The risks and rewards of leverage

Early-stage startups must often contemplate the most practical way to raise capital for their business. If traditional debt and equity methods are not available, different avenues to raising capital must be considered. Here are four alternatives to traditional debt and equity transactions:

Simple Agreement for Future Equity (SAFE)

A SAFE provides rights to an investor for future equity in a company without determining a specific price per share at the time of the initial investment (date of agreement), nor does it provide for interest or a maturity date. A SAFE investor receives future equity shares when a priced round or investment event occurs (e.g., a Series A preferred stock financing round), typically at a discounted rate. SAFEs are intended to provide a simpler mechanism for startups to seek initial funding.

Convertible note

A convertible note is a hybrid security containing components of both debt and equity. The loan can be converted into either a predetermined or a variable number of equity shares at a later date, usually upon the occurrence of an event such as a financing round or liquidity event. In some cases, these are complex agreements that require more involvement from legal counsel.

Keep It Simple Security (KISS)

A KISS can be structured as either a debt or equity agreement. An investor provides funding to the company in exchange for the right to convert the instrument to equity upon a future event when an equity round is raised and preferred shares are issued. Like a SAFE, KISS agreements delay the need for a valuation and can minimize legal expenses. Unlike SAFEs, KISS notes do provide for an interest rate and a maturity date. KISS securities frequently include a Most Favored Nation clause, which provides that should a better deal be provided to new investors at a later date, they would need to revise the terms of the KISS investments to match the new preferable terms. These are sometimes seen in SAFEs and convertible notes as well. A KISS is generally viewed as more investor-friendly because of the protections it provides.

Redeemable preferred stock

A type of preferred stock that allows the issuer (the company) to buy back (call) the stock at a certain share price and retire it. The call feature can be beneficial for the company, as it can eliminate equity if it becomes too expensive. Aside from the redemption feature, it sometimes contains common provisions of preferred stock such as fixed dividends to the holder ahead of payments to holders of common stock. Another version of this, mandatorily redeemable preferred stock, includes a put feature that allows the investor to request the funds back at a specific date including a return. Depending on the provisions in the contract, mandatorily redeemable preferred stock may be classified as debt on a company’s balance sheet.

This is not an all-inclusive list. There are other non-traditional methods of financing, including, but not limited to, peer-to-peer lending, crowdfunding, and government grants. Selecting the appropriate methods of raising capital for your business involves the consideration of numerous factors. Current macroeconomic trends, the company’s industry, and long-term strategic objectives are examples of factors you may want to consider.

If you have questions about raising capital and the related business, accounting, and tax implications, please contact our professionals. We can also provide guidance on other alternatives to raising capital.

Read this if your business is looking for ways to minimize cash flow risks.

As part of your business’s long-term strategy, you should consider incorporating risk mitigation measures. This includes identifying various business risks and determining the appropriate methods to address those risks.

Particularly in times of volatile swings in prices of commodities, currency exchange rates, and interest rates, one option for managing these risks is through the use of derivatives. Derivatives can be used to hedge against a company’s exposure to a particular risk, whether that be the purchase price of materials or equipment, the selling price of a product a company has already purchased the materials to produce, or a variable rate of interest on debt.   

Common derivatives that are often used to hedge cash flow risks are: 

1. Futures: Futures are contracts traded on an exchange that provides for the purchase and delivery of an asset, including currencies, on an agreed upon date at an agreed-upon price. For example, if a company is concerned the cost of steel will rise in the future as it is needed to produce goods they have committed to sell, they can purchase a future to buy steel at a pre-determined price that protects the company. In most cases, actual delivery of the steel will not be required; rather, the future may be “net settled” by receiving or paying cash on the difference in the price provided in the contract and the current market price. 
2. Forwards: Forward contracts are similar to futures, except that they are traded “over the counter” and are not on an exchange. This means that the contracts can be customized, since they need to sometimes be negotiated with the counterparty, and also means that there is an element of counterparty risk that they won’t perform as agreed to in the contract. In the case of forward contracts, net settlement isn’t always an option and the actual goods may actually need to be delivered. 
3. Options: Options are agreements to buy or sell an asset on an agreed-upon date at an agreed-upon price. The difference between options and futures is that with an option, the purchaser of the option is not obligated to perform, but they have the option to; however, if executing the transaction is not beneficial, they can let the option expire. 
4. Swaps: Swaps are used to exchange one kind of cash flow with another. The most common is interest rate swaps where a company that is party to variable rate debt with a bank may enter into a swap to pay a fixed rate and receive a variable rate (a receive-variable, pay-fixed interest rate swap). In this case, the variable rates being paid and received offset each other. If the terms of the swap are structured to match the debt, this can essentially convert a variable rate note into a fixed rate note. 

