Impact of the Tax Cuts and Jobs Act on…

By EdgePoint

The tax reform signed into law December of 2017 includes lower federal tax rates and several new tax deductions that apply to both C-Corporations pass through entities, including LLCs and S-Corps. Along with those tax deductions come a new set of restrictions on other deductions such as the ability to deduct state and local tax (SALT) against federal income tax, limitations on deducting interest on business loan payments, among other miscellaneous complicated new rules affecting business taxation.

It is difficult to determine what the effect of these new rates, deductions and limitations will be on a business without examining the unique aspects of the individual company, including what business activity it conducts, its asset and wage base, and its ownership since the new rules were targeted to encourage certain types of business activities over others. How this may affect a business owner looking to sell his/her company is further complicated by the lower tax rates on C-Corps that still carry a double tax on the sale of assets, and the promise of lower taxes on pass through entities that seemingly bring the income tax rate closer to the capital gains rate mostly enjoyed on a sale of the business. With all the counterbalancing built into the new tax law, it is important to review some of the key points of the new tax law to determine how this may impact an owner’s decision to sell.

Corporations and pass through entities will all benefit by having lower actual tax rates. C-Corporations rates drop to 21% and the top individual federal rate of 39.6% goes to 37%, with higher thresholds that save an individual over $31,000 on the first million dollars of income without considering any deductions. Additionally, amounts for bonus depreciation are increased significantly, allowing companies to deduct both new and used equipment purchases. Finally, there is a pass-through income deduction of 20% on Qualified Business Income (QBI) under 199A that applies to businesses not in a specified service or trade company. This 199A pass through deduction reduces K-1 business income by up to 20%, but is limited by several factors including how much W-2 wages the company pays and the amount of its gross depreciable assets.

On the limitations side, the SALT deduction is limited to $10,000 and business loan interest is limited to approximately 30% of EBITDA and phases down to approximately 30% of EBIT in 2022, which will lower the ability to deduct interest further. The 199A pass through deduction of 20% on QBI in the highest tax bracket is limited by 50% of W-2 wages or 25% of Wages plus 2.5% of gross depreciable assets. Thus, the deduction benefits lower income companies that may have more wage or asset intensive businesses, and is either non-existent for some service businesses or reduced for eligible businesses that happen to have high margins that make a commensurate high return on assets or labor.

Entity choice will continue to matter to business owners as C-Corps may have a lower effective tax rate than pass through companies, but are still double taxed on the sale of its assets resulting in an approximate 37% effective rate in no-tax states to higher than 45% for mid-taxed states. This is still better than double tax rates as high as a combined 58% before the tax reform. As most of sale transactions are taxed as “asset transactions”, pass-through entities such as S-Corp and LLCs will continue to be the clear tax choice for those owners looking to sell their companies. This is in addition to the fact that pass through entities will create tax basis (AAA) for their owners on the after-tax income that is not distributed, unlike C-Corp owners who do not benefit in that way.

From a tax rate perspective, pass through entities that qualify for the 199A pass-through 20% deduction and are not limited by any of the wage or asset tests will bring their federal rate down from 37% to 29.6% by applying the 20% deduction to their business income. Even so, the loss of the state deduction in the SALT limitation will add close to 2% additional effective taxes on a mid-level tax state resulting in a 31.5% effective comparable rate. Although this is down from the 39.6% top rate prior to the reform, most higher profit businesses will not qualify for the full deduction, and the best-case scenario income tax rate is still significantly higher than the capital gains rate of 20% on the sale of the goodwill of a pass-through entity. Therefore, when you capitalize earnings on a multiple of EBITDA, which is higher than taxable net income – especially when reduced by Capex and working capital reinvestment, owners will find that they simply cannot “work a few more years” and make what they would in the capitalized sale transaction taxed at predominantly capital gains.

The M&A professionals at EdgePoint have been doing transactions through several major legislative tax changes, and although the change at the time may seem to affect a business owner’s decision to sell, it is our experience that taxes are only a part of the decision. In fact, tax changes generally have not played a major role in our clients’ decision to sell, except to the potential accelerating by a few months during a known tax increase period such as the expiration of the Bush tax cuts in 2012.

