Capittal's view: can I sell my company with a tax audit or litigation open?

Quick answer

Capittal's view is that you can sell a company with a tax audit or open litigation, and that the only thing which genuinely kills the deal is hiding it. The buyer does not run from quantified risk: it runs from unknown risk that surfaces halfway through due diligence. A contingency you have measured, documented and disclosed yourself gets negotiated with an escrow, an indemnity or a price adjustment. The same contingency discovered by the buyer becomes a general discount and a loss of trust you do not recover.

Why is hiding it the one thing that actually breaks the deal?

Because due diligence finds open proceedings. They sit in the notices received, in the accounts, in the provisions booked, in the legal fees and in the tax clearance certificate. The buyer does not ask about them: it checks.

When one appears that you never mentioned, the buyer stops arguing about the contingency and starts arguing about you. The logic is simple: if this was missing, what else is missing. From that point it widens the scope of the review, raises the holdbacks across the whole file and hardens the warranties. The cost is not the amount of the contingency. It is the distrust discount applied to the entire transaction.

Concealment also carries its own legal consequences. The warranties in a share purchase agreement always include a statement about pending administrative and judicial proceedings. Signing it knowing it is false exposes the seller to a claim that normally falls outside the caps and time limits agreed for every other contingency.

How do I quantify the contingency before sitting down to negotiate?

A tax contingency is not one number. It is three separate layers and they have to be split, because each behaves differently.

• The tax itself. The amount the authorities consider underpaid. It is the most predictable layer and can be calculated from the assessment proposal or the inspection report.
• Late payment interest. It accrues from the end of the voluntary payment period and keeps running while the proceedings last. The longer the appeal, the bigger this layer.
• The penalty. The most uncertain and most arguable layer, because it requires culpability and proper reasoning. It may never be imposed and it can be annulled on appeal.

Next you have to place the proceedings at their actual stage: whether submissions are still open, whether the inspection report was signed in agreement or in disagreement, whether an administrative appeal or an economic-administrative claim has been filed, and whether a subsequent court appeal is available.

And you have to answer the question every buyer asks: whether the debt is stayed and against what guarantee. The Spanish General Tax Act allows enforcement of a challenged debt to be suspended by providing sufficient security, typically a bank guarantee, and it provides that enforcement of penalties is automatically stayed during the voluntary period when they are appealed in time and proper form, with no guarantee required. Whether the debt is stayed changes the cash timetable of the deal, and a live bank guarantee consumes banking lines the buyer will have to replace.

The output of the exercise is not a single figure. It is a range with scenarios: the amount if the appeal succeeds, the amount if it partly succeeds and the amount in the worst case, each with a reasoned probability and with a written opinion from the lawyer running the file.

What will it cost me in price and how does the market absorb it?

The market has four mechanisms for absorbing a quantified contingency. They are not alternatives: a single deal usually combines them.

• Escrow retention. Part of the price is placed in a blocked account for the estimated amount and released when the proceedings end or when the agreed period expires. It is the buyer's preferred mechanism, because the money is already there.
• Specific indemnity. The seller takes on that particular risk with its own cap and its own time limit, separate from the general warranty limits. It is the seller's preferred mechanism when it believes in the appeal, because it does not tie up cash.
• Direct price adjustment. The amount is deducted from the price and the matter ceases to exist for the seller. It is the cleanest solution and the most expensive: you pay the worst case even if you later win the appeal.
• Warranty and indemnity insurance. A policy covers breaches of the contractual warranties and makes sense when deal size justifies it. It is worth knowing that contingencies already known and disclosed are excluded from standard cover: insuring them requires specific cover, priced separately, and it is not always granted.

Choosing between escrow and indemnity is an economic decision for the seller, not a legal technicality. A retention ties up your money for years in exchange for closing the argument. An indemnity leaves you the money and leaves you the risk. If you genuinely believe in the appeal, a capped and time-limited indemnity is usually the better trade.

Who controls the defence of the proceedings after completion?

This is the clause most often drafted badly and the one that causes the most trouble. After completion the proceedings belong to the company, which now belongs to the buyer, but the bill still belongs to the seller through the indemnity or the escrow.

If the party paying does not control, the incentive breaks. The buyer has no reason to fight an appeal that costs it nothing, and settling is the short route. That is why the seller must reserve control of the proceedings in writing whenever it carries the cost.