It is worth noting that since the value of a derivative is based on the value of an underlying asset, the value of the derivative itself is subject to fluctuations and can make these contracts challenging to evaluate. Any decision by a company to use derivatives should be carefully thought out, considering all potential outcomes. When used with precision and sufficient due diligence, they can be a powerful tool to protect a company from cash flow risks. There are, of course, various financial reporting and tax considerations associated with the use of derivatives.  

BerryDunn’s Commercial Practice Group partners with clients to provide insights that inform effective growth strategies, help them assess and manage risk, and optimize return strategies for better profitability. Please contact any of our professionals if you are considering the use of derivatives and want to understand the impact to your company. 

Read this if you are a manufacturer.

Manufacturers will continue to face supply chain headwinds in 2023, a cause for concern following a turbulent few years. Economic uncertainty, supply shortages, rising costs, and frustrated customers threaten to impede growth.

Some supply chain industry pundits would have us believe there is little businesses can do about these disruptions, and they must be at the mercy of external factors outside of their control. Fortunately, manufacturers have options to mitigate the impact to their supply chains with a little clarity, discipline, and direction.

To help you navigate the next 12 months, we’ve answered three frequently asked questions from our clients on how to optimize their supply chains amid constant uncertainty and disruption.

Question one: Does a “China Plus One” strategy adequately diversify my supply chain?

By now, most US businesses and consumers understand that far-flung global supply chains have been too dependent on China. Even prior to 2020, many business leaders had already begun shifting away from China in the wake of the previous administration’s tariff challenges, intellectual property disputes, and ensuing trade war. Factory and port shutdowns in China in the early days of the pandemic and the issues that followed were wake-up calls for those that hadn’t seriously considered alternative sources of supply. An enduring lesson of the past few years is that sole sourcing from any vendor or vendors in one location comes at a high risk.

Building redundancy into the supply chain and maintaining inventory levels have become guiding principles for manufacturers. The “China Plus One” strategy has been on the radar of companies with China operations for several years but motivation to change didn’t materialize until the trade war, COVID-19 pandemic, and subsequent disruptions. The need to diversify supply chains is now a priority, with many manufacturers actively pursuing a “China Plus One” strategy by supplementing sourcing from China with another country in Southeast Asia. However, the supply chain crisis of the past two years shows this strategy may also be failing. As long as the goods produced are an ocean away from the markets that consume them, uncertainty from various disruptive factors can lead to shortages, higher costs, lower revenues, and customer dissatisfaction.

Reduce risk in your supply chain  

While decoupling from China is part of the equation, truly reducing the risk in the supply chain comes down to three things: optionality, redundancy, and market proximity to your customers. Redundancies should be intentionally created to avoid a single point of failure. And while fully onshoring production and/or sources of supply may not be operationally, economically, or logistically feasible, the supply network is less risky when it is closer to the market where it’s consumed.

Consider engaging with new suppliers and contract manufacturers in the Americas to better serve the US market. You should also review your supply base for any overreliance on a single source or geography, then consider options to decrease the distance between where your products are produced and where they’re purchased. Insourcing, onshoring, nearshoring, and acquiring companies are all on the table. The approach that makes sense for your business must consider cost, capacity, quality, control, and reputation, but regardless of your approach, the goal should be to improve supply chain resilience and flexibility so you can better manage disruptions.

