Over our 21 years advising family businesses and entrepreneurs as they contemplate selling their business or raising capital, we have pursued the standard of providing balanced guidance and nuanced insight. Most often, our review of their options results in advising company owners to stay the course rather than pursue an immediate deal. We frequently counsel owners in favor of exploring a transaction down the road, given our belief in a more optimal valuation outcome once they can address key matters in their business and market.
However, within this backdrop, we now see peak valuations in the M&A and capital markets, married with the high degree and magnitude of tax risks with the single-party majority in government, resulting in our advising company owners that a near-term transaction may optimize both gross valuation and net after-tax proceeds. This environment has created the “perfect storm” to consider a sale in 2021.
Supply and Demand Dynamics Driving Valuations Above Pre-COVID Levels for the Right Companies
Many business owners have been heads-down navigating their companies through COVID-19 and 2020’s economic headwinds—perhaps unaware of the compelling valuations their companies can potentially achieve in the current market.
Meanwhile, the fundamental law of supply and demand has taken hold in this post-COVID environment. Similar to the dynamics in the public markets, shorter supply has driven relative M&A valuations for the right companies to peak levels, comparable to other high points in middle-market M&A back in 1999 and 2007. In our estimation, only about half of the nation’s middle-market companies have fared well through the COVID-19 pandemic and fit buyers’ quality bar, shrinking the number of options for strategic and private equity buyers. These dynamics have put the right companies in the perfect environment to maximize their value in 2021. Transaction multiples for many companies across our core growth sub-vertical coverage areas have increased materially relative to the pre-COVID environment, often by 20-30%, and sometimes by 50% or more.
On the buyer demand side, there is the perfect combination of intense interest from both private equity and strategic buyers alike. Quite often, we are seeing private equity firms outbid strategic buyers in our processes, especially when the private equity firm is making a strategic add-on acquisition for their portfolio company. The private equity capital piles are robust, with nearly $1.6 trillion of uninvested capital waiting in the wings. This is roughly 3x the prior 10-year low of $559B in 2012 [1].
Strategics who paused M&A activity to get their own houses in order in the early days of the pandemic are focused squarely on acquisitions of high-growth companies as a way to retain the momentum in their business performance and value. The S&P 500 has $1.9 trillion of cash on balance sheets, as compared to $750 billion back in 2008 [2]. In addition, those who took PPP loans can now deduct the loan amount used for business expenses from their tax bill, creating even more capital pools for M&A.
If your business is among the high-performing, you are poised to achieve compelling valuations in this M&A market. This dynamic is true for companies that experienced revenue and profitability improvements (on the right side of the scale—i.e., at least $50M value or higher) through the pandemic period—and who have reason to believe that growth will continue.
On the balanced perspective side, buyer interest has dramatically waned for companies in struggling sectors or those with any material issues such as heavy customer concentration, high reliance on commodity fluctuations, or low margins.
High Risk of Tax Increases Creates a “Window of Opportunity”
High valuations are only one part of the story for business owners in 2021. As a critical element of considering whether and when to pursue a transaction, our family business and entrepreneur clients are often equally focused on what their after-tax net proceeds will be.
Most business owners we have spoken with post-election believe strongly that there will be material increases in capital gains or corporate taxes—more likely in both—at both the state and federal levels. We are certainly not prognosticators, so we cannot in good faith opine on whether this will happen or to what degree taxes may increase if they do. That said, in our world of M&A, the mere existence of this risk, especially coupled with the nearly unprecedented materiality of incremental dollars at stake, is enough in itself to drive strong consideration—if not action.
It would not be prudent for a company owner to decide to sell their business based mainly on tax risk. However, we believe that any business owner who has already made the election to sell at some point in the next five years should strongly consider completing that transaction in 2021.
While we cannot know for certain the timing of any tax changes, Goldman Sachs indicated in a January 11, 2021 report that the risk is low of these changes being implemented before 2022 or being retroactively applied to 2021. This creates an important window of opportunity for company owners to consider action in 2021.
This combination of market dynamics—incredibly high valuations married with unprecedented tax risk—creates a core truth for business owners: 2021 is likely an optimal environment to pursue a sale.
For those company owners who agree that 2021 is their year, it is best not to delay. Doing so could introduce the risk of potentially not closing before the year ends. Back in 2012 (another material capital gains tax change year), we received many late-breaking calls from business owners in September, October, and even November and had to advise them that it was too late to close by December 31. Even last year, we received calls from business owners requesting to close by year-end through much of Q4, even as late as December 15. We again had to communicate that it was much too late to be assured of a year-end close. If you are committed to closing a transaction in 2021, we would suggest you begin a process by May, and certainly no later than June, to ensure a higher probability of closing by year-end and avoid unnecessary tax risk.
Quantifying the Risk for the Dollars at Stake
Today, Federal capital gains for individual taxpayers are generally taxed at 20% for long-term investments, and the Net Investment Income Tax rate of 3.8% can apply for a total Federal tax of 23.8% on the gains in a company sale. While we don’t know exactly what will happen in the next one to five years, we can make an educated guess that President Biden’s tax proposal will result in some level of a tax increase for high-income earners at some point during his initial term in office. With Democrats in control of Congress, that likelihood is even higher.
Business owners in Washington state have the additional consideration of the potential implementation of a new 9% state capital gains tax. Read more on that here.
It is impossible to predict the precise details of what will move from campaign rhetoric into law. However, the materiality of the tax risk should be on every business owner’s mind.
We had a discussion with our friends at Moss Adams to assist in quantifying the total gross dollars of potential risk. We outline below the insights that Partner and Director of Tax Technical, National Tax Andy Cates and Bob Hinton, partner in charge Seattle shared with us.
For a hypothetical $100 million deal, no matter where in the U.S. your company is based:
- If President Biden’s tax plan is enacted as proposed, your incremental Federal gross tax risk sits at $19.6 million. That’s incremental risk—on top of the existing $23.8 million you would pay in Federal capital gains and Net Investment Income Tax if you sold today.
- Depending on your tax basis, your total Federal tax bill could be as high as $43.4 million.
The tax risk change has probably never been greater in recent history, and the incremental dollars at risk have not been as high since the 1950s.
Advice Amid Ambiguity
2020 taught us many lessons, not least of which was the reminder to expect the unexpected. As 2021 has already produced many headline-grabbing days and tax uncertainty continues to impact the business environment, business owners need to ensure they have the right data to make appropriate near and long-term decisions for themselves and their stakeholders.
Whether or not you elect to pursue any transaction in earnest, we believe evaluating your current market valuation and analyzing net after-tax proceeds for 2021 versus future years is an important fiduciary duty as a company owner. Our team stands ready to answer any questions you may have about your capital raising and M&A alternatives. You can find our contact information here.
[1] Source: Prequin Q3 2020 Research Report
[2] Source: S&P Market Intelligence. S&P cash on balance sheet metric is Ex-Financial companies, and the 2008 average is $800B, but $750B in its lowest quarterly snapshot for that year.