How Rising Capital Gain Tax Rates Might Impact Tomorrow’s M&A Market

Agencies Contemplating Selling Soon Should Understand Their Opportunity Costs First

Capital gain tax rates will increase when the current legislation sunsets at the end of 2010. The best case scenario is the current 15 percent rate reverting to 20 percent, but the federal budget outlook is grim which could mean even higher rates.

For business owners, the incremental tax bill on the proceeds of a business sale could be significant and could negate the benefits of any growth in your business. If you are willing to work hard to grow the revenues of your business by double digits over the next couple of years, just to net out of it what you would get if you exited today, then read no further.

If you do not enjoy working for free and your time horizon for an exit transaction is within the next four years, however, consider the following exhibit (see below).

Pick the line representing what you believe the future capital gain tax rate will be; from bottom to top the scenarios are 20 percent, 25 percent, 30 percent, or 35 percent. Decide how many years until you wish to sell your business (between one and four in this illustration) and look over to the left axis. This represents the growth rate at which you must grow your revenues every year just to generate the same after-tax proceeds under the future tax regime as you would capture in a 2010 sale.

The sooner you intend to exit, the bigger your opportunity cost of not doing so in 2010, while the rate is still at 15 percent. The longer you wait the less dramatic the impact, though you will still be required to grow somewhere in the single digits, year after year, just to break even on an after tax basis with what you would receive today.

The percentages work the same for any size firm, but the example agency we will discuss has $5 million in 2009 revenues with a 25 percent margin (pro forma earnings before interest, taxes, depreciation and amortization, or “EBITDA” of $1.25 million). In this example, the EBITDA is valued at 6.0x for a $7.5 million gross purchase price. Keeping the scenario simple and assuming no debt, working capital adjustment or fees, this seller under today’s regime would pay 15 percent federal capital gain tax and keep $6.4 million (though many states then dent you another 5 percent or so, we will focus on federal only to keep it simple).

Example 1: If you plan to exit your business within the next year and believe capital gain rates will increase to 30 percent, then the business would have to grow by 21 percent in just one year for you to break even and reach revenues of $6.1 million (up from $5.0 million in just one year … good luck with that!). The larger gross proceeds one year in the future of $9.1 million (6.0x $1.51 million EBITDA) would result in the same $6.4 million in “take home” after-tax proceeds.

Example 2: With a two-year horizon and a belief that rates will increase to only 25 percent, revenues would still have to grow by 6.5 percent each year; this gets the revenue line up to $5.7 million over two years, just to get the same net after-tax proceeds.

It gets worse, since these calculations ignore the concept of time value of money. Keep in mind that you’re not really breaking even since a dollar tomorrow is worth less than a dollar today for two reasons:

1. the forgone opportunity to invest it today, at least at the risk free rate, and
2. the bigger risk that you might never get it (you don’t know if the projected profit margin or sale multiple will materialize).

Here are some questions to ask yourself if you are considering a sale within the next few years.

Time Horizon

How much longer do you want to run the business? Any smart buyer will insist you stay around for three years or more; back into a sale date from there. Budget for the process to take at least six months, but nine months to one year may not be out of the ordinary.

Sweat Factor

How hard are you willing to work to grow over that time period, just to take home the same net after tax proceeds in future years? If you believe another tax cutting administration will take office in the near future, keep working. Otherwise, read on.

Strategy

If you are years away from an exit, the next question concerns how you are going to realize the growth required to break even. The last two years have proven how difficult that is. The flip side of easy hard market growth of 5 percent, 10 percent, or even 15 percent per year is here.

As I have been telling my annual valuation clients over the past year or two, “flat” is the new “up.” Without a well oiled new business development machine, the typical agency will continue to hemorrhage revenues and profits.

2009 has been a tough year in the mergers and acquisitions (M&A) market. Less deals have closed and at somewhat lower valuations than the boom of 2007 and prior years.

Still, premium deals are happening for businesses that have superior new business development capabilities, a dominant regional franchise, an attractive niche, or all of the above.

Converting what is likely your single largest asset into liquid proceeds in 2010 will allow you to:

• pay the 15 percent capital gains tax rate; lock in certainty for yourself and your family by investing the proceeds; and
• begin to do other things with your time while the business transitions under new ownership.

Seller’s Remorse? Unlikely

In order for you to regret at least exploring a sale in 2010, you would have to believe some combination of these unlikely events playing out over the next few years: taxes will stay flat or go down; multiples paid by buyers will increase markedly; supply of sellers will decrease.

If you are considering locking in the capital gain tax at 15 percent, consider at least exploring the process in the first quarter of 2010. If you decide to hold and grow, at least you will have thought through the process and know the opportunity cost that must be overcome in order for holding on to the business to make sense. If this is your decision, focus on organic revenue growth and active management of your profit margin above all else.

Topics Mergers & Acquisitions Trends Profit Loss Pricing Trends