as well.

I lead our transaction advisory practice where we focus on helping buyers and sellers get to a transaction. So we get involved very early, maybe a couple of years ahead of a transaction, all the way up to maybe the 90 or 120-day plan after a transaction as well. So basically anything that surrounds a transaction is where our TAS practice focuses.

David: Thanks, Hanny. I'm Dave LeGrand, tax partner with Warren Averett. I focus on merger and acquisitions, and then I also have a traditional tax practice. Shiv, really appreciate you having us on. Looking forward to the discussion.

Shiv: Awesome, thank you for that guys. And so what's really interesting about this group is we met at Silicon Y’all and that's headed up by Zane and the founders team. And really the topic of that conference is founders looking to exit their companies. And what I wanted to do by having you guys on is to talk about what founders need to think about as they are thinking about exiting their companies and what to look out for from a legal standpoint, from a tax standpoint, from a financial and an accounting standpoint. And so I think that's a good place to start.

And maybe we'll go to you, Zach - when a founder is thinking about their - about exiting their business, what are some of the top things that you advise them to be prepared for or get in order?

Zach: Yeah, sure. Happy to walk through some of the most common ones that we see. I mean, obviously, every company is unique. And so, work with your attorneys to get ready for a deal, as Hanny mentioned, you know, years in advance or at least a few months in advance to kind of get your house in order. That's what we always tell everybody is it's a lot easier to clean things up prior to a deal when you're not doing it under the gun of diligence with buyer's counsel who's there to force you to do it the way they want or to ding you on purchase price or to say we need another escrow or something like that.

If you can work with your counsel to get ready for a deal and stage your house appropriately, it'll make everything a lot easier when you get there. And so, in terms of that, a couple high-level things just to make sure that you do when you're starting your process is set up a data room, right? You're going to need to have one when you do a deal, and so it's good to go ahead and have one that has your contracts all uploaded, as opposed to in a drawer somewhere, goes through, and your counsel can take a look and say, this is what a standard request looks list would look like, if you don't have this, let's go ahead and put it in place, right? Let's make sure we have an IP assignment agreement from every employee. Let's make sure that employees are properly classified and if not, then we're getting things signed on that phase. Let's make sure that you're not using open source licenses that you're not allowed to use or in the wrong way. And so by doing this, you can go ahead and get ahead of the process so that then when the buyer comes and starts looking or if you're using an investment bank or they're ready to launch your data room, you're already ready here.

So that's my number one piece of advice in terms of when you're starting to get ready on the legal end.

Shiv: And when you say get the data room in order, there's a bunch of different things that need to go in there, but you're specifically talking on the legal side, and what are some essential things beyond IP assignments that you look to advise founders to make sure that they have in place inside those data rooms?

Zach: Yeah, I flagged IP assignments just because that's so important to tech companies when IP is the material value driver, but the cap table and making sure that all of the related documents tick and tie on the capitalization is going to be very important. And so, you know, if you need to go get people to sign and ratify stuff, you want to know that in advance. Having your key contracts in there with customers and making sure that those don't have any kind of right of first offer or most favourite nations provision that's going to endanger the deal is another important one. And then on the non-legal front, I mean, you're gonna need to have your financial statements in there, right? You're gonna need to have employment documentation in there. And so it's really just kind of going through with either an investment banker or a counsel and saying, can you send us a typical list so that we see what this looks like and can go ahead and see what we can load. Because a lot of times it's what you don't have that's the biggest issue.

Shiv: That's great. And so transitioning to you, Hanny, on the financial side, I think that's a great segue. What are some critical things that you look for, along with the statements, to make sure are prepared inside the data room?

