March 2021 – By Rick AndradeS
Managing a business is a 24/7 life-giving engagement. Which makes keeping up with important changes every Covid day another full-time gig on top of your existing full-time gig. But still. What if you wanted to sell the business in the next 24 months, or you know someone who’s been thinking about it? How has Covid affected that decision?
If your life’s work has been building a successful business, staying informed as to current market conditions has always been a smart move, and if you’re considering a transition over the next 24 months this NEWS ALERT is well worth it timely quick read.
You see, before Covid choosing “when” to transition or sell your business was more or less arbitrary to the market. Most owners didn’t give it much thought and accordingly while some got lucky selling into a hot market, some didn’t. But this time is different. And now is one of those times to take note. The M&A business is shifting quickly and simultaneously adapting to both Covid and a new U.S. Congress for the next 2-years. So then why would now be a good time to sell a business?
Here’s why: To keep 30%-40% (or more) of your hard-earned business proceeds from the tax man.
Selling a business in “normal” times is hard enough. But then came a Democratic Congress and a Global Pandemic to shake things up. As a result, BUYERS of profitable businesses in particular post Covid are changing the way they view SELLERS. And SELLERS are simultaneously trying to dodge a huge tax increase. This is making for a busy dance floor, and the impact to Estate Planning and Wealth Management decisions is significant. Consequently, for these reasons our firm believes these changes are critical enough at this time to issue this NEWS ALERT.
We summarized at a high level the most significant Sell-side process changes to be aware of Before Covid & After Covid so you can see the change. If you or someone you know is considering a capital gain business sale transaction before 2024, it would be wise to get familiar with these asap.
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Before: Before Covid most M&A advisors anticipated a standard list of Financial, Operations and Legal review inquires. A typical Data room was set-up online to help share and exchange these documents.
After: Post-Covid the changes to the Due Diligence review process can be summarized into 3 key areas: first, replacing face-to-face communication with video technology services such as video tours of the business, like virtual real estate tours, and using Zoom-like programs for online one on one and group video chat meetings. Second, placing more emphasis on reliable Data room software and storage capabilities to manage and exchange documents and videos. Third, BUYERS are more frequently requiring a Quality of Earnings (QoE) report. Many sellers are conducting QoEs in advance of selling their company or engaging BUYERS as both proof of earnings, and to identify potential pre-sale red flags. We think a post-Covid pre-sale QoE report from a 3rd party is a good idea.
Before: Valuations made from Free Cash Flow projections, recent market comparables, and current market conditions.
After: Recasting GAAP Accounting Financial statements will need to adjust and account for money spent on Covid. Your financial package will now need a post-Covid financial section break-out to help BUYERS separate the past from the future. Elsewhere the value of real estate, plant and equipment, and key operational systems and processes has shifted to favor as much hands-free touchless online transaction capability as possible, including expedited delivery, self-service and touchless location pick-ups, and the effective use of cash flow for the next 2 or-3 years. In short, BUYERS today want your M&A advisors to have greater insight and details about how your company will navigate the future. How well is your post-Covid business model working? Does a higher customer and/or supplier concentration need more investment to shore-up longer-term relationships? More specifically how effective have the Paycheck Protection Program (PPP) loan proceeds and the Economic Injury Disaster Loan (EIDL) programs been to date?
Before: For years profitable lower middle market businesses have generally sold for upper single-digit multiples of EBITDA. And while both higher and lower multiples were also part of the landscape, transaction proceeds were still mostly issued in cash at closing, with adjustments for Working Capital and standard hold-backs for certain unknown contingencies and Reps & Warranties.
After: Post-Covid the big changes in deal structure are trending toward more Earn-Outs and greater scrutiny of Reps & Warranties, particularly as they relate to post-Covid risks the BUYER is assuming. The good news for Earn-out deals is the potential to negotiate a stronger sale price, which means in most cases the seller “earns” an option to gain a higher payout over time by targeting and achieving higher sales and financial performance metrics. This may require the seller, however, to stay connected to the business longer to reach these targets. This is why having a professional M&A advisor on your side to help negotiate the terms of a post-Covid Earn-out deal structure is critical to understand.
Before: Under the Trump Tax Cuts & Jobs Act in 2017 Business Taxes were lowered to 21%. Long term Capital Gains tax is 20%, and the Estate & Gift tax threshold was $11.5 million for singles and $23 million for married filers.
After: Post-Covid the Biden Tax Plan wants to increase taxes across the board. The new plan calls for the Business Tax rate to revert back to 28%, or higher for the wealthy; Long term Capital Gains taxes 20% under Trump will be doubled under the plan. The Estate & Gift Tax is also going up. The Biden plan will dramatically lower the exemption threshold to $3.5 million and a whopping 45% tax on assets above that.