In our experience, business owners make the decision to sell when they feel they are ready to have the transition/succession discussion, the market cycle is favorable to them, and when their businesses are doing well. The tax cuts in the tax reform act of 2017 should add fuel to an already accelerating economy, and extend the market cycle to allow savvy business owners to take advantage of the current high valuations for their companies, while hopefully getting some tax relief in the process. That, we believe, will be the true impact of the new tax legislation.

© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com

What To Do With Real Estate Related to Selling…

By EdgePoint

When a business owner decides to sell their Company, an important decision must be made regarding real estate owned in the business or by a related entity. Selling business owners typically face three options:

1. Sell the real estate as part of business transaction;
2. Consummate a real estate sale with a third party real estate investor unassociated with the business transaction (Sale-Leaseback); or
3. Maintain ownership of the real estate and enter into a lease with acquirer of the business (Buyer)

Whether a business owner decides to sell the real estate at the time of their business sale depends on several factors:

• Is the business owner a real estate investor outside of the owner-occupied property associated with their business?
• Can a non-owner occupied (investment real estate) mortgage be secured at acceptable interest rates and loan terms if the real estate is retained?
• Do market conditions make it favorable to sell the property now or wait if the market is depressed?
• Does the Buyer have a preference or aversion to buying the real estate?
• What is the Seller’s investment horizon?

The Seller’s risk assessment and risk appetite are important initial considerations. If a Seller determines to divest the real estate with the business transaction, they may reallocate and diversify the proceeds into new market-based investments that may be more suitable, since the real estate asset may make up a larger allocation of their net worth than appropriate. Diversification is preferred by many Sellers as the perceived risk increases after they cease to have full control over the business which is usually the single tenant. Being reliant upon a single tenant, where business failure or facility migration may initiate an unknown period without lease revenue (depending on the lease or ability to secure a new tenant), may exceed a Seller’s risk appetite. Additionally, the value of the building at the time of the business transaction may be one of the highest because the Seller can use the business transaction to extract favorable lease terms or values from the business buyer, and the original lease term is generally the longest at the point of the original signing of the lease – which generally leads to a higher value.

Sellers preferring to maintain ownership of the real estate must consider the ability to procure a mortgage with interest rates and terms that may be different than an owner-occupied mortgage. If a Seller reduces their ownership in the business below 50%, the real estate generally becomes an “investment property”, and may be subject to higher interest rates and more restrictive terms, and some banks don’t offer those mortgages. Owner-occupied mortgages typically feature lower interest rates and more favorable terms (length of amortization, loan to value, etc.).

Sellers must determine whether market timing is optimal. Oftentimes, simultaneously selling the business and real estate is the most advantageous time to sell because a new longer-term lease can be negotiated as part of the business transaction. Even if the business buyer is not purchasing the real estate, the new lease that is negotiated during the business transaction can provide a third party sale-leaseback investor group with a longer lease with which to value the real estate. Because a longer lease term provides more certain and longer cashflows, banks will give these real estate buyers longer amortization (and sometimes higher loan to value) for their mortgages in order to purchase the real estate. Higher low-cost leverage and better cashflow due to the longer terms, allow real estate buyers to pay more for a building because the bank leverage increases their equity returns. Since the lease term will probably never be longer than when the lease is originally signed, this may be the best opportunity for an owner to sell its real estate.

Inversely, if a Seller determines that the timing is not yielding the desired value, they may opt to keep the property and collect rental income or sell to a third party in the future. This scenario presents potential risks to future value because lease terms and future cash flows, which Real Estate Investors use to generate values, may not align with financing secured to purchase the property. Most lease extensions are not as long as the original lease, which may make longer-term financing more challenging for a future buyer. Market timing must be considered in conjunction with the financing options that may be available currently that would also influence value.

A third-party sale-leaseback arrangement, which can be arranged by a commercial realtor, investment banker, or, sometimes the business buyer, can represent the best opportunity if the business buyer is not open to buying the real estate themselves. A sale-leaseback is a real estate transaction consummated with an unrelated third-party (real estate investor), preferably concurrently with the business transaction. The real estate investor enters into a lease agreement with the new tenant (business buyer). A real estate investor can maximize the value received by the Seller, and both of the transactions are completed for the Seller. The real estate investor benefits from the favorable terms (discussed previously) negotiated into the new lease, and the business buyer has an agreeable lease and is not required to own real estate, as may be their preference.