Hanny: Yeah, and I'll just piggyback on what Zach was saying. We didn't even chat beforehand, but I was gonna say get your financial house in order because there is a lot to do there. And to the point you guys were making, getting your financials in there is important, but making sure you're documenting everything that you need or that a buy-side is going to be looking for just to get assurances that you're following processes and procedures. So oftentimes folks don't document how they do what they do and they're not consistent with their application. And that can be a deal killer. Of course, as we come in, folks like ourselves come in and Zach comes in and starts asking questions around this transaction and that transaction, they're all being handled differently. And so having some processes and procedures in place - I know it seems mundane and it maybe sits on a shelf for a little while, which we wouldn't recommend. But, you know, these are the things that you want to document and make sure your employees are following certain processes and being consistent. Even if it may be consistently wrong - and I hate to say that in the wrong context, we may need to come back to that. But consistency is key, versus having all kinds of things happening. So the point that Zach was making about the cap table, we see all the time, you know, where we come in and start to try to get the equity in order, of course, on the balance sheet. And we find that the cap table isn't being kept up with. And sure enough, as we get along, there's an investor or two or three or four or five or a hundred that start to come out of the woodwork. And it really does start to get very, very complex. And I think, Zach, you mentioned this just a second ago, but just belabour the point for a second. I mean, verbal agreements are still, you know, they can still be enforced. And I can't tell you the number of times we've been in transactions where it's a large transaction, and, oh, by the way, that programmer comes out of nowhere and says, hey, you promised me half this business or whatever 10 years ago and you're using my code and whatever and so you really owe me 50 million dollars of your hundred million dollar deal for instance. And so to me, you know, I don't want to get off that point too quickly because I think that's a very important facet of, you know, something. So we'll come back to the VDR in a second but, Zach, I don't know if you want to - I'll pause there and just make sure you hit that point hard enough that our listeners are hearing this.

Zach: Yeah, that's certainly a good point there. And we've had that arise in deals and you can watch your deal go away so fast when something like that comes up because buyers have no risk tolerance for there being capitalization issues. They're not going to pay you a bunch of money for your company and then have someone else come and sue them and say they actually owned a third of it instead. And so your best case is that you're gonna have to agree to indemnify for that, meaning any losses the buyer has, you'll cover them.

Your worst case is they say, look, we can't trust your capitalization reps. So as a result, we're not able to go get rep warranty insurance, for example. And so we can no longer do the deal. And so if you find this out earlier, it's easy to go deal with this and say, hey, maybe we need to pay this person a bonus and get a release from them. Make sure that there's it's all buttoned up or maybe we got to go back and find that old handwritten agreement we had with them that said they don't own anything. It's all about, you know, knocking these things out on your time. And when you have the most leverage - because once they know a deal is pending, trust me, you don't have the leverage anymore.

Hanny: Yeah, and we have tattooed on our foreheads: time kills deals. And then once you get into the deal world, you'll know this. And sometimes our clients - on the sell side, at least - learn this the hard way. And I will say our buy-side clients as well sometimes learn it the hard way because, you know, you wanna dot all your I's, cross all your T's, and unfortunately sometimes things get out of hand and start to extend the timeline, which creates deal fatigue, and that creates, of course, you know, a really harder chance to get to that closing that everybody's looking for. So back to the theme of the virtual data room - I guess I would bucket that into just getting organized. That was going to be like my number one thing - so I think Zach and I are tracking pretty well - is getting organized. And so knowing the terms of your arrangements. For instance, I can't tell you the number of tech companies that we come across that have, you know, a variety of, you know, customer contracts out there. And those customer contracts are tough to deal with when, you know, you have 10 different versions floating around and each of them have different terms, concessions, discounts, whatever they may be. Those have a tremendous impact on revenue recognition, at least on the financial side. And when we're dealing with those kinds of things, I mean, your revenue, your ARR, your MRR, whatever it happens to be, could get thrown out of whack when you start to convert over to GAAP, which, you know, let's pause on GAAP. We'll get to that in a second. But back to the theme of getting organized. I think, you know, just knowing your terms of your arrangement. Zach mentioned having your employment agreements, having your cap table sorted out and reconciled, mAklng sure all the agreements are memorialized, whether they're verbal, convert those over to written. Trying to get all of these things organized. And then the only other thing I'll say is, mAklng sure you're tracking the data. You know, you may not be on GAAP, and we'll talk about GAAP in a second, but tracking your data. I mean, that's important. You know, knowing the lifetime value of your customers, showing your ARR and MRR. I can't tell you the number of folks that quote these numbers, but they don't really reconcile back. So every time we get into diligence and we get going, we hear, here's the ARR, here's the valuation of this business, here's how we came up with that valuation. And we go to reconcile that number and that number doesn't tie. And we're having to figure out, well, why doesn't it? Well, this agreement was included, that one fell off. So churn becomes something very important to keep up with as well, and oftentimes folks don't know their number there. And so tracking the data to have all of these KPIs.

Shiv: How - and just to jump in on that piece - how frequently do you find that founders don't have a tight grip on those KPIs and dashboards so that it's already in the data room before a deal cycle begins?

Hanny: Yeah, I'll let the others throw their opinion and vote on this, but it happens more often than not, to use an accounting terminology. It happens very often.

