Term Sheet Red Flags: Tax and Accounting Issues to Watch Before You Sign

A term sheet can make a business transaction look simple: a purchase price, an investment amount, an ownership percentage, and a few major conditions.

But the headline numbers rarely tell the entire story.

Whether you are selling a business, acquiring a company, or bringing in an investor, the terms negotiated at the beginning of a transaction can have significant tax and accounting consequences later.

One common mistake is waiting until the final agreement to involve a CPA or tax advisor. By that point, important economic terms may already be agreed upon and much harder to change.

Here are several tax and accounting red flags business owners and executives should consider before signing a term sheet.

1. The Purchase Price May Not Be the Amount You Actually Receive

A term sheet may state that a business is being purchased for a specific amount. However, the final amount paid to the seller can be affected by debt, cash, working capital, transaction expenses, and other adjustments.

For example, a company may have a stated value of $8 million but also have outstanding debt and a working capital adjustment at closing.

The seller should understand how those items will affect the final proceeds.

Red flag: The term sheet gives you a purchase price but does not clearly explain how debt, cash, and working capital will be treated.

The difference between the headline valuation and the actual amount you receive can be significant.

2. Asset Sale vs. Stock Sale Can Change the Tax Result

One of the most important questions in a business transaction is whether the buyer is purchasing the company’s assets or its ownership interests.

These structures can produce very different tax consequences.

In an asset transaction, the purchase price may be allocated among assets such as equipment, inventory, intellectual property, and goodwill. The allocation can affect the seller’s tax liability and the buyer’s future depreciation or amortization deductions.

A stock or equity transaction may produce a different result.

Example:  Suppose a business is being sold for $5 million.

The seller may prefer one transaction structure because it could produce a more favorable tax result, while the buyer may prefer another because of potential future tax deductions.

The important point is that a $5 million transaction is not necessarily the same transaction from a tax perspective simply because the purchase price is $5 million.

The structure matters.

3. Earn-Outs Can Create More Questions Than They Answer

Earn-outs are often used when the buyer and seller disagree about the current value of a business.

For example, the buyer may offer $4 million at closing plus another $1 million if the company reaches certain revenue or profitability targets.

This can help bridge a valuation gap, but the tax and accounting treatment should be considered before agreeing to the terms.

Questions may arise regarding:

• How the earn-out is calculated
• When it becomes payable
• How it is reported for tax purposes
• Whether the payment represents purchase price or compensation
• What happens if the seller continues working for the business

Red flag: An earn-out is based on future performance but the term sheet does not clearly define the financial metrics or how they will be calculated.

A seemingly attractive earn-out can become difficult to collect or create unexpected tax consequences if the terms are not carefully structured.

4. Working Capital Adjustments Can Reduce the Final Proceeds

Many transactions include a working capital target.

The purchase price may be based on the assumption that the company will have a normal level of working capital at closing.

If actual working capital is lower than the agreed target, the purchase price may be reduced.

For example, if the agreed working capital target is $1 million but the closing calculation shows $750,000, the seller could potentially receive less than expected.

The issue is often not whether the business is profitable. It is how “working capital” is defined and calculated for purposes of the transaction.

Red flag: The term sheet mentions a working capital adjustment without clearly defining what accounts and accounting methods will be used.

5. Historical Tax Liabilities Should Not Be Overlooked

A business may have tax exposure that is not immediately obvious from its financial statements.

Depending on the company and where it operates, this could involve:

• Federal income taxes
• State income or franchise taxes
• Sales and use taxes
• Payroll taxes
• Multi-state filing obligations
• Tax audits or unresolved notices

This becomes particularly important when a company has employees, contractors, customers, or other business activity in multiple states.

Example: A company headquartered in California may also have employees working remotely in other states.

Even if the company’s primary office is in California, its activities elsewhere may create additional state tax or registration considerations.

A buyer should understand the company’s tax history before agreeing to transaction terms, while a seller should identify potential liabilities that could affect the negotiation.

6. “Adjusted EBITDA” Is Not Always as Simple as It Sounds

EBITDA and adjusted EBITDA are frequently used when valuing businesses. However, the parties may not always agree on which expenses should be included or excluded.

For example, a seller may consider certain expenses to be one-time costs and add them back when calculating adjusted EBITDA. The buyer may disagree and determine that those expenses are actually recurring. Even a relatively small EBITDA adjustment can have a large impact on valuation when a transaction uses a multiple.

Example: If EBITDA is adjusted downward by $200,000 and the agreed valuation multiple is 6×, the difference could represent approximately $1.2 million in valuation.

This is why the accounting definition behind the number matters just as much as the number itself.

7. Taxes on the Transaction Can Significantly Affect the Economics

A transaction should not be evaluated based only on the gross amount being offered.

The seller should consider the potential after-tax proceeds. The tax result can depend on factors such as:

• Type of transaction
• Entity structure
• Tax basis
• Allocation of the purchase price
• Federal tax treatment
• State tax consequences
• Other transaction-specific circumstances

Two transactions with the same $5 million purchase price can potentially produce very different after-tax results.

That is why tax planning should begin before the transaction structure is finalized, rather than after the closing documents have already been negotiated.

What Should Business Owners Do Before Signing?

You do not need to turn a term sheet into a lengthy accounting document. But before signing, it is worth identifying the financial and tax provisions that could materially affect the transaction.

At a minimum, consider asking:

• What exactly is being purchased or sold?
• Is the transaction an asset sale or an equity sale?
• How will debt and cash affect the purchase price?
• Is there a working capital adjustment?
• How will an earn-out be calculated?
• What tax liabilities could affect the transaction?
• How will the transaction be taxed?
• What could the estimated after-tax proceeds look like?

Your attorney can address the legal terms of the transaction. Your CPA or tax advisor can help evaluate the financial and tax consequences.

Ideally, these professionals should be involved before you sign, when there is still an opportunity to negotiate.

Final Thoughts

A term sheet may be only a few pages long, but the financial consequences of its terms can extend far beyond those pages.

The purchase price, transaction structure, working capital provisions, earn-outs, and tax treatment can all affect what a buyer ultimately pays and what a seller ultimately keeps.

The goal is not to predict every issue that could arise during a transaction.

It is to identify the important financial and tax issues early enough to make informed decisions.

If you are considering selling a business, acquiring a company, or bringing in an investor, having your CPA review the tax and accounting aspects of the proposed terms before you sign can help you understand the deal from an after-tax perspective.

Need Help Reviewing Your Company’s Transaction and Tax Strategy?

Business transactions can involve tax planning, accounting analysis, purchase-price considerations, financial reporting, and long-term tax consequences. The right approach depends on the company’s structure, the type of transaction, the terms being negotiated, and the company’s current financial circumstances.

Velin & Associates, Inc. is a tax strategy and compliance firm helping corporations evaluate tax issues, transaction structures, financial reporting, and business planning.

If your company is preparing to sell a business, acquire another company, bring in an investor, or review proposed transaction terms, a proactive tax and accounting review can help identify potential issues before they become expensive to correct. For more information about our tax planning and tax compliance services, contact Velin & Associates, Inc. today.

Velin & Associates, Inc.

8159 Santa Monica Blvd STE 198/200
West Hollywood, CA 90046
📞 323-902-1000
📧 dmitriy@losangelescpa.org

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This article is for general informational purposes only and does not constitute individualized tax, accounting, legal, valuation, or financial advice.