Our ebiz Due Diligence experience: When VAT becomes a material issue

In this article we attempt to explain in a simplified way the impact VAT can have on determining the purchase price of an ebusiness company during a due diligence process. This should be of special interest for investors investing in ebusinesses and also for owners of a start-up when planning to gain additional capital or when playing with the idea of selling their companies some time in the future.

We have explained in previous posts that as of 1.1.2015 all ebusinesses providing eservices to non-VAT registered customers in the EU will have to charge VAT at the rate applicable in the EU country the customer resides in. It is important to note, that these rules are already in place for all ebusinesses that are not established within the EU.

In practice, most of the EU tax authorities are not effectively chasing ebusinesses that are selling eservices to EU residents without accounting for VAT. However, this practice should not be ignored during a due diligence. In a tax due diligence the assessment of the target company always includes looking for any tax risk from the past and the potential effect of these taxes on the future operating cash flow of the company. The VAT risk and liability assessment plays a significant role in this process.

At a very high level we can state that the present value of a company is a combination of two elements: its present Enterprise Value and its Discounted Cash Flow. Please bear in mind that the below summary is a very simplified explanation for the purpose of illustration only – the reality of the due diligence purchase price assessment is much more complex.

Enterprise value

In principle this is the current value of all the target company’s assets less any debts and debt-like liabilities (inclusive of past VAT risk).

A typical ebiz related scenario we encounter quite often in practice is that a non-EU target company is not familiar with the European VAT rules and has therefore not bothered with registering and accounting for European VAT. One of the important first steps is to determine how much of the European sales are actually liable to VAT – this is in principle equal to the percentage of the sales made to the European customers that are not registered for VAT. Here are some typical examples:

  • What is the likelihood that sales of an online game provider are made to non-VAT registered customers? Quite likely 100% as in this case most of the clients are private individuals. There could be some companies amongst the customers, but their number is usually insignificant.
  • What is the likelihood that sales made by a system backup provider are made to non-VAT registered customers? Quite low, probably less than 10% as most of the customers are probably bigger companies that are registered for VAT. But there could be smaller businesses, governmental and non-governmental organizations that are not registered for VAT.
  • What is the likelihood that sales of an antivirus software provider are made to non-VAT registered customers? Here your guess is as good as mine – in practice it is probably somewhere between 10% and 90%; not a very reliable assessment.

By taking into account an average VAT rate in the EU of approximately 22% and based on the above estimates, it should be relatively easy to estimate the value of the past VAT liability.

However the real catch lies in the fact that in practice the ebusinesses that do not comply with the EU VAT rules, often do not collect sufficient data to be able to prove which of their EU customers are registered for VAT. This can, in the worst case, result in a situation where the VAT liability has to be applied to all past sales made to European customers.

The alternative (and actually the only fully correct and compliant process) would be to clean up the past by identifying the non-VAT registered clients and their country of residence, to make a voluntarily tax disclosure and pay the full historical VAT liability with late payment interests and any applicable penalties. The costs of this “clean-up” process (without taking into account the actual VAT liability, interests and penalties) can easily exceed several 100.000 EUR.

Discounted Cash Flow

Here we assume that the target company will sell its eservices at the highest possible market value – this means that the final sales price (incl. of VAT) will be the maximum possible. This in practice means that VAT decreases the maximum net sales price and thus the future revenue of the target company.

Based on our estimate of the likely percentage of non-VAT registered clients in the EU we can proceed to estimate the effected revenue, multiply it by approximately 0.8 and calculate the target company’s value by applying the discounted cash flow method.

Conclusion

VAT can have a material impact on the market value of the target company and can substantially impact the purchase price investors are willing to pay for the target company.

In addition, any historical risks can be attributed to the past owners which might be held liable for any “sins” in the past – i.e. tax liabilities, interest, penalties and any costs of tax procedures related to them.

Our recommendation to a smart investor in an ebiz company is to check the company’s VAT setup, risks and liabilities. If you are about to invest into it, you could find a bargaining chip to reduce the purchase price and to protect yourself from any past VAT risk.

If you have already invested in an ebusiness, reviewing its VAT setup might be a right step toward protecting your investment and raising its sales price in the future. This is also the advisable course of action for any owner of an ebiz start-up.