Shiv: Zach, has that been your experience as well?

Zach: Yeah, certainly. So, you know, we wish that it happened less often. And that's part of, you know, having good service providers in advance of a deal and, you know, going back to our original theme of getting your house in order. But yeah, it happens a lot. And we're trying to help reduce that over time. And I'm sure Hanny is as well. But yeah, I agree.

Shiv: Yeah, we've seen it on our front too, where companies don't have a full understanding of where revenue is coming from and then they're not able to figure out how to invest more. And it likely affects valuations too, because if you don't have that information on hand, it's harder to tell a story about the future potential of a company, right?

Hanny: No question, no question. I mean, that number changes even a little bit. Your multiple may change, assuming we can get into multiples if you want to, but I mean, your multiple may start changing if that number drops below a certain size that folks were expecting. Those investors are expecting a certain size business. They'll throw a size multiple on top of that if they need to pay a premium. As that ARR or MRR starts to fluctuate, valuation definitely changes, but I mean, I think trust and confidence in the deal is probably that much more important because I mean, once one thing, the most important thing doesn't tie. What else have you told us that, you know, we need to dig into? So certainly, yeah, absolutely.

Shiv: That doesn't add up. Right. And you mentioned GAAP. So I think this is a good place to touch on this. And then I want to bring David into the conversation after you answer this - is the ARR and the growth metrics and the churn - that's like one side of the data house. And then you have like your actual financial metrics and your revenue recognition and all of that needs to be in order. And then that also affects tax implications. So, Hanny, maybe you can start with the GAAP side of things and then David, I'd love for you to jump in there as well.

Hanny: Yeah, no question. So generally accepted accounting principles is what we're talking about, United States GAAP. Most every investor, small or large deals alike - I mean, we work on a wide range of deal sizes. So really, you can't say ‘the small deals don't really need this, the big ones do’. Almost every deal we work on, the investors require the financials to be under US GAAP. And it's to create consistency, of course, so they can kind of value these businesses, you know, based on what they've seen across the board. 

And so that US GAAP is what we're talking about. And it's really accrual-based accounting, right? So getting away from tax-based accounting, getting away from cash-based accounting, getting away from hybrids, because there's plenty of those out there, and truly focusing on what does GAAP, the standards, thell us to do, and then reporting your numbers based on that. And so the biggest thing for tech companies - there’s three, probably, ones that I would bucket, revenue recognition, which we just talked about, you know, knowing your performance obligations, creating a fair value for those, and recognizing them at the right time. And all too often tech companies recognize revenue earlier than they should. And so the standards are written in a way to defer as much as possible, unless you're assured that you've earned - basically earned the revenue that, you know, you're about to record. So oftentimes tech companies will bill in advance. And of course, they'll recognize all of that revenue during billing, and the standards would require you to defer that and recognize it over time or as you deliver the performance obligation. So we won't dig into that on this podcast. We certainly can get into the standards when the time's right. So revenue recognition is one and deferred revenue is a big component of that. So ARR becomes a lot less if you start going under GAAP. Generally speaking, in a growth business, you have to assume that revenue is less under GAAP than it is under cash basis.

Shiv: And the reason for that is that you may have an ARR run rate by the end of the year, that's 10 million. But if you did it by GAAP, that future run rate isn't earned till the next December or whatever it is. So you're waiting on that revenue. So you might be closer to 8 million, for example.

Hanny: That's right. That's right. And it doesn't mean the revenue is not there. I think that's an important point that sometimes investors and diligence teams get lost in. So I am going to say, hey, always kind of step back and think about, you know, the mechanics and what the true essence of the deal is. I mean, it doesn't mean the revenue doesn't exist and we won't get into diligent situations where the revenue truly doesn't exist. In this case, just talking about GAAP, it happens where, you know, your revenue is deferred and it's sitting on the balance sheet, but it'll come in, like you said, into the next year and it'll work its way up. So again, as a growth business, if you are truly growing, typically GAAP would show less revenue than more.

And so you're expecting that revenue to start to make its way in. There is a reconciliation to get to MRR and ARR. You just have to kind of work that through. That's what we were talking about, you know, earlier about getting the GAAP and then knowing your ARR and MRR and knowing how to get to that number. So that's one bucket of revenue, deferred revenue. The other one is capitalizing your software costs. So GAAP allows you - it actually requires you to capitalize those costs. And so all too often our business owners don't know what those numbers are.

