Cash payments to employees

January 19, 2024

by a searcher from Columbia University in New York, NY, USA

Hey Searchfund Community,

How have other searches treated cash payments to employees when evaluating a potential acquisition? I am negotiating an LOI on a services business and discovered that employees are on payroll for approximately 65% of their compensation and the other 35% is paid in cash. The owner has been expensing the cash in the financials but has not been treating it as payroll (i.e. no withholding or employment taxes).

From a financial standpoint there needs to be an adjustment to SDE to capture the true cost of the payments, but is this operationally a big red flag? The simple solution seems to be to put 100% of employee compensation on payroll day 1, but I have to imagine employees won't be happy as that is effectively a pay decrease when you factor in withholding and other payroll expenses (and assuming they aren't voluntarily paying taxes on their cash receipts).. Any insight would be greatly appreciated as I imagine many businesses in the SMB space have some level of cash payment to employees.

Reply by a lender
from Eastern Illinois University in 900 E Diehl Rd, Naperville, IL 60563, USA

I would concur with what has already been said. It is a red flag. There are a number of issues that exist here. First, you have to call into question what else the seller might be doing to avoid taxes and what risks that might pose. Secondly, once you switch to normal payoff, the employees might not be as happy as they will be paying more in taxes. So to pay them the same you might have to increase their payroll quite a bit. Third, it could be an issue for lenders if disclosed as they will be concerned about the business and past management. I would be very cautious and be sure you are getting the business for a solid price if you decide to move forward and you have plenty of protections for the unexpected.

Reply by a searcher
from IESE Business School in Long Island, New York, USA

Recently encountered this a few times, seems to be a trend in certain parts of the New York small business landscape. As others have pointed out, make sure to factor in the full cost of above board payroll, with labor burden and increased WC insurance costs... and adjust purchase price accordingly. Protect yourself with an APA and do a gut check on your trust with the seller and whether or not other skeletons may be in the closet. In my experience, employees (if made whole) didn't mind going above board.

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