Deciding between a real estate sale or lease/own arrangement may depend on the Seller’s investment horizon. The Seller must determine whether they would maintain the investment long enough to realize an advantageous return over an acceptable time period versus an immediate sale with reinvestment of the proceeds. Shorter to intermediate-term investment horizons typically provide an advantageous return if the real estate is sold concurrently with the business. Sellers must also consider the liquidity of real estate compared to other market-based forms of investments as it relates to their risk profile and retirement income needs.

Common to every transaction, tax consequences should be considered carefully. If the real estate is sold at the time of the transaction, the Seller will likely incur tax at the capital gains rate, which is currently at 20% federal. Additionally, the Seller can reinvest the post-tax gain into other assets immediately. Inversely, if real estate ownership is maintained and leased to the Buyer, rental income is treated as ordinary income, and the tax rate is currently around 40% (highest income tax rate for individuals is 39.6%), with no deduction for principal payments on mortgages.

The investment horizon and tax consequences are best demonstrated in the example below with the following assumptions:

First, calculate total net proceeds if the Seller chooses to divest the real estate concurrently with the business. In this example, the net after tax and debt proceeds are $500 thousand if the property is sold for $2.0 million with capital gains tax treatment, a state income tax rate of five percent, and $1.0 million remaining on the existing mortgage.

Alternatively, if the real estate is held post-transaction and leased to the Buyer using a triple net lease (tenant agrees to pay all real estate taxes, building insurance and maintenance expense), the Seller will receive cash flow after tax and mortgage payments of approximately $27k annually.

From the two calculations above, the estimated payback period of the net proceeds can be compared for an immediate real estate sale versus the lease model by dividing the real estate sale proceeds by the annual rental net cash flow, which is illustrated below:

As illustrated above, the Seller would break even on cashflow after 18.5 years. Reinvesting sale proceeds at a 4-5% conservative market return would extend the payback period to well more than 20 years on a. Of course, holding real estate indefinitely can return a higher overall value, so long as the real estate continues to appreciate. Otherwise, selling is still generally the best financial conclusion over the short and intermediate term.

The decision to sell or maintain and lease real estate after a business sale can be complicated depending on the Seller’s financial goals, investment risk tolerances and timeframes, and post-transaction roles in the business. However, careful analysis of the above considerations and input from trusted advisors can help a Seller determine the optimal course of action for real estate in a business transaction.

© Copyright by EdgePoint, M&A advisors. You can reach us at 216-831-2430, or on the web at www.edgepoint.com

Using the SBA 7(a) Loan in M&A Transactions

By EdgePoint

One of the least understood and used financing sources for M&A transactions is the SBA 7(a) term loan. Because of its maximum loan size of $5mm, it can be used in smaller middle-market transactions, especially individual, management and partner buyouts with companies up to $3mm in EBITDA. This type of loan is made by a bank, and is guaranteed by the SBA up to 75% against any potential losses that the bank may have on a defaulted loan. The SBA rules (also called SOPs) must be strictly followed by banks to be eligible for default reimbursement.

For those transactions that are appropriate and qualify, the terms of the loan structure are very attractive. Banks are allowed to extend up to 10 year terms, on a mortgage amortization basis (level payments) and are capped on the interest they are allowed to charge at prime plus 2.75%. There is supposed to be no minimum collateral requirement, but some banks apply arbitrary collateral standards for the transactions they are willing to enter into. For those banks that follow the SBA guidelines, no minimum collateral is required, which makes these loans especially useful for services, distribution, or high margin businesses, where there would not be a sufficient amount of collateral available to secure the loan amount.

For normal cashflow loans, most lenders that are willing to do an under-collateralized transaction under $3mm in EBITDA would require repayment terms of 3-5 years, and generally recapture excess cashflow to pay back the loan in the shortest amount of time they can. This uses precious cashflow for repayment of senior debt in the first years after a transaction, which generally could have been used more effectively for growth, working capital and any transition issues that may have come up. Instead, the bank requires the accelerated repayment of its loans, and that can stifle the growth of the business. SBA loans generally have 7-10 year repayment terms, with no cashflow recapture, allowing the business to use the cashflow for those more important reasons.

In order to consider whether this loan program is appropriate for any transaction, certain pre-requisites apply. First, this is a personally guaranteed loan, which would prohibit most funded private equity groups from using this loan structure. Individuals or investor groups willing to guarantee the loans are required in order for the bank to make this type of a loan. In fact, any investor that owns 20% or more of the equity post-transaction is required to sign personally jointly and severally for the full amount of the loan. Many buyers misunderstand and believe that they have to have the amount of guaranteed loan available to the bank to collect, which is not true. The bank is required by the SBA to get the guarantees to comply with the loan guarantee program, but it is not necessary to actually have any particular net worth to qualify for the loan.