So tracking those and following what GAAP says is going to be important. There's a lot of rules that we won't get into today, but definitely understanding the rules, at least on the surface, and tracking the data is what I mentioned before. That's what I would suggest today. And then stock-based compensation, so stock options, things like that we mentioned earlier. We really need to just make sure you're tracking all of that as well. So those are the three major GAAP items. There's plenty more, of course, but these are the three that we see all the time.

Zach: And on my end, you see this play through in the legal documentation of a purchase agreement when you're dealing with it as well, right? Because you're going to be making reps and warranties to your financial statements and are you going to be able to say those are actually GAAP? Are they GAAP-ish? Are they completely something different to where we've got to work with your accountants to come up with a standard that the buyer can get comfortable with? Because all of these things flow through the financial definitions in the purchase agreement. So when you're setting a working capital target, right? When you're doing true ups for determining what's cash? What's debt? Things like that. They're typically tied to GAAP definitions. So if you don't do GAAP accounting, there could be a disconnect there where you're not recognizing bonuses correctly or things like that. And it really, you know, can slow things down in the deal. And as we talked about, you know, time is the killer of all deals. Well, this could be one that can mess things up, especially if you don't have a strong CFO or accounting firm.

Shiv: David, what are your thoughts on that from a tax perspective, and companies not having this data organized and then as they're getting the revenue rack, what are the tax implications of that?

David: Yeah, so when somebody comes to me and they're thinking about selling their company in 6, 12, 18 months, I usually ask three questions just to back up a little bit, big picture. I say, number one, do you have an attorney that specializes in mergers and acquisitions? Not your high school buddy who dabbles on the side, but somebody who specializes in this because it is just so, so critical. I also ask if Hanny and his group can talk to them about EBITDA, ask them some questions about their financials to start getting ready in that sense. And then I also ask, have you engaged an investment banker? Are you looking to run a formal process? Kind of what's your timeline to try to get, you know, the landscape of what they're thinking about and what they're trying to achieve. And then I guess specific from a tax perspective, when we're doing buy-side diligence, we keep seeing the same four or five things pop up pretty consistently irrespective of deal size, whether it's a $2 million deal or a $250 million deal, we see these same five things pop up kind of over and over again. And I can get specific into them as you want. But if you're an S corporation, which a lot of the targets and the deals that we work on are, is your S election bad? Do you have disproportionate distributions, more than one class of stock? Have you done some things with owners or other things that you may have done in the past that may violate your S election? Because that can completely change the paradigm and the entire tax landscape and how a business gets taxed when either you sell it or when you buy it. So I think that's a really important point.

Second, are you current with your sales and use taxes? Do you have all of that covered? Because there's 50 states and there's 50 sets of rules with respect to sales tax, and particularly in a SaaS context, they all treat it differently. And a lot of times, you know, people aren't organized with that, and they've got a lot of exposure there. And we see a lot of deals set up big escrows or get retraded over sales tax issues. A third thing would probably be state income taxes, either from a physical nexus standpoint, meaning, do you have payroll there? Do you have property there? Are you filing a tax return in all those states? And then from an economic presence standpoint, a lot of the states are moving to more of an economic test whereby if you just have sales there over a certain amount or a certain number of sales, they believe that they have a right to tax a piece of your federal income in that state as well. So we see a lot of exposure in the state income tax area with these nexus questions that - nexus is just a state's right to tax a piece of your federal income. So that's another area that we run into things a lot.

Another thing that's - two quick ones that are new is R&D expenses were typically deducted as you paid them. There's a new law that has kind of come into play effective last year, in 22 forward, where you're required - Hanny had mentioned that you capitalize your software development expenses for GAAP. Starting in 22, for tax you capitalize those R&D expenses five years domestic and if you've got some offshore R&D development

We see this a lot. It's a 15-year amortization. So if you've got a couple million dollars of expenses there, you're supposed to capitalize those over potentially 15 years. So you get like one 30th of it in the first year. This can kind of be a big timing difference for people, can provide some exposure. And so buyers can get a little concerned if you're not paying attention to that. Business interest is another area that has changed in 22. These are kind of some of the back end revenue raisers on the tax cuts and jobs acts from 2017. The last five years of that 10 year score.

These couple of things have come into play and they've caused some timing differences. They're reducing business interest. They changed the formula for that with respect to depreciation and amortization, which can be a big number for a lot of private equity and venture buyers. So that's another piece. The other thing we see is employee retention tax credits. This is a reasonably controversial area. There's some bad actors out there that are pushing these with a lot of our clients and other people out in the business community.

