Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Signing Fee Trap That Buried a $40 Million Deal
Transcript
- Lucas: Let me tell you about the signing fee that turned a $40 million deal into a $2 million nightmare for the sellers. Luna: A signing fee? That's usually just a tiny fraction of the purchase price — maybe one percent. How does that become a nightmare? Lucas: Right. In this case, the buyer — a mid-market private equity firm — offered a $400,000 signing fee to lock in exclusivity while they completed due diligence. The sellers, a family that had run an industrial parts distributor for three generations, thought it was a gesture of good faith. They took it as a deposit against the purchase price. Luna: And that's where the trouble started — how they classified it? Lucas: Exactly. The signing fee was structured as a non-refundable payment that would be credited against the purchase price at closing. The sellers treated it as a deposit — essentially a prepayment of the eventual proceeds. But the buyer's lawyers structured it as a separate fee for entering the exclusivity agreement, not as part of the purchase price. Luna: So the tax treatment was completely different. If it's a deposit, it's just a timing thing — the sellers would pay capital gains tax on the full $40 million when the deal closes. But if it's a fee… Lucas: Then it's ordinary income in the year received, regardless of whether the deal closes. The sellers took the $400,000, spent some of it on legal fees and a family celebration, and then six months later the buyer walked away. Luna: Wait — the buyer walked away? I thought the fee was non-refundable. So the sellers kept the money? Lucas: They kept the $400,000. But here's the twist: the buyer's letter of intent included a 'good faith' clause that let them terminate if due diligence uncovered a material issue. They found a minor environmental problem — a storage tank leak from the 1990s that the sellers had already remediated. It was a pretext. Luna: So the sellers were stuck with $400,000 of ordinary income, a failed deal, and a cleanup bill they thought was behind them. Lucas: And a tax bill. Because the signing fee was classified as a fee for services — specifically, for granting exclusivity — the IRS treated it as ordinary income. The sellers owed roughly $160,000 in federal and state taxes on that $400,000. They had already spent $50,000 on lawyers and $30,000 on a new forklift they bought anticipating the deal. Luna: So they ended up net negative on the signing fee. And the deal was dead. Lucas: Worse — the buyer sued to claw back the fee, arguing that the sellers had misrepresented the environmental issue. The sellers had to spend another $200,000 defending themselves. In the end, they settled for keeping $250,000 after legal fees and taxes. A $40 million deal evaporated, and they were out nearly $200,000. Luna: This is brutal. So what's the lesson for sellers? How do you avoid this trap? Lucas: First, the structure matters. If you're a seller and a buyer offers a signing fee, insist that it be structured as a refundable deposit against the purchase price — not as a separate fee. That means if the deal closes, it's just a prepayment, and if it doesn't, the buyer gets it back. No tax consequence for you. Luna: But that's the opposite of what buyers want. They want non-refundable to lock you up. Lucas: Right. And that's where negotiation comes in. If the buyer insists on non-refundable, then you need to negotiate two things: first, that the fee is credited against the purchase price at closing, so it's treated as part of the capital gain, not ordinary income. And second, that the buyer's right to terminate and keep the fee is limited to specific, objective conditions — not a 'material adverse change' clause that gives them a free exit. Luna: So you want a 'for cause' termination only — like fraud or a material breach by the seller. Lucas: Exactly. In this case, the buyer terminated based on a minor environmental issue that was disclosed in the data room. If the sellers had negotiated that the fee was only forfeited if the seller committed fraud or willfully misrepresented something material, they would have kept the full $400,000, and the buyer couldn't have used a pretext. Luna: What about the tax side? Could they have structured it differently? Lucas: There's a mechanism called a 'deposit on the purchase price' that's treated as a reduction of the purchase price — meaning the seller doesn't recognize income until the deal closes. If the deal fails, the buyer gets the money back, so the seller never has to pay tax on it. But that only works if the fee is refundable. Luna: And if the buyer won't agree to refundable? Lucas: Then you push for the fee to be paid into escrow, with the escrow agent holding it until closing or a defined termination event. That way, the seller doesn't have constructive receipt of the money, so there's no tax until it's actually released. The IRS has ruled that escrow arrangements can defer recognition if the seller's access is restricted. Luna: So the escrow acts as a shield — the seller gets the benefit of the buyer's commitment without the tax bomb. Lucas: Right. And the escrow also protects the buyer — if the seller breaches, the buyer can still get the money back. It's a cleaner structure. Luna: I'm curious — how common are signing fees in mid-market M&A? I always thought they were more of a public company thing. Lucas: They're becoming more common, especially in competitive auctions where buyers want to lock in exclusivity. According to a 2025 survey by the M&A Leadership Council, about 15 percent of private-target