Capital Gains Taxes- Paying Uncle Sam Less

By Russ Warren, Managing Director and
Tom Zucker, President

M&A activity has returned after taking a breather during the recent economic downturn, and it’s a seller’s market. Private equity and strategic acquirers alike are deploying cash to acquire middle market businesses at attractive multiples of healthy earnings. Yet, “it’s not what you sell for, but how much you take home after tax, that counts”. So, in addition to a market-based valuation of your business, it is worthwhile to have your tax advisor calculate the expected tax bite when planning a liquidity transaction. The key tax rate is that on long-term capital gains (LTCG) – the difference between basis and proceeds.

The LTCG tax rate has a volatile history since it began in 1913 as part of the income tax on individuals and corporations authorized by the 16th Amendment. It has been as low as 7% and as high 77%. At 15%, today’s maximum LTCG tax rate is the lowest it has been in the last 78 years

From 1913 until 1922, capital gains were taxed as ordinary income (at 77% when America was fighting World War I). In 1922, when the highest rate on income was 58%, a separate lower maximum rate for capital gains was adopted – 12.5%, until 1934, the second year of FDR’s first term. The rate was then raised to 32% for two years, 39% for two years and then 30% until the United States entered World War II in December 1941. Interestingly, from 1942 until 1968 – through WWII, Korea, Vietnam and with the Cold War on-going – the LTCG rate remained at 25%. It then crept up to 40% during Nixon, Ford and Carter years. Under Ronald Reagan it was cut to 20% for five years, then raised to 28%, which lasted for ten years, until, under Bill Clinton it was lowered to 20%. In 2003, under George W. Bush, the present rate of 15% was adopted with a sunset provision that now takes effect at the end of 2012.

The LTCG rate will go back up to 20% on January 1, 2013 if Congress takes no action. President Obama has stated he will not allow the Bush tax rates to be extended again. Will they be 20% again, or, with current budget deficits and a $14 trillion national debt, will revenue sources be on the table? If so, where better in Washington’s view to raise taxes, than to return capital gains to more historical levels? Pundits and tax-watching organizations diverge on their estimates, with Citizens for Tax Justice in January 2011 seeing a 25% LTCG maximum rate in 2013. Howard Gleckman, of the Tax Policy Center writing in the Christian Science Monitor in April 2010 said his “best guess is that the top tax rate on capital gains and dividends in 2013 will be almost 24%.” In February 2011, The Kiplinger Tax Letter said Obama wants Congres

While many factors enter into choosing the best time to sell a specific business, the prospect of paying more to Uncle Sam if the sale (of all or part) of that business closes after December 31, 2012 is already on the minds of some savvy owners contemplating an exit event within the next three years or so. Consider the following two hypothetical examples.

Today, if a business owner has $10 million in long-term capital gains, the tax at 15% will be $1.5 million. However, if the LTCG rate were to return to 28%, the extra $1.3 million tax bite would reduce take-home proceeds from $8.5 million to $7.2 million, a 15% shrinkage loss for family and philanthropic uses.

Alternatively, to realize today’s after-tax proceeds at higher future LTCG rates (and a constant pricing multiple), the business would have to generate a significantly higher Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) as shown below (in $000s).

Where do you think the long-term capital gains rate is going, and how will that affect your plans? How much would you need to increase your revenues at a constant profit margin to cover the added tax burden, and how long would that take?

If you are an owner who intends to harvest your long-term investment soon, Uncle Sam is making an attractive limited-time offer – the endangered 15% Capital Gains Tax. But to take advantage of this offer, action is required. The typical sale of a middle market business – to an unrelated party, an ESOP or even management – requires six to twelve months (depending on factors often beyond the seller team’s control) from the time a financial advisor is engaged. To close a transaction by December 31, 2012, discussions and planning should begin soon. As that deadline draws nearer, buyers and advisors will get busier. In the world of taxes, ‘almost getting it closed by the deadline’ doesn’t count, and could cost you a lot of money.

If EdgePoint can be helpful to you, please call us at (216) 831-2430. Russ is at extension 207; Tom is at 204.

© Copyrighted by EdgePoint. Russ Warren can be reached at 216-342-5859 or via email at rwarren@edgepoint.com. Tom Zucker can be reached at 216-342-5858 or via email at tzucker@edgepoint.com.

Aligning the Stars for Exit- What Turns Buyers On?

By Russ Warren,
Managing Director

Oddly, many a business owner carefully planning a plant expansion or new sales initiative thinks little about meaningfully preparing for perhaps his or her most important project—selling the business at the highest price and on the best terms.