So people may have some credits out there, may have gotten some money with respect to these payroll tax refunds that may not be good. And we're seeing a lot of people getting nervous about that, setting up a lot of escrows and re-trading deals there. So those are probably the five biggest tax areas that we've run into the last couple of years.

Shiv: How often are you coming into a situation where you kind of have to rebuild everything from scratch to make sure that all of this is - all the T's are crossed off and all the I's are dotted just in the right order, just to make sure that the acquisition goes through? And then one of the things, Hanny, you said earlier, is just that time kills deals. And you kind of are a little bit under the gun to do all this and at the same time do it in the right way. So how do you strike that balancing act?

Hanny: Yeah, I think it - Zach's mentioned this earlier. I think it starts far sooner than a transaction, right? So I mean, you may be considering doing a transaction in a year or two or three when you hit a certain metric or accomplish a certain goal that you're trying to accomplish. So, you should be hiring the right advisors at that moment. You should be thinking about the transaction at that moment so that all your ducks are in a row basically. And so do you get audits or reviews from our perspective?

Zach, I’ll let you chime in here in a second, but do you get audits or reviews? Reviews are a nice step to get to an audit, but audits can add value to the business in a lot of different ways. And so at what point do you engage an independent accounting firm, independent accounting firm, to come in and do some of this assurance-type work?

Zach mentioned investment bankers before - it's never too early to talk to those guys. They're always willing to talk. There's plenty of good ones out there. And the idea is to just kind of have a conversation around, here's what my business looks like, and how should it look in the future? And then we have, as I mentioned, we have services called Value Creation. Before a transaction is two, three years in advance, it's exit planning in a nutshell. There's plenty of folks that do this from the legal, financial, other sides, operational side even, and just talking to those folks about, okay, where are our weaknesses today? What is valuable to a buyer? How do we build this business so that it's very attractive and therefore yields the best result down the road?

And so having these discussions early - I think that was going to be one of the points we discussed was, you know, getting organized, get your VDR in order and make sure you hire the right folks or find the right mentors at the right time. And so to answer your question, Shiv, I think it starts far sooner than most think. And so how often do we rebuild financials? I mean, it happens… often. It's not always as disastrous as we're making it seem. I mean, there are situations where we'll find adjustments and things during what we're doing in diligence and does it create a retrade situation? Maybe, it just all depends. But we see it often enough that we have enough diligence adjustments that they will require people to think a little bit harder about the deal itself and you never want that. So, back to the point, let's just make sure we avoid all the unexpected issues and the way you do that is proper planning. I mean it just it just requires you to plan ahead.

Zach: Yeah, on my end, you know, I agree with all that, the one that kind of rears it’s head the most in our deals, especially if they don't have a long standing relationship with an accounting firm that is in this space, is sales and use tax. And so a lot of times we'll be dealing with someone that thinks, okay, well, I do have an accountant. So I've been, you know, I've been GAAPish or close enough. And so I'm doing everything right. And then we're in a deal and all of a sudden diligence gets in sales and use tax and they don't know what that is and their accountant is unsophisticated and doesn't know what that is. And then we're trying to scramble to bring in new accountants that are larger, that have more experience than that. And that's one of the worst ones that you can have to deal with, you know, at the end on a deal because you're going to have a buyer that's going to take a very, very conservative approach and try to ding you for the largest amount possible. Whereas if you had been remitting sales and use tax over the years or doing the VDA process to remediate and stuff, you could have ended up saving yourself a lot of money and a lot of time and effort there at the end.

And so that's the one that's a real pain point on our end, probably just because I had it come up with a deal last month, but it's one we see a lot.

Hanny: And we're in the middle of one right now. And I don't know, Dave, if you're - you've seen this one, but I mean, our sales and use guys calculated zero to $2 million of escrow, which is a massive range. It's a billion dollar fund that's trying to purchase an add-on. So basically a small deal that doesn't warrant a $2 million escrow for sure. But I mean, it can derail the deal and it's - we're in the middle of negotiating that right now. And the business owner, unfortunately, all too often doesn't understand that this issue doesn't go away with another buyer. It will always be there. And it's just something that you weren't aware of before. Now, you know, the diligence team has found this. The only answer is to escrow at best case scenario. Walking away from the deal isn't going to take away the exposure. So, you know, how do you fix that situation when you as the buyer, or, sorry, you as the seller were expecting to have a windfall of cash coming your way at the deal closing, and now you're not getting that same windfall. And, you know, maybe you have to wait a year or two or three for that money to hit your account. It's a tough pill to swallow. So I'll just kind of...