deals under $100 million now include a signing fee. That's up from about 5 percent five years ago. Luna: Wow — tripled. And I bet most sellers don't think about the tax angle. Lucas: They don't. And here's the kicker: even when the deal does close, a poorly structured signing fee can create problems. If the fee is treated as a separate payment, the seller recognizes ordinary income on it in the year received, and then capital gain on the rest of the purchase price later. That creates a mismatch that can cost tens of thousands in additional taxes. Luna: So what's the right way to handle this from the start? Lucas: The ideal structure from a seller's perspective is: the signing fee is a refundable deposit held in escrow, credited against the purchase price at closing, and the buyer can only keep it if the seller breaches a fundamental representation or commits fraud. That's the gold standard. Luna: And if the buyer pushes back? Lucas: Then you need to price the risk. If the buyer wants non-refundable, ask for a higher fee to compensate for the tax hit and the risk of a bad-faith termination. And get a tax opinion from your accountant before you sign anything. The IRS has been aggressive on this — they've audited several deals where signing fees were misclassified. Luna: You know, talking about hidden traps in deal structures reminds me — this show exists because listeners help us keep it going. A handful of people chip in monthly through Buy Me a Coffee at buy me a coffee dot com slash fexingo, and that's literally what funds making episodes like this one. Lucas: Yeah, it's true. We don't run ads, and we don't have a big corporate backer. So if these conversations have moved your work forward in some small way, that's the only reason we can keep doing them. No pressure, just a fact. Luna: Alright — back to signing fees. Lucas, you mentioned that even in deals that close, the tax mismatch can be costly. Can you walk us through a real example? Lucas: Sure. Take a hypothetical $10 million deal with a $100,000 signing fee. If the fee is ordinary income, the seller pays about $37,000 in taxes on it at federal and state rates. If the rest of the deal is capital gain at 23.8 percent, the total tax is about $2.35 million. But if the fee had been structured as a deposit, the entire $10 million is capital gain — tax of $2.38 million. The difference is only $30,000, but the seller also had to pay the tax on the fee a year earlier, losing the time value of that money. Luna: So it's not just about the amount — it's about timing and cash flow. Lucas: Exactly. And if the seller had to borrow to pay the tax early, that's an additional cost. In the $400,000 case, the sellers had to take out a personal loan to cover the tax bill because they had spent the money. That loan cost them $15,000 in interest. Luna: Okay, so let's say I'm a seller and a buyer puts a signing fee on the table. What's my checklist? Lucas: First, ask: is this refundable or non-refundable? If refundable, great — structure it as a deposit against purchase price. If non-refundable, ask for escrow. Second, negotiate the termination triggers — limit them to fraud, willful misrepresentation, or failure of a clearly defined condition. Third, get a tax opinion that confirms the fee will be treated as part of the purchase price for tax purposes. Fourth, don't spend the money until the deal closes. Luna: That last one is hard — a family sees $400,000 and thinks it's a bonus. Lucas: It's human nature. But if you treat it as a deposit, you don't have it yet. The buyer can still walk, and you could be left holding the tax bag. A good rule of thumb: assume the deal won't close until the wire hits your account. Luna: And what about buyers? What's the trap from their side? Lucas: For buyers, the risk is that if the fee is refundable and they walk, they might have to sue to get it back. In the case we discussed, the buyer spent $200,000 in legal fees trying to claw back a $400,000 fee. That's a terrible return on investment. Better to structure the fee as a non-refundable option premium — like a call option on the business — where the buyer pays for the right to walk away for any reason, but the seller keeps the money. That's cleaner. Luna: So essentially a break-up fee for the seller's benefit. Lucas: Right. And it's actually more common in larger deals. The key is to be explicit about the nature of the payment. If it's an option premium, the seller recognizes it as ordinary income, but at least they know that upfront and can plan for it. The problem in the $40 million deal was that everyone thought it was a deposit, but the documents said it was a fee. Luna: So the lesson is: read the documents, don't just rely on what people say. Lucas: And hire a tax advisor who specializes in M&A. A good one would have caught this in the letter of intent stage. The sellers in our case used their longtime family accountant, who was great for annual returns but had never seen a signing fee before. Luna: That's a common mistake — using your regular CPA for a once-in-a-lifetime deal. They might not know the nuances. Lucas: Exactly. The M&A tax world is full of traps like this — signing fees, earnout structures, working capital true-ups. Each one can cost you six or seven figures if you're not careful. The signing fee trap is just one of many, but it's one of the most insidious because it seems so simple. Luna: Simple on the surface, devastating underneath. Thanks for breaking this one down, Lucas. Lucas: Sure thing. Next time we'll talk about the 'no shop' clause that can kill your backup plan — another seemingly standard clause that can blow up a deal.