This article, based on experience advising hundreds of owners on the sale of middle-market businesses with sales of $10-100 million, should give you a handle on the process to achieve that goal.

Three Stars need to align for a ”successful exit.” Think: What’s really important to you?

Macro Star – Overall conditions in the hands of others: world markets, the U.S. economy, and industry conditions. M&A pricing markets fluctuate with macro factors: supply of and demand for sellers, financing availability and economic outlook. In April 2015,Macro Staris about as good as it gets, with historically-low interest rates and capital gains taxes. Private equity buyers are eager to deploy cash and lenders are equally eager to deploy capital as they actively pursue opportunities.

Business Star – Attributes you can control or influence (a main focus of this article).

Owner Star – Includes controllable events (e.g., retirement, estate planning, and pursuit of other interests) and noncontrollable concerns (e.g., health issues) of the owner(s). Controllable events can be aligned with Macro Star and Business Star. To some extent, the impact of noncontrollable events can be tempered by planning techniques like leveraged refinancing.

Let’s look at Business Star, and what turns buyers on.
To sell your business for the highest price and on the best terms, you need to optimize and communicate the attributes that buyers are willing to pay a premium for, including:

Corporate Clarity – A business they can understand, and a business model that says “sustainable competitive advantage.”

• Can you state the essence of your business in a sentence?
• Have you clearly defined your target customer groups and the value proposition your business offers them?
• What is your competitive advantage? Is it sustainable?
• How do your financial results compare with peer companies? Do you benchmark against industry data?

Profitability – Operating profit as a percent of sales and as return on investment (equity). To earn a premium multiple for your size and type of company, buyers want to see an EBITDA margin (adjusted for owner-discretionary expenses) above industry peers.

Predictability – The ability to credibly predict EBITDA (gross cash flow) and operating profit, and the absence of financial surprises.

• How far ahead can you see into your revenue stream? How could you improve predictability?
• How dependent is your business on one or a few customers, suppliers or employees?
• How variable were your revenues in 2008-10? Have you made changes since then?
• Do you have pricing power? Have you challenged your pricing policies recently?
• What is changing in the competitive landscape? Do you have a plan to deal with that change?

Growth – Steadily increasing EBITDA and profits over a normal planning horizon (e.g., five years).

• Have you demonstrated growth in the last five years? Do you havecrediblesales growth projections?
• Do you understand your addressable markets? Do you have a plan to add geography, customer groups, or new products? Have you made or targeted strategic acquisitions?
• Is your business scalable?

Financial acquirers will pay for clarity, profitability, predictability and growth.

Strategic acquirers (typically larger companies in your market space) are attracted specifically to things like your intellectual property, reputation or key talent, but they value clarity, profitability, predictability and growth viewed through the lens of “what can we do with the combined business – how much can your business add to our value?”

Getting to alignment – Embarking on the exit planning journey
A well-run sale process normally takes six to nine months from engaging an investment bank until closing. But thinking of how to align those stars … ah, that could take a few months or a few years.

First, clearly define a successful exit – what you want from the event. Certainly, a full, fair price is important – but what else?

• A customized role for yourself after closing?
• Protecting key employees or family in the business?
• Protecting the business’ reputation and service customer levels?

Second, know what your business is worth today, and what after-tax proceeds you expect from a transaction, to see if your personal, family and philanthropic objectives will be met.

Business valuations come in all stripes.For exit planning, you need the amount a willing buyer will pay if the business is offered in a professionally run auction process to an appropriate number of selected buyers. A valuation computes enterprise value (equity plus outstanding debt). In a transaction closing, the owner(s) pay off the debt and keep the cash. Your tax advisor can then compute your expected proceeds, based on enterprise value.

Competition creates value.Surprising to most owners, private-equity firms today may pay more than strategic acquirers. A competitive process generates the highest price, best terms, and greatest certainty of close. The remaining variable is timing. Is time your friend or foe, and what is the risk that your Macro Star will plunge out of alignment at the worst time? Think: Murphy’s Law.

Finally, decide on a start date and assemble your exit advisory team. Working with an attorney with M&A transaction experience can shorten the process and increase your certainty of close. A Tax Advisor, your CPA and any specialists needed to burnish the Business Star or align the Personal Star also have valuable roles to play. The investment banker acts as advisor and quarterback until closing, to keep the process on track. He or she drafts the marketing materials, identifies dozens to a few hundred buyers with a clear reason to own your business, handles communications, and negotiates issues with buyers. Once you have all the stars in alignment, you’re ready to begin the sale process.

© Copyrighted by EdgePoint. Russ Warren can be reached at 216-342-5859 or via email at rwarren@edgepoint.com.