Shiv: Good. Can you explain that process on the escrow side? Because yeah, there's what you get in the term sheet and then terms can be adjusted and all that. But just for founders who don't understand like how something like that can affect their outcomes.

Hanny: Yeah, I'll let Zach - why don't you start with the legal side and Dave, I'd love for you to finish that off and talk about how tax actually impacts deals far more, not just sales and use tax, but the actual after-tax proceeds.

Zach: Yeah.

David: And planning ahead. Like I'm gonna talk about a five-year-ahead situation here in a minute.

Hanny: Yeah. All right, y'all go for it.

Zach: Yeah, so on the escrow piece of it, generally you're going to get an enterprise value that's going to say this is the high-level money that we're paying you and then it's going to be broken down into different components and you're going to have more often than not an escrow or a hold back for indemnification coverage. Sometimes for other things - we'd like to minimize those as much as possible - typically a small one for working capital adjustment. But what we're talking about here with the sales and use tax is, buyer identifies that there's exposure there for those kind of taxes -  or other taxes. There can be other things, right? You know, a specific litigation, certain things that want to renegotiate and have another separate escrow. And what the escrow means is, money, instead of getting paid to you and your shareholders at closing, gets stuck with an escrow agent and sits there for the time period in order to secure obligations that you may have. And so for the sales tax example, any taxes that they identify within that period - which is typically going to be a couple of years because they're looking back and they're going to take a couple of years to go handle them - is going to get taken out of that escrow account by the buyer to pay those off. And only what's left will be reduced to you - released to you, sorry. So if you have a $5 million sales tax escrow, they have to use three and a half million of it to go pay taxes and penalties that are associated with them and their cost of their experts and things like that. You're only going to get 1.5 of that. So all of a sudden your 100 million dollar deal that you thought, oh, I'm going to get it all, well, you didn't get all of it. And so the less that we can keep in escrow and the more that we can get paid to you at closing, the better, because it's tougher for them to come take it back than it is to not release it to you.

David: Yeah, on the sales tax, I've got one with an escrow that we're working. There are some voluntary disclosure agreements now to try to get that mitigated and try to get our guys as much of that - much of that escrow going to the sellers as we can. Got one of those going on right now. Happens more often than people realize on the sales tax. And then I guess just going back to the planning that Hanny had kind of touched on, just specifically one of the - one of the areas of the tax law that is really taxpayer friendly is it's called Section 1202, but a lot of people call it Qualified Small Business Stock, QSBS. If you're a domestic C corporation for tax, you can exclude 100% of your federal capital gain from taxation if you meet all the requirements for this. And it's just, it's really wonderful when it works. And it's really unpleasant when somebody thinks that they have that and they don't because they did a redemption or they did something that disqualifies them from this particular area of the tax law. So one of the things with 1202 stock is you have to hold that stock for five years. So going back to the planning, you can go back five years before you think you might do a deal and you want to be set up with that kind of structure so that your shareholders can hold that type of stock for five years to hopefully achieve that tax result. So you talk about a $100 million deal, the limitation is like $10 million per shareholder, per issuing corporation. And then if you've got, it's the greater of that or five times your basis. So if you've got somebody who puts $5 million into a C corporation, they can exclude $50 million of gain. That's $10 million of tax at the federal level at long-term capital gains rate. So it can be a really material element of your deal that can really make things a lot more efficient, put a lot more cash in your pocket when you get done paying off your debt, paying all your fees and paying your taxes. You want that final number, that final wire, that you get to keep, to the sellers to be as high as possible. And I think good tax planning can just be a huge piece of that.

Shiv: And so how would founders go about structuring things the right way? Like if they are thinking about this, David, at least from your perspective, what would be the right steps to take to protect themselves as much as possible here?