Question two: Does having a backup plan mean I’m prepared for future supply chain disruption?

Maybe, if that backup plan has built-in agility and can be adapted and activated swiftly based on a variety of external factors. In the last few years, many manufacturers discovered static backup plans were not adequate to address the rapidly changing conditions across the globe. These backup strategies were not agile enough to be effective amid complex disruption. Consequently, manufacturers struggled to get the level of service they needed from existing suppliers or quickly identify new suppliers, resulting in processes that simply were not feasible from an implementation or sustainable cost standpoint.

Backup plans have their place, but they’re generally based on known risks. As global supply chains grow more intertwined and the universe of uncertainty expands, new risks and variables come into play. You can’t just plan for one contingency—you need to weigh the outcomes of multiple options across different scenarios. Changes in manufacturing locations and sourcing strategies aren’t the only scenarios worth evaluating, nor is resilience to disruption the only outcome worth measuring. For example, if you’re considering expanding into a new market or adding to your product mix, those strategic adjustments should be factored into your supply chain model and assessed for plausibility. Tax liabilities, trade compliance risks, and total cost to serve are no less critical considerations than deliverability or lead times.

The reality is you cannot prepare for every contingency, so scenario planning needs to evolve to detect signals of disruption earlier and enable greater agility in supply chain decision-making when the unexpected occurs.

Scenario planning of your supply chain model

Review your supply chain model to reflect current constraints and incorporate points of vulnerability and conduct a scenario planning exercise to address a specific problem or inform your next strategic move. Ideally, you should simulate multiple scenarios to pressure test the supply chain, anticipate issues, and chart the best path forward when disruption hits. Scenario planning should become a regular business practice so you can quickly respond to unforeseen events.

Question three: Is raising prices the only way to offset increases in material and transportation costs?

It's not the only way, but tradeoffs will need to be made. Higher costs are an unfortunate reality for most manufacturers in the current supply chain environment, and they’re likely to persist. As cost reductions are not always easy to achieve, many companies focus instead on cost containment in parts of their supply chains where they have strong control.

That doesn’t mean there aren’t efficiencies you may be overlooking. Intercompany movements, for example, are often rife with inefficiency or seldom get the level of scrutiny they deserve. If parts and finished goods are shipped intercompany, ask why: Is there a value add, is it because your business has always done it that way, or is it an enabling factor to hedge against process inefficiencies? If your global supply chain is failing to consistently meet the needs of local markets, does the original rationale for keeping production and sources of supply at a distance still stand, or would it be beneficial to establish a near or local market capability? The use of a contract manufacturer model can be a quicker way to further evaluate whether it makes sense to establish an in-house capability.

It’s also a good time to revisit lean initiatives that you may have previously dismissed or deprioritized—but be wary of prioritizing efficiency at the expense of resilience. And beyond your own four walls, there are a few foundational measures of good supply chain hygiene that may help with cost takeout:

• Shift from transportation spot rates to contract rates to stabilize pricing.
• Ensure you have contracts with alternate suppliers—don’t rely on a single source.
• Encourage your customers to optimize order volume for full truck or container loads through more rigorous enforcement of transactional service standards.

These measures may help manage costs to some degree but are unlikely to completely offset them. Instead of passing additional costs onto all your customers, consider segmenting them (we like the 80-20 method) and developing pricing strategies based on level of priority. You may not want to raise prices for your most critical customers, but there is little downside to increasing rates for your lowest-priority customers.

Analyze customers and your product selection

Analyze your customer base and product suite to understand the most profitable and least profitable segments. Consider implementing a price segmentation strategy that shifts the heaviest burden of cost increases to your least profitable (and least desirable) customers. Also take a close look at your least profitable product segments and how they line up with cost distribution. Do you have slow-moving SKUs driving a disproportionate amount of costs? It may make sense to rationalize them.

Read this if your company is considering financing through a sale leaseback.

