There are tons of models out there showing potential company acquisitions, along with the distribution of cash flows across debt obligations, equity investor returns, and manager carry. These are a great place to start.

However, after spending a lot of time with these beautiful Excel models, I realized I had a problem.

Most of the advice I've received to-date had little to say about taxes. Some books mention investor tax liability in passing, as a minor concern. But after some considerable conversations with my accountant, I've started to totally rebuild my spreadsheets to reflect tax liability, and it's not fun. I'm posting here with two potential goals: (1) Please, someone tell me that my accountant is wrong and that I don't face the tax exposure that I'm going to outline below; or (2) If my accountant is (unfortunately) correct, then please all people searching for a company should adjust their cash flow models accordingly.

First and foremost, your cash flow models have to reflect the fact that while you're paying down debt on your acquisition your company is generating earnings that aren't distributed to shareholders. This part is easy--your principal repayments each year are going to be taxable (but not-distributed) earnings for your shareholders. If you're only looking at your equity investors, this is likely a relatively small amount and won't affect your modeling all that much.

Here's the bad news. During the years that you're paying down debt and/or repaying investor capital, the manager is going to have tax liability on his/her (equity %) share of corporate earnings, even though for many of those years the company won't be paying the manager a dime. Further, it's not just ordinary income rates: it's self-employment taxes--that's both employee and employer portions of FICA and Medicaid. While FICA will likely be phased out after a reasonable manager salary, the remaining Medicaid portion plus the additional Obamacare 0.9% Medicaid assessment on high-income filers mean that successful searchers will likely face a tax liability on their equity share of company income possibly approaching 50% between the marginal federal tax, Medicaid taxes, and state taxes. The need to pay this amount out to the manager to cover tax liability has, at least in smaller company acquisitions, a significant impact on the financial modeling.

I know that personally I like to just model the economics and assume that taxes apply equally after the fact. But that is definitely not the case here, at least as far as what my accounting advisors have told me. Should anyone have a magic bullet wherein I can avoid these taxes while I pay down my acquisition debt, I would love to learn more. Absent that, I'm posting this as a PSA for everyone to rebuild their models with a realistic tax liability expectation in place.

Many thanks,