Cole Phillip Corbin looks at the impact of indirect taxes on the measurements of business valuation as it pertains

to comparable methodology often applied by private equity firms, beginning by summarizing the overall costs
of indirect tax liabilities to business and further explaining the importance of considering carryover tax liabilities
when it comes evaluating an acquisition. He also covers the in-depth workings of three specific indirect tax
liabilities: property tax, sales and use tax and, finally, payroll tax.
Introduction
In mergers and acquisitions, both private equity and corporate acquirers often ignore the consequences of
indirect taxes. Indirect taxes, which often occur at the state and local level, are the nonincome taxes levied
against taxpayers (e.g., payroll tax, sales and use tax, and property tax). Overlooking their impact in the due
diligence phase of an acquisition can be very costly to the acquirer, as indirect taxes affect both the purchase
price of a business and the rate of return of the investment. This article focuses primarily on the impact of
indirect taxes on the measurements of business valuation as it pertains to comparable methodology (specifically,
accounting-based multiples) often applied by private equity firms. To the extent that corporate acquirers use the
same methodology in valuing firms, indirect tax due diligence and planning can also apply.
To provide context, this article begins by summarizing the overall costs of indirect tax liabilities to business.
Since tax due diligence is generally associated with income tax, the reader must be able to distinguish precisely
which costs are associated with indirect taxes and how these costs affect on the bottom line. Once this has been
established, this article further explains the importance of considering carryover tax liabilities when it comes
evaluating an acquisition. Next, the article covers the in-depth workings of three specific indirect tax liabilities:
property tax, sales and use tax, and, finally, payroll tax. Each indirect tax section examines both the pre-
acquisition diligence, as well as several post-acquisition planning theories for each type of tax.
The Cost of Indirect Taxes
In the United States, businesses paid nearly 5400 billion in indirect taxes, up approximately 10 percent from FY
2000. (1) (See Exhibit 1). By contrast, businesses only paid $35 billion in state and local income/franchise taxes
and paid a total of $131 billion in federal income taxes in FY 2003, down significantly from FY 2000. (2) Of the
specific types of indirect taxes addressed in this article, property taxes account for the largest single portion of
tax for business. In 2003, businesses handed over nearly $156 billion to the states in property tax. (3) Sales and
use taxes amounted to $100 billion for businesses. (4) Payroll tax, meanwhile, cost businesses some $30 billion
in tax liabilities in 2003. (5)
Despite their size and impact on business, indirect taxes are not as evident to investors as direct taxes. They
reside often in the company's financial statements among the cost of goods sold, selling, general administration
and other expenses. Investors are far more familiar with the impact of direct income/franchise and capital taxes
on their net income and cash flow. As a result, due diligence and tax planning in business acquisitions generally
revolves around planning for direct taxes (e.g., income and franchise tax). Considering the increasing costs of
indirect taxes, acquirers may be missing ample opportunities to maximize their rate of return on their
investment. Planning for indirect taxes, in addition to direct taxes, may not only save the acquiring company on
purchase price, it can also lead to larger future cash flows and a higher selling price upon exiting the investment.
Valuing a Business Acquisition
In order to better understand the impact of indirect taxes on an acquisition, the reader must determine the effects
of such taxes on valuing a business. The following section discusses specifically the workings of comparable
methodology in valuing a business. Every investor that seeks a business acquisition needs to have dependable
methods of valuation. Those methods, however, may vary widely depending on the interests of the acquirer.
Acquiring corporations, for instance, may measure value in operating synergies between their own operations
and those of the target business; or, they may be looking to increase the diversity of their product line by adding
the target company. By contrast, private equity purchasers often look for evidence of cash flows to see if the
target company can support certain amounts of financial leverage. Even among private equity firms, methods of
valuation can be drastically different. Venture capital firms, for instance, place little value on cash flows and
profitability, but look at potential growth and research and development in valuing a firm. (6)
One of the most effective valuation approaches used among private equity firms is the comparable method
approach. (7) The comparable method attempts to make an "apples-to-apples" comparison of businesses by
eliminating some of the effects capital structure can have on its earnings. (8) Private equity firms often use
EBITDA (earnings before interest, taxes, depreciation and amortization) as the foundation for valuation
methodologies and determining debt-servicing capabilities. (9) EBITDA is a measure of a business's
profitability and is calculated by taking a company's net earnings and adding back expenses for interest, federal,
state and local income taxes, depreciation and amortization. EBITDA eliminates the effects that financing,
accounting methods and tax strategies have on reported earnings. (10) As such, EBITDA gives private equity a
clearer comparison for valuing a firm than using net earnings or operating income. This explanation does not to
confuse EBITDA with cash flow. Instead, EBITDA measures a company's profitability before certain
nonoperating expenses and accounting methods are taken into consideration.
The importance of EBITDA as a measure of a business' value, however, is limited to the industry in which it
resides. Profitability generated from high-growth industries, for example, may be worth more to investors than
profitability from low-growth industries. In addition, an industry with a high barrier for entry may have a higher
multiple as investors perceive the business is less likely to succumb to competition. This is reflected in the
industry multiple used to define a company's enterprise value. An industry multiple "provides a measure of
relative valuation to an underlying financial statistic." (11) The industry multiple is calculated by taking the
reported or known acquisition price of businesses in a specific industry divided by the EBITDA of the firms.
This yields the multiple at which the company was valued. The average of these individual multiples results in
the industry multiple. The product of the industry multiple and the company's EBITDA is also known as the
business' enterprise value. Failure to review a company's indirect tax exposure can cost a company two-fold:
first, it can lead to missed opportunities in reducing the purchase price; and second, it can lead to carryover tax
liabilities for the successor corporation.
Indirect tax consequences impact a company's EBITDA (since their costs are often associated with "above the
line" expenses such as cost of goods …