In today’s economic climate, some companies are looking for financing alternatives to traditional senior or mezzanine debt with financial institutions. As such, more companies are considering entering into sale leaseback arrangements. Depending on your company’s situation and goals, a sale leaseback may be a good option. Before you decide, here are some advantages and disadvantages that you should consider.

What is a sale leaseback?

A sale leaseback is when a company sells an asset and simultaneously enters into a lease contract with the buyer for the same asset. This transaction can be used as a method of financing, as the company is able to retrieve cash from the sale of the asset while still being able to use the asset through the lease term. Sale leaseback arrangements can be a viable alternative to traditional financing for a company that owns significant “hard assets” and has a need for liquidity with limited borrowing capacity from traditional financial institutions, or when the company is looking to supplement its financing mix.

Below are notable advantages, disadvantages, and other considerations for companies to consider when contemplating a sale leaseback transaction:

Advantages of using a sale leaseback

Sale leasebacks may be able to help your company: 

• Increase working capital to deploy at a greater rate of return, if opportunities exist
• Maintain control of the asset during the lease term
• Avoid restrictive covenants associated with traditional financing
• Capitalize on market conditions, if the fair value of an asset has increased dramatically
• Reduce financing fees
• Receive sale proceeds equal to or greater than the fair value of the asset, which generally is contingent on the company’s ability to fund future lease commitments

Disadvantages of using a sale leaseback

On the other hand, a sale leaseback may:

• Create a current tax obligation for capital gains; however, the company will be able to deduct future lease payments.
• Cause loss of right to receive any future appreciation in the fair value of the asset
• Cause a lack of control of the asset at the end of the lease term
• Require long-term financial commitments with fixed payments
• Create loss of operational flexibility (e.g., ability to move from a leased facility in the future)
• Create a lost opportunity to diversify risk by owning the asset

Other considerations in assessing if a sale leaseback is right for you

Here are some questions you should ask before deciding if a sale leaseback is the right course of action for your company: 

• What are the length and terms of the lease?
• Are the owners considering a sale of the company in the near future?
• Is the asset core to the company’s operations?
• Is entering into the transaction fulfilling your fiduciary duty to shareholders and investors?
• What is the volatility in the fair value of the asset?
• Does the transaction create any other tax opportunities, obligations, or exposures?

The Financial Accounting Standards Board’s new standard on leases, Accounting Standards Codification (ASC) Topic 842, is now effective for both public and private companies. Accounting for sale leaseback transactions under ASC Topic 842 can be very complex with varying outcomes depending on the structure of the transaction. It is important to determine if a sale has occurred, based on guidance provided by ASC Topic 842, as it will determine the initial and subsequent accounting treatment.

The structure of a sale leaseback transactions can also significantly impact a company’s tax position and tax attributes. If you’re contemplating a sale leaseback transaction, reach out to our team of experts to discuss whether this is the right path for you.

Read this if you are a business owner or leader in a company.

To expand or contract a business as market conditions change requires flexibility, agility, and foresight. For companies who want to be positioned as well as possible at the forefront of a recession, taking concrete steps now can ease the pain of an economic downturn or other unforeseen challenge.

How can companies navigate economic uncertainty and build resilience in their organizations?

• Contain costs. When met with financial constraints—or the need to rapidly invest in growth areas—it will be critical to contain unnecessary expenses. Consider what costs can be pared back:
  • Can you pause certain projects and initiatives and reallocate funds where there is the greatest opportunity for growth?
  • Do you need to maintain your physical workplace, or can you trim the overhead?
  • Can you consider alternative staffing models to reduce costs?
• Build a safety net of liquidity. Whether your business needs a capital reserve to invest in areas of growth or to pay the bills while waiting out the storm, conserving liquidity will help fortify the financial health of your company. Investigate all potential funding sources available, as well as the terms attached to potential loans and grants.
• Cultivate a nimble workforce. An adaptable workforce is key to scaling your business up or down. Be prepared to: reskill and upskill your existing workers to fill new roles; staff for agility so workers can serve as pinch hitters to serve areas with spikes in demand; and consider hiring contractors and freelancers in roles with a lot of variance of demand.
• Outsource infrastructural needs. One way to minimize fixed costs and help ensure best-in-class operational agility is by hiring external experts for non-core business functions, such as technology, finance, accounting, and human capital resources. Business operations are critical to maximizing workforce productivity and financially navigating a challenging climate. External experts working with companies across industries to scale during a recession can offer tried and true best practices to chart what would otherwise be uncharted territory.

