Archive for April, 2008

C-Corp: A Business Seller’s Nightmare

Tuesday, April 29th, 2008

The Horror of C-Corp Asset Sale

 

“I’m proud of paying taxes. The only thing is–I could be just as proud for half the money.” – Arthur Godfrey 

We recently completed the sale of a healthcare deal where the seller had his business incorporated as a C-Corporation. When we informed him of the downside of a C-Corp in a asset sale, the business owner was stunned. While C-Corp business sale has no disadvantages when it comes to a stock sale, the tax burden on the asset sale of a C-Corp can be onerous to a business owner.

To begin with, C-Corp shareholders suffer from double taxation. All corporate income is taxed at the corporate level and any distributions of the profits to shareholders in the form of dividends are taxed at the shareholders personal level. For most mid-market businesses in California, the gains at the corporate level are taxed at the corporate tax rate of 42.84% (34% federal and 8.84% CA State). Further compounding the problem is the fact that there is no such thing as Capital Gains for C-Corps. All income, including income on properties held on a long term basis, is taxed at the same rate.

Assuming an asset sale, which is the preferred type of sale for most acquirers, and worst case allocations, the seller is looking at a potential tax liability of 42.84% at the corporate level and a further 44.3% tax liability at the personal level (35% Federal and 9.3% CA State) leaving him with an effective tax rate of about 68% of the gains on the transaction price! Ouch!!

The worst case scenario for an S-Corp asset sale is far superior. The seller only needs to pay 1.5% at the Corporate level (0% Federal and 1.5% CA State) and a further 44.3% at the personal level. The difference in sale proceeds from a C-Corp and an S-Corp amounts to 22% of the gains in this worst case allocation scenario. On a $10M transaction gain, that boils down to $2.2M!

This above scenario is the worst case and with more reasonable allocations and with some creativity in deal making, this difference can be narrowed significantly. However, even in highly optimistic allocation scenarios, sellers are looking at about a 15% difference in take home just because they chose a wrong corporate structure!

In the case of our healthcare business owner, we could locate a buyer who was willing to do a stock sale and we were able to put together a dramatically better deal for the seller with a 24.3% tax bite (15% Federal Capital Gains Tax and 9.3% CA State). That’s about a 44% savings on taxes compared to the worst case asset sale scenario! We were pleased with how well we could serve this client, but not all stories end so well.

If you are a business owner with a C-Corp, here are some options to help avoid the nightmare at exit:

1.    Unless there is a compelling reason to remain as a C-Corp, switch to an S-Corp. Note that there is a 10 year recapture period before the conversion is complete. Consult your CPA or M&A advisor for advice on steps that you need to take if you plan to sell the business within the 10 year window.

2.    Consider moving or retaining the ownership of all appreciating assets outside of the C-Corp into a different entity such as an S-Corp or an LLC.

3.    For all future incorporations, avoid a C-Corp structure altogether unless there is a very compelling reason to be a C-Corp (ex: having plans to go public or having a lot of shareholders).

4.    If you have a C-Corp, for all practical purposes, you must aim for a stock sale. Look for an M&A advisor who has the proper licensing and experience in doing stock deals. Anecdotally, about 1% of the small to mid-market business intermediaries have the proper licenses to do stock sales. Surprisingly, most business intermediaries are unaware of the licensing requirements required in stock transactions.

Unfortunately, for the business owner, if an unlicensed intermediary does a stock deal, the acquirer may be able to rescind the transaction for up to 3 years after the close of escrow per the provisions of Section 29 of Securities Exchange Act of 1934. Yet another nightmare scenario! For Information about licensing requirements and the SEC act of 1934, see:

http://www.law.uc.edu/CCL/34Act/sec29.html  http://www.californiachronicle.com/articles/52091

Tax laws are complex and change constantly. This article is only intended to provide an insight into some of the major implications of choosing a particular corporate structure. Contact your CPA for tax advice. For information about the specific tax bracket you are in, see: http://www.smbiz.com/sbrl001.html  

Posted in Exit Planning, M&A, Tax Related | No Comments »

How to Sell Your Distribution Business

Tuesday, April 29th, 2008

10 Step Plan To Exiting A Mid-Market Distribution Business

 

“He who fails to plan, plans to fail” – An old proverb 

You have worked hard for many years to build your distribution business. It has provided you income, satisfaction, prestige and purpose. Now is the time to do one final deal on the business and exit your business while making sure that that you get what you deserve.