David: Yeah, so I'd say just call us or your tax advisor and talk through the requirements of 1202 qualified small business stock. You wanna have a domestic C corporation that's clean, that has original issued stock to your shareholders. There's five or six other requirements, but the biggest issue is domestic C corp, five year hold, the right type of industry can kick you out, don't do any redemptions. This is a provision in the tax law that Congress intended to incentivize people to invest in small corporations. So I think there's a $50 million enterprise value, asset value requirement, but if you wanna check all the boxes and be real careful about it, and what we like to do in that situation is we'll write a memo and walk through each of the requirements and how we believe your corporation likely meets that requirement so that we can have that memo go out to the CFO or the board of the company that's selling and they can get that memo out to the shareholders' individual CPAs because the exclusion is actually taken at the individual shareholder level. So a lot of times we're not the CPA for the individual shareholder. So we like to have a memo. And a lot of times the lawyers will put that with a signature package and say, here's some of the tax ramifications that have been planned for you. Here's a memo you can put in your file. And here's a way to kind of document the position that we're taking here.

Zach: Yeah, and it's a big part of the way that we structure growth equity and venture capital financing as well, right? A lot of those have secondary components of it where the founders want to take some liquidity off the table. And there's ways that you can structure that to not be a disqualifying redemption if you're using counsel that kind of knows what they're doing in this space. The number of times that we've had clients come to us that we didn't start as their counsel and they come and they ask about QSBS because they just heard about it. And then they say, oh yeah, but the company bought out my co-founder last year and we paid him this amount of money. And we said, sorry, you're not going to be able to get it, you know, or you didn't - you just didn't think through and structure. It happens all the time. And so I agree with planning well ahead and in advance of an exit for that because it may be available and you didn't know it. And if it's the difference in selling, you know, six months earlier versus waiting and you avoiding all of that taxable gain, it can be a deal changer.

David: Yeah, 1202 qualified small business stock can be really, really material.

Shiv: Right, right. And from a founder's perspective, and just, you know, I'm a small business owner, there's so many small businesses, even if you're a software company, let's say doing 10 million in ARR, relatively, it's not a massive company. There's a lot of work here, right, that can sometimes be taken by founders as distracting work, right? There's a cost to it, it takes time, there's a trade-off between doing this work versus other work. And at the same time, those founders don't have full-time CFOs or maybe they have some sort of an accountant doing their basic bookkeeping and all of that. So taking on this work before you actually have a potential deal feels like a bit of a risk because you're paying for the bankers, you're paying for the legal help, you're paying for the financial help. So just curious to hear your take on that piece because founders are always kind of balancing their cashflow and limited resources and trying to prioritize this when at the end of it, there might not be a deal at the end of it all anyways.

Just want to hear what you think about that.

Hanny: It's a tough question. I'll jump in first and let these guys simmer on it. But I've been a small business owner myself and it's like you said, you're wearing multiple hats, you've got limited resources as you know, and you gotta pick your battles. So, you know, you gotta prioritize best you can, like you said, I mean, we're talking two, three, four years in advance of a transaction here.

At that stage, it's so far in the distance, like you said, maybe a deal isn't to be had. But the ideas here that we're promoting, at least beyond just the structuring, maybe QSBS falls outside of this, but the ideas we're promoting is more about planning ahead and increasing value in the business regardless, right? So GAAP accounting, for instance, doesn't really add a lot of value, right? You're looking at it and saying, well, I could get on GAAP and what good does that do me today? I should be out beating the street, finding new customers, getting them in here. If you wait too long, it's gonna be hard to reconstruct your books back to what people are expecting to see, right? So while you're right, that maybe the time commitment isn't quite - it doesn't quite provide the value you're looking for today, at some point, it'll catch up to you and it may bite you and that's what we're trying to avoid. And so you gotta find enough time. So that's why I put it in terms of tracking the data and getting organized - you don't have to be on GAAP today as a great example, but getting to GAAP-ish or having the data to rebuild GAAP when you need it. So knowing the terms of your arrangement as an example, knowing where your deferred revenue may fall out, having all of those terms in place so that somebody like ourselves can come in and recalculate that quickly so it doesn't take forever. That's the key. So as a small business owner, for me, I would say you're right. You're completely right. Focus on the bread and butter of the business. Build the business, but continue to sophisticated the business in little ways all along the way and track that data. Make sure you know what you need. So that's why you need to talk to advisors, mentors, whoever, know the data that you need and start tracking it and keep it organized. That doesn't require your entire day. Doesn't require you to have a CFO or a controller. But at the right time, hire the right advisors, hire the right CFO, hire the right legal team, whoever it is. So I'll stop there and let Zach jump in.