While it’s impossible to know precisely what lies ahead, companies that take these four steps will be better poised to contend with whatever comes their way—whether it be a recession or an unprecedented growth opportunity.

Read this if you invest in research and development. 

Businesses that invest in research and development, particularly those in the technology industry, should be aware of a major change to the tax treatment of research and experimental (R&E) expenses. Under the 2017 Tax Cuts and Jobs Act (TCJA), R&E expenditures incurred or paid for tax years beginning after December 31, 2021, will no longer be immediately deductible for tax purposes. Instead, businesses are now required to capitalize and amortize R&E expenditures over a period of five years for research conducted within the U.S. or 15 years for research conducted in a foreign jurisdiction. The new mandatory capitalization rules also apply to software development costs, regardless of whether the software is developed for sale or license to customers or for internal use.

Tax implications of mandatory capitalization rules

Under the new mandatory capitalization rules, amortization of R&E expenditures begins from the midpoint of the taxable year in which the expenses are paid or incurred, resulting in a negative year one tax and cash flow impact when compared to the previous rules that allowed an immediate deduction.

For example, assume a calendar-year taxpayer incurs $50 million of US R&E expenditures in 2022. Prior to the TCJA amendment, the taxpayer would have immediately deducted all $50 million on its 2022 tax return. Under the new rules, however, the taxpayer will be entitled to deduct amortization expense of $5,000,000 in 2022, calculated by dividing $50 million by five years, and then applying the midpoint convention. The example’s $45 million decrease in year one deductions emphasizes the magnitude of the new rules for companies that invest heavily in technology and/or software development.

The new rules present additional considerations for businesses that invest in R&E, which are discussed below.

Cost/benefit of offshoring R&E activities

As noted above, R&E expenditures incurred for activities performed overseas are subject to an amortization period of 15 years, as opposed to a five-year amortization period for R&E activities carried out in the US. Given the prevalence of outsourcing R&E and software development activities to foreign jurisdictions, taxpayers that currently incur these costs outside the US are likely to experience an even more significant impact from the new rules than their counterparts that conduct R&E activities domestically. Businesses should carefully consider the tax impacts of the longer 15-year recovery period when weighing the cost savings from shifting R&E activities overseas. Further complexities may arise if the entity that is incurring the foreign R&E expenditures is a foreign corporation owned by a US taxpayer, as the new mandatory capitalization rules may also increase the US taxpayer’s Global Intangible Low-taxed Income (GILTI) inclusion.

Identifying and documenting R&E expenditures

Unless repealed or delayed by Congress (see below), the new mandatory amortization rules apply for tax years beginning after December 31, 2021. Taxpayers with R&E activities should begin assessing what actions are necessary to identify qualifying expenditures and to ensure compliance with the new rules. Some taxpayers may be able to leverage from existing financial reporting systems or tracking procedures to identify R&E; for instance, companies may already be identifying certain types of research costs for financial reporting under ASC 730 or calculating qualifying research expenditures for purposes of the research tax credit. Companies that are not currently identifying R&E costs for other purposes may have to undertake a more robust analysis, including performing interviews with operations and financial accounting personnel and developing reasonable allocation methodologies to the extent that a particular expense (e.g., rent) relates to both R&E and non-R&E activities.

Importantly, all taxpayers with R&E expenditures, regardless of industry or size, should gather and retain contemporaneous documentation necessary for the identification and calculation of costs amortized on their tax return. This documentation can play a critical role in sustaining a more favorable tax treatment upon examination by the IRS as well as demonstrating compliance with the tax law during a future M&A due diligence process.