A mid-market distribution business, the type of business you have, is typically characterized by strong customer relationships, good logistics and material management system, moderate amount of equipment, and sometimes a large amount of inventory. This combination of assets creates a unique set of challenges when it is time to sell.

Here is a 10-step plan to maximizing your return on the sale of your mid-market distribution business.

1.    Be aware that for a distribution company with a valuation in the $3 million to $100 million range, funding from the Small Business Administration is not feasible and there are very few individual buyers capable of financing this type of deal on personal credit. The most likely acquirer is another private company, a public company, or a PEG (see “Is Private Equity The Right Option For Your Business”). These are professional buyers who have experience from multiple deals. Hire a competent M&A advisor or an investment banker to bring deal making experience to the table. Acquirers think in terms of multiples of EBITDA for comparable companies when it comes to valuation. A good M&A specialist will help increase the EBITDA, ratchet up the multiple, and expose the strategic value of the business to get you more for your business. An M&A Advisor will also be keenly familiar with the tradeoffs necessary to maximize your after tax proceeds.

2.    Check if your corporate structure is the appropriate one for a business sale. Are you a C-Corp? S-Corp? LLC? Do you have multiple entities with multiple purposes? Regardless of the type of corporation(s) you have, if your distribution company has a large amount of depreciated assets, depreciation recapture may be a big issue for you. For distribution companies with a substantial amount of assets, being a C-Corp can be a major tax disadvantage as most acquirers prefer an asset sale to a stock sale. In a C-Corp asset sale you get taxed twice – once at the company level and once at the individual level! For most distribution company owners, it is worth getting your M&A advisor to fight for a stock sale.

3.    Make sure your books are in order and your financial statements are compiled, reviewed or audited as may be appropriate for your business. Your current bookkeeping practices and tax structure may be designed to keep your taxes low on an operating basis but they may not be right for exiting your business (see “What Every Business Owner Needs To Know About Taxes & Valuation”). If your CPA firm does not have any deal making experience, consider working with a firm that has the experience. In mid-market transactions, good tax advice may be worth hundreds of thousands, if not millions, of dollars.

4.    Retain the right attorney for the deal. An attorney with transactional experience as opposed to litigation experience is more likely to help put together a successful deal. Many deals collapse due to attorneys who are not familiar with transaction negotiations.

5.    Understand how your competition is performing and how you measure up. How good are your profit margins? How about inventory turns? Is your equipment outdated? Do you have a lot of dead inventory on the books? Some of the value in the deal comes from the acquirer’s perception of how you rate in your peer group. Excellent companies get excellent valuations and mediocre companies get mediocre valuations. A competent M&A advisor can also help package your company to get the best deal out of it.

6.    Reduce risk by diversifying the customer and supplier base. What percent of your business is tied to one customer? How dependent are you on one supplier? What can you do to ensure the customers and suppliers will continue to stay with the business after the business sale? Are your contracts being written so that they can stay with the business regardless of ownership changes?

7.    Understand and have a documented plan for your growth. How do you plan to grow? Wider product lines? More services? Increasing geographic coverage? What part of your business is online? How good is your website? Do you do business outside of the immediate geographic area? What differentiates you in non-local markets? A good growth plan makes sales projections more credible.

8.    Take steps to ensure that your distribution business transitions easily to the acquirer. What percent of your business is under contracts? Are they long term? How much of your business is recurring? Do you have any maintenance contracts? Do any of the supplier contracts provide meaningful exclusivity? Do you have a reliable sales team or do the customer relationships begin and end with you?

9.    Do you have any known latent liabilities? Legal actions? Workers comp issues? ESOP issues? Do you have reasonable insurance coverage or you exposed to that one shipment or warehouse catching fire and taking you down with it? If possible address these and other similar issues before putting the business up for sale. If not, discuss these with your M&A advisor to make sure that they do not become a drag on valuation or deal killers. Addressing these issues is especially important if you are seeking a tax advantageous stock sale.