Zach: Yeah, I mean, I think that's spot on, right? It's about balance. It's about doing what you can now with the time that you have and the resources that you have now and makilng sure that you kind of talk to the right advisors for someone that's your size and the amount of time and resources that you have, right? It wouldn't make sense if you're a young startup company to go get a big four to do all of your accounting work or the same on the legal perspective. You don't necessarily need the largest law firm in the world to help you out. You should work with people that are used to working with companies your size and what you're hoping to get to, that are willing to be flexible with you and know that you have finite resources and time, and are used to working with startup companies because those are the people that are going to tell you, in honest advice, ‘here's what you need to do now. Here's what it would be nice if you could do eventually. And here's what's not really relevant to you, so don't waste your time and money on it.’ That's called being a good partner as a service provider. And you know, Hanny's point about choosing the right one, it can be worth its weight in gold for sure. When you get to this exit and you realize, wait a second, this person just saved me millions of dollars, you know, that I wouldn't have had.

David: Yeah, and on the tax side, I think like Hanny said, it's prioritizing. I mean, if I can take a look for a couple of days at some returns and ask some questions, maybe an hour phone call, that'd be about it. Try to get the landscape. Do you have a big nexus issue? Are you missing a bunch of states with sales and use taxes? You're S election bad. If we can kind of pick out the biggest two or three things, then over a couple of years, you can work on that and not chew up too much of your day. I think that can provide a nice return when you get ready to go to market.

Hanny: It's just all too often business owners pinch pennies. It's fine, right? You're running with a short stack anyway. So you wanna try to pinch the pennies, put it in the best place, but you get what you pay for, and sometimes you get what you don't pay for, and so you just have to be careful. So to Dave's point and Zach's, I mean, just not waiting so long and pinching so many pennies that you hired the wrong folks to do your tax return that didn't know anything about having to file in this state or that state or whatever. Maybe you had to pay an extra 100 or 500 or $1,000 that year and the next year and the next year. That comes in worth its weight in gold down the road, knowing that, you know, you've checked all the boxes you need. So that's the part about not pinching pennies so much that it actually hurts you in the end. But being frugal isn't a bad thing either.

Shiv: Yeah, I think just in my experience, we've found a lot of success - we don't have a full-time CFO, we have part-time help. And I found, just as a CEO, keeping on top of finances at a, at a very simplified level, like our cashflow, what's our revenue projection, what's our EBITDA margin going to look like, how much are we going to owe in taxes every year and remitting that regularly, making sure we're budgeting for all the activities in a good way, whether or not the business is going to get acquired is almost less relevant. That foundational work helps you actually scale faster because knowing how much cash you actually have on hand is, is like a superpower because you know how much you have to invest in and, and what kind of targets you can kind of work towards. So I think all of that is, is a really, really sound advice. And that's a good, good way to kind of end the episode. So with that said, if there are founders listening, how can they learn more about the work that you guys do and avail themselves of your services?

Zach: Yeah, on my end, I mean, you can visit our firm website. Morris, Manning and Martin is the name of the firm again. To reiterate my email address, which I'm sure we can post with the podcast, is [email protected]. We've got lots of free materials outlining a lot of these points that I've gone over that you could take a look at. So to the point about, you know, using resources effectively, they're free. And I'm always happy to chat, kind of as Dave previewed, I'll go through with an hour for you and talk through things and just identify high level for you so that we can hopefully be your partner eventually.

Hanny: Yeah, and we're no different. So warrenavart.com, our website, has plenty. I think our transaction advisory page has probably a lot of these materials that we're talking about as well. And to Zach's point, I mean, our firms are very similar in this regard. We love taking these kinds of phone calls, no matter how small or large the businesses are, we work with all of them. Dave and I both - and I think Zach, you are as well - mentors to smaller companies, startups even. And so we're always happy to take these calls and just walk through things that people need to know. An hour, or two or three never hurts. We're always happy to do so and give back to the community. So for us, we'd love for y'all to reach out. Let's just talk through whatever the issues are. If we don't have an answer or can't be helpful, we obviously know some people that do, so that's the way we generally operate. So check out our website.

Shiv: Awesome. So we'll be sure to include all of that in the show notes. And just from my side, I know you guys have worked on a ton of deals, sometimes together and with a bunch of common friends and other investors and companies that we know. So hopefully that testimonial goes a long way. And with that said, thank you guys for doing this. I thought it was a really interesting conversation. I actually wish we had more time, but I think at least it's a good starting point for people to come in and learn more about what you guys do. So thank you.

Hanny: Thanks for having us

Zach: Thanks for having us.

David: Thanks for having us. We appreciate it.