The second consideration is the type of transaction that is being proposed. There are certain rules that need to be followed according to the SBA SOPs. Some of those rules are below:

• Buyer must purchase 100% of the equity of the selling shareholders or own 100% of the equity after buying assets. Selling shareholders cannot “roll over” equity, or be partially bought out. The buyer needs to purchase the entire business in this transaction.
• No Earnouts – the price must be a fixed price, and cannot have any contingencies to the valuation such as earnouts, royalties, extensive commissions to the sellers, etc.
• The buyer must have functional control over the business after the transaction. If there are investors backing a manager to run the company, the manager cannot generally be fired.
• Certain types of companies and industries are excluded: firearms, multilevel marketing, and other specific industries are not allowed to use the SBA loan programs.

Another consideration for 7(a) loans is the equity contribution. For any loan that is not fully collateralized, and the company has more than $500k of goodwill (which will be most lower middle market transactions), the SBA requires that there be 25% “equity” in the transaction. That equity can be made up of existing equity (partner buyout), cash and/or seller notes that are deferred for two years, with no payments of interest or principal until the third year, and then can be paid as agreed. Most banks will require at least 10% cash or existing equity for acquisition transactions, but the remaining amount can be in the form of a deferred seller note. This gives a great deal of leverage to the buyer with essentially 9x leverage on equity, with 10 year terms for a senior bank loan and seller notes.

The credit test for the banks that follow the SBA guidelines is that the deal must cashflow to a 1.15x fixed charge coverage, meaning that the EBITDA needs to be 1.15x the Principal, Interest, Taxes, and Unfunded Capex, and the SBA considers that to be sufficient cashflow to make the loan. On a 10 year, low interest rate loan, this generally accommodates between 3-4x EBITDA comfortably against this test. Some banks will require higher financial ratio tests, or cap the loans at a senior debt multiple, but generally those caps are still much better than what you would get at a traditional cashflow lender and at lower interest rates.

Some advisors and buyers erroneously believe that the fees are too expensive to make the SBA loan worth it. Loan fees for the SBA are a graduated percentage that goes up to 3% as a loan closing fee that is paid to the SBA. Even on a $5mm loan, with a higher than actual full 3% fee ($150k), the cashflow savings in the first year assuming a 10 year loan term rather than a 5 year term is almost $500k. The interest savings from a lower rate versus a cashflow lender is probably a breakeven in 1-3 years, and easy to justify over the term of the loan. SBA loan fees should be irrelevant when considering this structure as they pay for themselves many times over.

Unfortunately, most small business banker lenders don’t fully understand the SBA rules, especially when it comes to acquisition transactions. Most middle market lenders never use this tool. Further, most banks make additional rules and credit standards which are more limiting than the SBA actual guidelines of the transaction structures they would support. This is partly because if the bank doesn’t follow the SBA SOPs, the government will decline to honor the guarantee, and the bank is facing a large loss that wasn’t anticipated when they made the uncollateralized loan in the first place.

EdgePoint has worked with banks across the country to develop transaction and loan structures that comply with the SBA guidelines and have formed relationships with the banks that do these types of deals. Knowing who to go to, what to ask for, and how to follow the SBA SOP rules have allowed us to close numerous transactions for our clients using this incredibly effective but highly misunderstood financing tool.

© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com

Speed, Decisiveness, and Focus are Critical to Closing a…

By EdgePoint

Imagine for a moment you have worked decades to build a successful business, have made the decision to sell your company, have done a fantastic job identifying the right buyer and negotiating the price and other sale terms, have signed a letter of intent (“LOI”) with the selected party and are scheduled to close your transaction in a short 90 days. “What could possibly go wrong?” you may think to yourself. The short answer – a lot! The window to sell is always closing and can slam shut in the blink of an eye, especially after the “honeymoon” of reaching an agreement and after the (LOI) is signed. Our experience closing hundreds of deals reminds us that “time is the enemy of all deals” and to be ever wary of “deal drift” during this period.

Every deal has its own life and momentum. Recognizing the ebb and flow of these characteristics is critical to deal success. Time is the enemy of all deals, and with each passing day, the window to successfully sell your company closes a little further. There are a number of factors that can contribute to deals failing to close, all of which become a greater risk with each delay in the closing process.