The defence clause has to state five things: who selects and pays the lawyers, within what deadline the seller is notified of anything received, who decides whether to appeal or accept the assessment, that neither party may settle or concede without the other's written consent, and that the buyer is obliged to provide documents, access and signatures on filings.

The notification point matters more than it looks. Appeal deadlines are strict and non-extendable. A seller who learns of a notice too late has lost the appeal it was funding.

Does the same approach work for employment, commercial or customer claims?

The framework is identical: quantify, disclose, choose the mechanism and reserve the defence. What changes is how the layers are calculated and what the buyer looks at.

• Employment litigation. Quantified with the compensation claimed, back pay where applicable and the associated social security contributions. What worries the buyer is not the individual claim but whether it is replicable: if an entire category of the workforce could bring the same claim, the contingency stops being a case and becomes a policy.
• Commercial litigation. Supplier claims, contractual disputes and shareholder conflicts. The relevant risk is usually the effect on the contract rather than the amount: losing a case against your distributor may cost less than losing the distributor.
• Customer claims. Beyond the amount, the buyer looks at recurrence and at the effect on product or service warranties. A quality claim may be pointing at a process problem that affects future orders.

In all three cases the buyer will ask for the same document: the schedule of open proceedings with amount claimed, status, instance, accounting provision booked and counsel's opinion. Having that table ready before it is requested changes the tone of the whole conversation.

When do I disclose it, in the information memorandum or in due diligence?

In the information memorandum. Disclosing late is the most expensive timing mistake a seller makes. A contingency declared from the outset is a fact in the file. The same contingency discovered in week six of due diligence is a finding.

The difference is the signal each option sends. Disclosing it yourself says you know your own company, you have the matter under control and you have put the bad scenario on the table. Letting the buyer find it says that either you did not know, or you preferred it not to be known. Neither reading helps you defend a price.

How you disclose it also matters. It is not a footnote: it is a page setting out the origin of the proceedings, the years affected, the amount by layer, the current stage, the accounting provision, counsel's view and the seller's proposal for how to handle it in the contract. Arriving with the proposed solution leaves you negotiating the mechanism instead of negotiating whether the problem exists.

There is a further price effect. An offer made without knowing about the contingency will be revised downwards once it surfaces. An offer made knowing about it is a real offer from day one.

What do I do if the audit opens once the process is already running?

Tell the buyer immediately, before it sees the file. A procedure opening mid-process is not the seller's fault. Sitting on it for two weeks is.

Then the work is to bound it fast: which tax, which years and what scope the notice of commencement covers, because a partial scope over one tax and one year is not the same as a general one. With that established you can estimate the exposure range and put it in writing.

On timing there are two routes. Waiting for the audit to finish stretches the process by many months and ages every piece of information already delivered. Closing with the audit live is the normal outcome and is resolved with a retention or an indemnity sized to the actual scope. Waiting only makes sense when the scope is so broad that no buyer can bound the risk, or when the assessment is about to be finalised and signing it improves the picture.

What does not work is asking the buyer to ignore the matter. If the exposure is not bounded, the buyer will bound it instead, and it will always do so on the high side.

What is the next step if I have a tax audit or litigation open?

The first step is to build the contingency schedule before you speak to anyone: every open proceeding with its tax, its interest, its possible penalty, its stage, whether it is stayed and against what guarantee, the accounting provision booked and the lawyer's written opinion. With that in front of you, you can decide whether to go to market now or wait, and which contractual mechanism to ask for. Without it you negotiate blind on a risk the buyer will estimate on its own, and always on the high side.

At Capittal Transacciones we work on quantifying and structuring tax and litigation contingencies as part of the confidential valuation we prepare for owners considering a sale. We are a mid-market M&A boutique operating in the approximate range of 3 to 250 million euros, with eight offices in Spain (Barcelona as headquarters, Madrid, Girona, Lleida, Tarragona, Palma, Zaragoza and Valencia) and we are part of the NRRO group. The partner handles each mandate directly, including the conversation about how to present an open tax audit to a buyer.

Keep reading

• Guide: every decision you face when selling your company
• The buyer cuts the price after due diligence
• What happens to your contracts, lease and bank facilities on a change of control

Sell with an open contingency without losing price: talk to Capittal