It seems almost inevitable that personal taxes, business taxes, capital gains and estate taxes are all going up to some degree under a Biden Presidency according to the Tax Foundation.org. Many promises were made, and new taxes are among them. As it looks in Congress now, the Democrats can push through new legislation without any Republican votes. The Biden tax plan proposes substantial increases in all these areas which can significantly lower a seller’s net proceeds from a sale. Proper advance tax planning has now become a fundamental necessity for business owners, especially if you’re selling your business in the next 24 months and you’re thinking about how best to mitigate these increases.
Before: Most companies are guided by both Federal, State and local laws that provide employers with guidance and rules to comply with daily employee health, safety and security at work pre-Covid. A BUYER’s standard review of insurance coverage, claims and policy inquiries looked for cause and effect and prescriptive remediations as needed.
After: Post-Covid the impact is widespread by industry. Service businesses may need limited PPE and social distancing procedures, while larger companies may require much heftier investments in new ventilation, worker separation barriers, Covid testing, PPE and other capital investments and ongoing measures as deemed necessary. BUYERS today are now reviewing these conditions more closely for any on-going investment needed to sustain and grow sales post-Covid. This includes calculating what-if case scenarios should Covid or any another virus endure in the months ahead. Are you ready?
Before: Technology review is still generally a component of the Due Diligence team review. Typical of such reviews is to benchmark current-state ERP operating and transaction systems and software with industry norms, and calculating the cost of remediations and upgrades.
After: According to a recent IBM Study the Covid pandemic has accelerated online e-Commerce by 5 years or more. This adds conformance pressures across the entire integrated global economy to move more business online to stay competitive. From Supplier to customer and back Covid has brought forward many years of transitioning to online processes and communications in favor of “touchless transactions.” Nevertheless, BUYERS are more closely evaluating each internal technology system and process for automation gaps, and will in turn attempt to lower the offer price accordingly. Higher valuation comes with smaller technology gaps from current state to best practice post-Covid. Knowing where your company stands on that spectrum beforehand can help your advisors negotiate these gaps.
Before: Before Covid projecting business sales growth was not easy, like clouds shifting above predicting sales was a moving target. But in most cases forecasting growth was still more straightforward. But that was yesterday.
After: Today, post-Covid BUYERS are even less confident about the accuracy of forecasting. As a result, BUYERS want a deeper dive into the numbers with more robust sensitivity analysis of best-case and worst-case growth scenarios. Given a touchless economy for the foreseeable days ahead the move to online eCommerce is clearly here to stay. However, this does not mean you can sit on your hands and hope for the best. The further behind the shifting consumer demand curve post-Covid a business is the more capital investment and time needed to stay competitive. On a scale of 1 to 10 a business below 6 may not get the highest price from BUYERS if new sales forecasts rely precariously on past consumer practices. But this too can be negotiated.
Before: We typically advise clients that it will take between 9 months and 18 months to resolve most BUYER issues and close the deal. There are always exceptions, but none as widespread as Covid.
After: Today closing transactions has obviously taken more time. This was expected as BUYERS adapted to post-Covid business models and accounted for more unknowns as discussed above. To our surprise however, closing M&A transactions is only taking longer in direct proportion to the seller’s prepared ability to address post-Covid inquiries and concerns. In other words, the more prepared you are in advance of these inquiries the faster the deal gets done. That’s why again we recommend hiring a reputable M&A industry advisor who is on the front lines working with post-Covid BUYERS’ requests each day.
Finally, would you like to know something you should not do before selling your business? Do not rush out and get an Appraisal. It’s among the biggest food industry rookie mistakes. Many sellers believe an appraisal is the best place to start in order to get a feeling for the value of their business. And that may be true for Fair Market Value Opinions for ESOPs, lending and other profit-sharing programs, but it’s not a good measure to identify the value of your business in the current M&A marketplace.
The problem is any recent official appraisal must be disclosed to BUYERS, and that figure can artificially set a price level far below letting the market do that. There’s no point shooting yourself in the foot before you get started, right?
That means given all the above impending changes that will significantly impact the value of your ultimate transaction proceeds your first step should be to call an M&A advisor with experience in our industry. Let them organize a team of professionals to manage the proper and effective sale of your business from initial LOIs to final closing agreements in this unprecedented environment. Depending on the size of the transaction your ideal deal team can be as few as a CPA, an M&A attorney, and your M&A advisor.
The Bottom Line: Investing time and money with an experienced M&A deal team to help navigate a post-Covid business world is sure to save time and tax money. Put your life’s work in good hands. Give us a call.
Rick Andrade
About the author: Rick Andrade is an investment banker at Janas Associates in Pasadena, Ca, where he helps CEOs and business owners buy, sell, and finance middle-market companies. Rick earned his BA and MBA from UCLA, along with his Series 7, 63, & 79 FINRA securities licenses. He is also a CA Real Estate Broker, a volunteer SBA/SCORE instructor, and blogs at www.RickAndrade.com on issues important to business owners. He can be reached at RJA@JanasCorp.com. Please note this article is for informational purposes only and should not be considered in any way an offer to buy or sell a security. Securities are offered through JCC Capital Markets LLC, Member FINRA/SIPC.