Common examples that result in a transaction failing to close post-LOI include:

1. New Opportunities: Buyers who were excited about the opportunity to acquire a business can suddenly become enamored with a new and seemingly “better” opportunity (“the next shiny object”).
2. Protracted Due Diligence Process: An inefficient or drawn out due diligence process is one of the most frequent cause of delays. If a buyer does not have a strong due diligence team and process, or if the seller is not prepared to respond to a buyer’s due diligence requests in a prompt manner, deal momentum is lost in addition to potential “warts” of the company becoming more prominent and discouraging to the buyer.
3. Material Changes: There is an ongoing risk of material changes in the business’s operations that can occur during closing. While a number of these changes may be completely out of a business owner’s control (i.e., loss of a major customer, loss of a key supplier, sudden change in interest rates, sudden changes in the seller’s industry that could impact the buyer’s investment, etc.). Keeping the deal focused and moving towards close as quickly as possible helps minimize the risk of these occurrences happening before close.
4. Over / Renegotiating the Terms of a Deal: Over-negotiating and/or renegotiating by the buyer or seller of the terms, conditions, structure, and representations and warranties of a transaction can be a deal killer. At the very least, back-tracking deal components that have been previously agreed upon slows deal momentum, adds time, and causes “deal fatigue.” It also fosters distrust and can call into question all other components of the deal structure previously negotiated. All this can lead to either the buyer or seller second guessing or exiting from the deal.
5. Greed & Reaching for the Bottom Dollar: It is completely understandable that sellers who have put everything into their business want to get every dollar they can out of their business. Often, owners lose sight of the original value they desired to achieve from the sale of their Company and their valuation expectations continue to drift higher. Even after agreeing to a value in an LOI, owners tend to believe their business is worth more and more each day, often without any true fundamental change in operations or profitability to justify this perspective. It is not uncommon for owners to decide to pass on a deal, believing that the next potential buyer will pay more than the current potential buyer. Conversely, we have seen good buyers terminate negotiations and the LOI rescinded due to increasing and unrealistic valuation expectations by the seller. It is not uncommon for a multi-million dollar deal to fall apart in the final days over a few thousand dollars.

While some of the conditions that result in a transaction failing to close described above may be out of a seller’s control, there is one thing that a business owner involved in a sale process can control – their own speed and decisiveness. Below are some thoughts and best practices post LOI learned through decades’ of shared experience and hundreds of successful transactions completed by EdgePoint’s professionals.

• Don’t Make Mountains Out of Mole Hills: Work with your advisors to make a clearly defined list of key items to negotiate in a purchase document. It is a delicate balance between over-negotiating and throwing in the towel on key points, but a seller must do their best to identify what they really care about. Decide what is really important, and clearly communicate this to the advisor team. Your investment banker and attorney should collaborate on these items and determine the best negotiating strategy for these critical legal and deal terms. This avoids any unnecessary delays and miscommunications on the buyers and sellers side.
• Avoid Complacency / Dictate Timelines: Do not allow yourself to fall into a sense of comfort and complacency once the LOI is signed. This is when the real work begins. Sellers must keep in mind that they have not successfully sold their business until signatures on all purchase documents have been exchanged and funds have been transferred. Until this moment, sellers must respond to all requests from a buyer quickly and push the buyer to adhere to a detailed, agreed upon timeframe. Don’t be complacent. Push hard to set up any important technical reviews (quality of earnings), the due diligence meetings, the reference calls, customer calls – any key items that are critical conditions to closing. Your investment banker is skilled at anticipating where there might be preparation gaps in your due diligence and guide you to be better prepared to avoid any of these delays that might distract buyers.
• Stay Focused on the Ultimate Goal: Remember what your goals and desires were when you initially made the decision to sell your business and hired an investment banking advisor. The process of selling a company is an emotional one. Owners will experience a number of highs and lows during the journey. Once an LOI has been signed, sellers need to stay focused and continuously remind themselves of their desired outcome at the beginning of the process.

Focusing on this guidance provides a seller with the best opportunity to speedily and decisively achieve the goals and objectives he or she originally desired at the start of the sale journey.

—

EdgePoint is a leading investment banking firm focused on providing lower middle market business owners with merger and acquisition advisory services.

© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com