Software and sales tax: Why investors care about the state of your compliance

Growing software companies focus all their energy on exactly that: growth. Planned, sustained, scalable growth that paints a picture of stability for investors.

So, sure, some lesser priorities — business activities that don’t fuel growth — might fall by the wayside every now and then. But you can shore up all that later, right?

Not so fast.

While they may not generate revenue, certain endeavors are still vital to the overall health of your company — sales tax compliance, for example.

Far from generating revenue, sales tax compliance is actually an enormous drain for companies, large and small. After all, you need considerable resources to manage the calculation, collection, and filing of sales tax in all the states where you have nexus, the obligation to remit sales tax to a state — resources that often equate to headcount. The average company employs six finance professionals who spend nearly 25 percent of their time on sales and use tax, according to a 2017 Wakefield Research study.

And there’s a domino effect: As you grow, it’s likely your growth-related activities will trigger even more sales tax obligations, causing an even bigger drain on resources. So there’s no putting off sales tax compliance, not even for a little while to focus on growth and revenue drivers. Because as much as it takes to keep up with sales tax compliance, it takes even more to play catch up.

Implementing a smart strategy for your sales tax compliance isn’t just something you should do. It’s something you must do, especially if you want to avoid potentially devastating audit penalties. But there’s more. Your sales tax strategy impacts how investors view your company, as part of your overall financial health.

In fact, trouble in the sales tax arena could sabotage opportunities related to mergers or acquisitions, company valuations, funding, and initial public offerings (IPO). Awareness of such implications is high. In the 2017 Avalara Sales Tax Survey for Software Companies, the majority of responders profess to knowing the risk that being out of compliance with sales tax regulations poses to company valuations and funding.

Andrew Johnson, CPA and managing partner at Peisner Johnson & Company LLP, a tax consulting firm, has seen it all before. He emphasizes the role sales tax compliance plays in the typical funding or exit event — for buyers and investors, as well as the company under scrutiny.

“We’ve been on both sides of these (funding-related) transactions,” Johnson says, “and seen many instances where sales tax exposure is the single biggest obstacle to overcome. It makes sense to buyers to be cautious because, even in a pure asset sale, the buyer may bear the burden of any past sales tax exposure. It’s very important for a company looking to sell, or even just seeking outside funding, to make sure they’re on top of potential exposure.”

Sales tax matters to your business and to your growth, and it matters to your investors or buyers, as well. Consider these scenarios:

• Best-case scenario: You stay current on your sales tax liabilities, always
  
  The best way to avoid a sales tax problem, of course, is not to let one develop. Stay on top of your current sales tax obligations, collecting the right amounts on the right transactions and filing on time. That goes for all the states and districts in which you need to collect and file, according to where you have nexus.
  
  Of course, there’s more to it than that. In many states,software sales tax regulations are currently in flux, and your compliance strategy needs to keep up. You also need to future-proof your sales tax compliance strategy so as your company grows and your compliance obligations change, you don’t fall behind.

• Not-the-best, not-the-worst scenario: You catch and correct a problem with your sales tax compliance before beginning the funding or sale process
  
  Given the complexity of software sales tax, it’s entirely possible for auditors conducting a financial review to find past sales tax liabilities that have been neglected or mismanaged, such as not paid in full. If you’re thinking “uh-oh,” you’re right.
  
  All of a sudden, you’re not as attractive to potential investors or buyers as you initially thought. They’ll see your past tax liabilities as a risk. So know what’s in your closet — if anything — before opening the door to investors or buyers, whether you’re looking at VC backing, private funding, an IPO, a merger, or an acquisition. And if you find some skeletons, start cleaning them up right away.
  
  A tax advisor may be able to help you secure a voluntary disclosure agreement (VDA) with certain states to make it less painful. With some VDAs, the state may waive or reduce some of the penalties and/or interest it would typically charge on unpaid back taxes.
  
  Yes, this will add to your funding or exit timeline, but there’s no time like the present to get compliant with sales tax. Your future, IPO-ready self will thank you.

• Worst-case scenario: You identify sales tax trouble mid-funding or mid-sale
  
  It takes a lot to gear up for a funding round, an IPO, or an acquisition. Now just imagine it all crashing down because of neglected sales tax.
  
  Even if it seems far-fetched for sales tax to derail your company’s future, it’s not, as Malcolm Ellerbe, a tax partner at Armanino LLP, points out.
  
  “Discovering large prior period liabilities during due diligence or by your financial statement auditors during an exit compounds an already complicated process,” says Ellerbe. “No executive wants to get caught flat-footed by the auditors or by the board of directors with something that can easily be mitigated early on.”
  
  Your deal and your company’s growth (at least temporarily), dead in the water, and all because of sales tax. It, unfortunately, can happen. After all, what investor or buyer would want to take full or partial responsibility for a sales tax mess, one that’s likely to come with costly effects?

Sales tax can stand in the way of growth. It’s that simple. That’s why, if you haven’t already, it’s time to prioritize sales tax compliance as a business activity, as part of your growth plan, and certainly as part of any funding or exit strategy.

To learn more about building a future-forward sales tax strategy to support your growth, download The Software Executive’s Guide to Sales Tax (Part 1). It’s the first of a three-part series exploring how software companies can reduce risk by carefully managing sales tax.