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Free Article - PMR Consulting Mergers and Acquisitions in CEE: a practical guide part II

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Are Central and Eastern European entrepreneurs and owners of small and midsize companies prepared to sell their businesses? Will these companies receive a friendly takeover amicably? How do investors identify the key risks and obstacles that stand in the way of a successful acquisition? What are the do's and don'ts for prospective investors when looking for targets of opportunity in the CEE?

In this series of articles, we will present specifics in a local context as seen amidst the broader M&A area that investors should be aware of before deploying significant capital.

Business setup and tax implications

The first issue we want to bring to your attention is the clash of legal status of the target company and owners together with corporation assets management. We don't intend, however, to look into the legal provisions. Instead, the idea is to examine the general aspects of a business that pose tangible transactional risks, which in extreme cases may be deal-breakers.

Regional law in CEE is fairly homogenous with regards to dividing types of legal entities into sole proprietorships, partnerships and corporations (mainly limited liability companies and joint-stock companies). In Poland alone there are more than 250,000 limited liability companies and 10,000 stock companies, and these numbers have been expanding with a compound annual growth rate (CAGR) of 5% over the past 10 years. Thus, in perusing through small and midsize companies (gross revenues of €10 million to €100 million) you will most likely come face to face with one of these two legal structures. Caveat emptor: both types of companies impose double tax burdens on the owners the moment any cash out occurs. To be exact, this means a corporate income tax (CIT) that the company pays; the tax ranges from 16% in Romania to 19% in Poland, Czech Republic, Slovakia or Hungary. There is also the personal income tax (PIT) on capital gains that ranges from 15% in Czech Republic through 16% in Romania and Hungary up to 19% in Poland and Slovakia. This structure imposes in total tax payables at the level of 25-35% of corporate gross income.

Non-core assets and company's acquisition

The second aspect previously mentioned is the manner in which owners and corporations manage their assets.

Many times, the small and medium enterprises (SMEs) found in the region are family-owned businesses that local entrepreneurs established in the early 1990s. Since their founding, the businesses have expanded to a considerable size. This often results in a balance sheet stocked with a variety of non-operational assets, typically plots of land and buildings, acquired over time as capital investment in the company. From the investor's perspective, this is a no-brainer: there is no reason to purchase non-operational assets simply because they were part of the setup. A discounted cash flow (DCF) valuation that utilises a pure and sustainable cash flow rationale will obviously not cover additional assets. Thus, the business perspective will demand that these assets be excluded from the transaction. The problem here, though, is not the price itself but the tax implications. Non-core assets might either be included and paid for (as has been stated: a rare case) or be excluded from the transaction. If the latter, the most straightforward solution for cases involving limited liability company or joint-stock company includes a value increase that would have to be recognized at the moment of assets transfer. The point is that non-operational assets even though not sold, still have to be assigned to particular entity and therefore they produce additional costs.

Risk minimising

Now its time to gather up these pieces of the puzzle – legal entity, asset structure, and the fact that in approaching an SME in CEE you might often directly deal with owners lacking financial and legal advisors – and go forth. However, you might end up in a situation fraught with risk. On the one hand, a potential transaction in underway and most likely capital resources are being deployed. Yet on the other hand, tax-related matters that you have never encountered before must be taken under consideration. In extreme cases, non-core assets may exceed the company value. If these assets were acquired a relatively long time ago, with e.g. real estate CAGR at 7.2% over the last seven years, we end up with a significant tax burden that would not occur if it was not for the takeover. In this case, the owner would certainly think long and hard before moving forward with the transaction.

CEE-oriented investors can learn something from this case: conduct due diligence before deploying significant investment. Working together with owners to verify tax-related status and to understand available options will result in a stronger position for all involved. You will gain comfort from knowing that a potential transaction obstacle is being addressed as you get closer to pre-defined business goals. You will also mitigate risk inherent in the process while gaining the trust of the owner. In the end, you demonstrate that you not only care about what is in it for you, but that you also care about the transaction success in the wider context.

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