10. Be cognizant of the fact that business valuations are not written in stone and there is a huge variability in what you can get for your business (see “The Myth Of Fair Business Valuation”). The more you would like to get for your business, the more planning and work your deal making team needs to do and the longer it is likely to take. Plan early if you want to maximize your return.

Good luck with your business sale and let us know if we can help you.

Posted in Exit Planning, Finance, M&A, Miscellaneous | 1 Comment »

Waiting For The Big Sales Contract To Come Through Before You Exit Your Company

Tuesday, April 29th, 2008

When Is It The Right Time To Sell My Company?

 

“All good things arrive unto them that wait – and don’t die in the meantime” – Mark TwainWe recently had a client who had intentions of selling his business for a long time but was unable to decide when to start. His big dilemma was that he was expecting to be rewarded a government contract and believed that his business would be worth substantially more once that happened. The seller did not want to put the business in the market until the contract came through. Sounds like the right thing to do, doesn’t it? Our advice in this and similar situations is for the business owner to consider the trade-offs of starting the business sale immediately as opposed to waiting until the “big sale” closes.First, let’s look at this type of contract from a potential acquirer’s perspective:Ø  If the company that is being acquired has recently landed a big contract, how desirable is it and how much life is left in the contract? Ø  If the company has not gotten the contract but is likely to get it, what could it be worth?Ø  Is this contract potentially a large percent of the company’s revenues and does the contract pose a material risk to rest of the company if something were to go wrong?Ø  What is the economic benefit of it going forward? Is this contract a sustainable one or is it more of an aberration? Ø  Can the contract be leveraged into something bigger and better?Now, let’s look at the contract from the business owner’s perspective:Ø  What is the lead time for the contract? Is it 6 months? A year? Longer? Assuming delays or disruptions, which are common for big contracts, does the business owner have the time?Ø  What if the business owner does not get the contract or, worse yet, the process drags on? How will it affect the company’s operations? How long can the seller wait to recover?Ø  For most companies, the sales pipeline is almost always bigger than the current backlog. What are the chances that this contract will materialize or that there will be another bigger deal on the horizon after this deal? What does history say about how the company grows?Ø  The time it takes to sell a mid market business is typically about a year. If the business owner waits for the contract to put the business in the market, how much of a residual value will the contract have, post close? Ø  Between now and the anticipated close date of the business sale, is the competition getting stronger? Is there new competition? Are there deep pockets moving into the niche and threatening to make it more difficult for existing players? Does the business owner who is planning on an exit have the energy and drive to take on the new competition?Ø  How about the market? Are there any fundamental changes that are likely to happen over the next few years? Are there big investments needed to continue growing?Ø  Is there any potential upside an acquirer can bring to the deal? Is it more likely that the company will get the contract with the current management or with the acquirer? So, what should the business owner do once the trade-offs are understood? The critical element to consider in this situation is the reason why the business owner wants to sell the business in the first place. Does the business owner not have the energy to continue driving the business aggressively? Is he/she under any time pressure for health, personal, or other reasons? Does the future look brighter now compared to what it will be after the contract? Does the owner not have the deep pockets or risk tolerance necessary to drive the business to the next level? Does he/she need the backing of a larger company or a PEG to continue to grow? Whatever else the reason may be, is it still valid? If the answer to any of these questions is “yes”, now is the time to put the business sale process in motion. If you are in a similar scenario, the faster you attract the right acquirer, the better your chances are for a more favorable outcome. A competent M&A advisor can get the right acquirers to the table – the acquirers who are willing to pay for the future. The payout may not be upfront cash and could be an earn-out based on you winning the contract or generating the revenue growth. The measurement and payout could be any terms that are mutually acceptable.  While the M&A advisor negotiates the deal for you, you can focus on making sure that contract comes through and other attractive deals in your sales pipeline materialize. If the acquirer is a name brand or a PEG with deep pockets motivated to drive the growth, your earn-out could be worth a lot more than it would be if you were running the business all by yourself.In this particular case, the seller needed to be done with his business sale within 18 months due to his own personal reasons that had nothing to do with the business. The choice was clear!

When it comes to waiting for a big sales contract before you sell your business, consider the trade-offs before you make a decision.

Posted in Valuation | No Comments »