How do R&D Credits effect the M&A process
It is no small secret that the Research and Development Tax Credit is one of the most popular tax strategies for startups and small businesses. The credit offers a dollar for dollar offset to income taxes (or payroll taxes for qualified startups) for any company engaged in qualified research activities (QRA). Many companies engage in R&D with an aim to eventually sell the business, thus it is important to think about how R&D Tax Credits can become a part of a business transaction.
- Legal Exposure
As I mentioned, R&D Tax Credits have become extremely popular. With this increase in popularity, many companies have sought to qualify their QRA and calculate their R&D expenses without any expert guidance. The definition of R&D under this tax credit is often more complex than people understand, and the IRS knows that this can lead to companies misstating R&D expenses or failing to provide sufficient substantiation. As a result, the IRS has sought to litigate this issue and has won victories against taxpayers that had a weak legal defense.
Large corporations have come to understand that claiming R&D credits without a backup study and legal framework presents legal risk during a transaction. As we teach our clients through our Strategic Valuation process, a buyer’s due diligence team will look for any exposure that will allow them to discount their price offering (more on that here). We have seen buyers become wary when a business is claiming significant R&D Tax Credits with no backing study. As of this writing we are working with a client who has a large buyer in the tech industry expressing concerns over the legal exposure from a lack of reporting behind their R&D Credit claim.
This underscores the importance of making sure that proper due diligence and backup is performed when claiming R&D Tax Credits.
- Improves Free Cash Flow
Utilizing R&D Tax Credits can help the seller in a transaction. Reducing either income or payroll taxes will lead to a higher free cash flow (FCF) calculation. This can be used as tool by the seller to negotiate a higher price with the buyer since there can be an expected increase in cash flow opposed to a comparable company that does not have such tax credits. The goal of the buyer is always to try to discount their estimate of a selling company’s present value. Utilizing R&D Tax Credits can help a selling company improve its negotiating position since it shows a higher
- Deferred Tax Assets
It’s not uncommon for startups and companies that spent a lot of money on R&D to carry forward unused R&D Tax Credits (credits can be carried forward for 20 years). In these cases, unused credits become a deferred tax asset (DTA) balance sheet item. While it’s true that DTAs are only seen as valuable if there will be future profit, most M&A transactions are done on the buyer’s expectation that the selling company can be profitable. Therefore, R&D Tax Credit DTAs can help increase a company’s valuation since they provide the buyer with future tax savings and improved cash flows. This underscores the importance of ensuring that a company that plans to sell is taking advantage of R&D Tax Credits, even if there is no potential for immediate tax savings.
Obviously, R&D Credits are one of many variables in the overall due diligence process. However, as these credits become increasingly valuable, it is important to have an expert in your pocket who can help quantify and substantiate any tax credit claim.
