Prepare and Prevent Common Due Diligence Issues in Health IT Transactions: Accounting and Tax Considerations (Part 1 of 6)September 28, 2017
Over the next few months, HGP is publishing a 6-part research series covering a range of due diligence issues that are common to Health IT and Services transactions. The 6 sections cover: Accounting and Tax, Legal, Human Resources, Operations, Intellectual Property, and Technology. In today’s edition, we are covering the Accounting & Finance topics.
When a buyer performs due diligence, they will mostly likely perform a “quality of earnings” analysis (QoE) of the seller’s accounting records. The QoE involves a third-party accounting or consulting firm retained to analyze the books of the selling company to ensure accuracy in accounting from a GAAP perspective. The most common pitfall experienced by sellers during this process is failure to comply with GAAP standards of revenue recognition. Health IT is notorious for a range of revenue models, including perpetual license, term license, prepaid subscription, monthly subscription, implementation, prepaid maintenance and other core revenue streams. Given the potential accounting complexity coupled with accounting standards that can be hard to interpret, it is not uncommon for companies to be out of compliance with GAAP accounting policies for revenue recognition.
Most health IT companies that we see at HGP do not capitalize any research & development (R&D) expenditures. The minority that do must ensure that they are performing this accounting tactic both accurately and consistently, from both a GAAP and tax perspective. Sellers should also be prepared for a buyer to challenge the policy of capitalizing expenses, and if they expect to be valued off EBITDA, be wary of how valuation might be impacted with or without expense capitalization. Finally, sellers should be self-aware about whether capitalized R&D is a one-time expense for software development or a recurring expense for software maintenance. A seller has a stronger case to take EBITDA capitalization adjustments for a one-time development project than for recurring development costs.
For businesses that are closely held, shareholder operators may pay themselves an above market or below market compensation package. Most buyers will “normalize” owner compensation to market rates when purchasing a business. Sellers should be self-aware of whether owner compensation will be adjusted up or down to market rates when considering how to value their business. Fair market value of owner compensation may also have an impact on tax matters, which is discussed later in this document.
While deferred revenue is directly impacted by revenue recognition policies, in this case, we are referring to deferred revenue as a balance sheet liability. Deferred revenue is revenue that has been invoiced or collected but not yet earned (e.g., collecting upfront for a 1-year subscription agreement). In this example, if a company were to be sold on day 2 of the 1-year subscription agreement, a buyer would be responsible for delivering 364 days of subscription services without collecting any cash revenue (since the revenue was prepaid and received by the seller). Disputes often arise between buyers and sellers about if and how to adjust working capital (or purchase price) to account for revenue that is collected by the seller for services that are to be delivered by the buyer. Purchase accounting also puts limitations on how much deferred revenue may be recognized by the buyer (to a cost-plus measure). The range of outcomes for the treatment of deferred revenue in a transaction is varied and depends on the buyer practices and the specific circumstances of the deferred revenue.
In most transactions, working capital is defined as current assets (usually cash-free) minus debt-free current liabilities (and deferred revenue, which is often a separate negotiation that rolls into working capital). A working capital target is designed to protect a buyer from a situation where a seller runs down accounts receivable through aggressive collections and runs up accounts payable by falling behind on payables leading up to closing a transaction, and then handing over this lopsided balance sheet to the unsuspecting buyer. In transactions with high variability in current assets and liabilities (e.g., businesses that sell large ticket, enterprise solutions that may create big swings in accounts receivable and deferred revenue), working capital may be a hotly contested item that can have significant implications on overall deal value. The treatment of excess cash or the retention of a certain amount of cash on the balance sheet is an often-debated point.
Revenue recognition and deferred revenue are both components of a bigger issue – accounting standards. Expense issues also arise when companies do not follow GAAP standards, particularly in booking accruals for items such as PTO, bonuses, and commissions, and to a less material extent, the booking of prepaid expenses. We encourage companies to implement GAAP accounting standards as early as possible. All companies must maintain consistent and complete accounting with thorough documentation.
While not a necessity, it is encouraged that potential sellers undergo a financial audit prior to initiating a sale transaction. The audit will help a seller preemptively identify GAAP accounting issues as well as strengthen accounting controls. Further, an audit is key for the option to underwrite rep & warranty insurance, which can de-risk a transaction for both buyer and seller, if economically viable. A financial review is a secondary alternative to an audit, however, in most cases, neither is a requirement for middle market transactions. In addition to audits, a preemptive quality of earnings may also help a seller fast track the debt-financing process on behalf of a buyer.
The most common tax issue in a health IT transaction is sales tax. Any company operating in the health IT space should be aware of sales tax law, such as the definition of nexus and the tax status of customers, which taken together can materially impact the applicability of sales tax. In healthcare, many non-profit customers are tax exempt, which often exempts the requirement to pay sales tax, if that is the case, a company should collect tax exempt certificates from these customers to document this status. In certain situations, there are customer contracts that state that the customer is responsible for paying sales tax if any tax is due – this is generally not an effective solution, and the IRS may ultimately come down on the company itself when it comes time to recover unpaid sales tax. To the extent that sales tax is due, a buyer may undertake a voluntary disclosure process and require a seller to set aside a special escrow for sales tax claims. Rules vary by state, and companies should closely monitor the applicable guidelines.
Federal income tax issues are also common in transactions. Assuming a company is generally compliant with federal income tax guidelines, there are two common sources of federal income tax issues: 1) owner compensation, and 2) expense capitalization. Owner compensation involves an owner taking corporate deductions on above market compensation to reduce taxable income at the corporate level (in a C-corp). Expense capitalization issues typically involve capitalizing expenses and taking an amortization tax shelter, but doing so with an incorrect accounting policy. Finally, income tax issues arise when the transaction results in a seller switching accounting policies. For example, if a buyer follows the accrual method of tax reporting and a seller follows the cash method, any additional tax due from adjusting the seller from cash to accrual tax reporting may be negotiated between buyer and seller, which is known as a Section 481 adjustment. The allocation of purchase price is also an important aspect of an asset, partnership or 338 transaction (further discussion can be found under Legal Issues). Sellers need to do their homework and agree with the buyer on the methodology of the purchase price allocation so sellers do not subject themselves to unexpected ordinary income tax on certain transacted assets.
Finally, an overlooked section of the tax code is Section 1202. Section 1202 stipulates that certain investors in Qualified Small Business Stock may be eligible for an exclusion (sometimes in whole and sometimes in part) for gain in certain small business stock sales. The lookback extends to 1993, however, for qualified small business stock acquired between September 27, 2010, until the end of 2013, the exclusion is 100%, and includes an exclusion from the alternative minimum tax. In other words, there are situations where capital gains can be avoided entirely for eligible investors in eligible stock.
Companies should ensure that stock options are priced at or above fair market value and maintain documentation that supports this fact. More discussion on stock options is found in the Human Resources section of this paper.
Addbacks abound for all companies, large, small, public, and private. Addbacks are adjustments made to expenses (and sometimes revenue) to account for one-time or unusual events. Companies should be honest with addbacks, and include only those that are legitimate. Treating operating expenses as addbacks may result in the loss of trust, and trust is a key attribute to any transaction’s due diligence process and negotiation. All addbacks need to be supportable under the assumption that a buyer will take a seller through a rigorous QoE process. Furthermore, addbacks and synergies are distinct and should be considered in separate categories.