Impact on financial reporting under ASC 740

Taxpayers also need to consider the impact of the mandatory capitalization rules on their tax provisions. In general, the addback of R&E expenditures in situations where the amounts are deducted currently for financial reporting purposes will create a new deferred tax asset. Although the book/tax disparity in the treatment of R&E expenditures is viewed as a temporary difference (the R&E amounts will eventually be deducted for tax purposes), the ancillary effects of the new rules could have other tax impacts, such as on the calculation of GILTI inclusions and Foreign-Derived Intangible Income (FDII) deductions, which ordinarily give rise to permanent differences that increase or decrease a company’s effective tax rate. The U.S. valuation allowance assessment for deferred tax assets could also be impacted due to an increase in taxable income. Further, changes to both GILTI and FDII amounts should be considered in valuation allowance assessments, as such amounts are factors in forecasts of future profitability.

The new mandatory capitalization rules for R&E expenditures and resulting increase in taxable income will likely impact the computation of quarterly estimated tax payments and extension payments owed for the 2022 tax year. Even taxpayers with net operating loss carryforwards should be aware of the tax implications of the new rules, as they may find themselves utilizing more net operating losses (NOLs) than expected in 2022 and future years, or ending up in a taxable position if the deferral of the R&E expenditures is material (or if NOLs are limited under Section 382 or the TCJA). In such instances, companies may find it prudent to examine other tax planning opportunities, such as performing an R&D tax credit study or assessing their eligibility for the FDII deduction, which may help lower their overall tax liability.

Will the new rules be delayed?

The version of the Build Back Better Act that was passed by the US House of Representatives in November 2021 would have delayed the effective date of the TCJA’s mandatory capitalization rules for R&E expenditures until tax years beginning after December 31, 2025. While this specific provision of the House bill enjoyed broad bipartisan support, the BBBA bill did not make it out of the Senate, and recent comments by some members of the Senate have indicated that the BBB bill is unlikely to become law in its latest form. Accordingly, the original effective date contained in the TCJA (i.e., taxable years beginning after December 31, 2021) for the mandatory capitalization of R&E expenditures remains in place.
 
The changes to the tax treatment of R&E expenditures can be complex. While taxpayers and tax practitioners alike remain hopeful that Congress will agree on a bill that allows for uninterrupted immediate deductibility of these expenditures, at least for now, companies must start considering the implications of the new rules as currently enacted. 

Read this if you work at a renewable energy company, developer, or other related business. 

When entering into agreements involving tangible long-lived assets, an asset retirement obligation can arise in the form of a legal obligation to retire the asset(s) at a certain date. In the alternative/renewable energy industry, these frequently present themselves in leases for property on which equipment (i.e., solar panels) is placed. In the leases there may be a requirement, for example, that at the conclusion of the lease, the lessee remove the equipment and return to the property to its original condition.

When an asset retirement obligation is present in a contract, a company should record the liability when it has been incurred (usually in the same period the asset is installed or placed in service) and can be reasonably estimated. The fair value of the liability, typically calculated using a present value technique, is recorded along with a corresponding increase to the basis of the asset to be retired. Subsequent to the initial recognition, the liability is accreted annually up to its future value, and the asset, including the increase for the asset retirement obligation, is depreciated over its useful life.

As a company gets closer to the date the obligation is realized, the estimate of the obligation will most likely become more accurate. When revisions to the estimate are determined, the liability should be adjusted in that period.

It is important to note that this accounting does not have any income tax implications, including any potential increase to the investment tax credit (ITC).

These obligations are estimates and should be developed by your management through collaboration with companies or individuals that have performed similar projects and have insight as to the expected cost. While this is an estimate and not a perfect science, it is important information to share with investors and work into cash flow models for the project, as the cost of removing such equipment can be significant. 

Recording the liability on the balance sheet is a good reminder of the approximate cash outflow that will take place in the final year of the lease. If you have any questions or would like to discuss with us, contact a member of the renewable energy team. We’re here to help.