As the first quarter of 2021 comes to an end, mergers and acquisitions activity is robust. In fact, this could be a record year due to the amount of money currently available in the market.
Many private equity groups raised record-level funds and need to either deploy that capital or give it back—something they never want to do. Many consolidations and roll-ups are going on, and independent sponsors are highly active. We’re also in a period of potentially rising tax rates, which is sure to affect the way we structure and plan transactions.
Combined, these dynamics have created an environment where M&A activity is skyrocketing. If you’re a business owner looking to sell your business in the next few years, acquire another business or get a sense of what your business might be worth, here is what you need to know.
Know How Paycheck Protection Program (PPP) Loans Impact M&A
If your company is receiving PPP funds, the loan, if not forgiven pre-close, will be a deal point to negotiate. We’ve seen PPP loans primarily treated in one of two ways:
- Most often, the PPP loan balance is placed in escrow and netted from the closing wires. If forgiven post-close, the funds are released to the seller. Otherwise, the funds flow back to the buyer or SBA. If we are on the sell-side, we suggest our side request to maintain control of the forgiveness process, as the buy-side will likely not be particularly motivated to work for forgiveness to push the funds back to seller.
- If the buyer doesn’t want the PPP loan—for public relations or other reasons—they may treat the funds as pure debt. In this case, they will net the balance from the closing wires if the loan isn’t forgiven before closing. When this takes place, we see the sell-side try to negotiate for something else they want if they concede this deal point.
Understand Why Business Valuations are High
Business valuations are coming in much higher than we’ve seen in recent years. Businesses that made it through the early days of the pandemic are now priced higher than they were before because they’ve proven themselves to be pandemic resistant.
More and more businesses are coming to market to get ahead of the imminent tax law changes. In our current low interest rate environment, it’s a perfect storm. If you’re interested in getting an idea of what your business is currently worth, a private equity group or investor can answer that question at any time. Your Warren Averett advisor can also be helpful.
Keep an Eye on New Tax Legislation
M&A transactions can have significant tax implications, so business owners need to keep a close eye on developing tax legislation. A few areas we’re watching include long-term capital gains rates, the corporate tax rate, carried interest and the effective date of the package.
Long-Term Capital Gains Rates
A potential change to tax long-term capital gains to increase these to the same rate as ordinary income rates would see maximum rates on long-term capital gains nearly double from 20% to 39.6% (exclusive of the existing 3.8% ACA net investment income tax). This would be an earthquake in M&A taxation.
This would significantly impact structuring and planning transactions for the sell-side. Typically, we like to work with the current rate arbitrage of 17% between ordinary and capital gains tax rates in an attempt to shift ordinary gains to capital gains. If working towards optimizing the character of the gain becomes irrelevant, that strategy will need to change with a greater focus on trying to reduce or defer gains.
One upside is that Section 1202 qualified small business stock and Opportunity Zone planning could become significantly more powerful in this higher capital gain rate environment. These are areas of the tax law that may allow qualifying gains to be deferred or excluded from capital gains taxes.
Corporate Tax Rate
A potential increase in the corporate tax rate from 21% to 28% would result in corporate structures being less tax efficient to operate post-close. Buy-side amortizable goodwill deductions with a corporate acquisition entity (often called a step-up) would be more valuable.
Carried Interest Taxation
Carried Interests (sometimes called a promote) enable selected allocations typically in a partnership to be taxed at preferential capital gains rates. Under current law, this tax treatment is available if a three-year hold is met.
This change could alter the structuring of certain private equity and real estate deals.
Currently, the potential effective date of such legislation remains unclear. If enacted, it could be effective for the 2021 tax year, mid-year 2021 (date signed into law), or for tax years 2022 or later.
If you’re considering an exit in the next few years, talk to an advisor right away. If these potential changes become law, sell-side economics would be inherently less tax-efficient, significantly reducing after-tax proceeds available to sellers.
Higher tax rates will also make planning acquisitions more important for buyers, as goodwill and tax attributes will be more valuable. We can run models and walk you through the impacts of all these changes as you’re negotiating or planning your deal.
Be Aware of the Next Steps for Business Owners
Even if you aren’t planning on selling any time soon, knowing what your business is worth can help you make strategic decisions. Here are your next steps:
- Research the market to know what your competitors are doing
- Shore up your business processes, track key performance indicators and strengthen your management team
- Connect with the right strategic, legal and tax advisors to get advice on your specific situation and run before and after models
If you have any questions about valuing your business or structuring an M&A transaction, please reach out to your Warren Averett advisor, or have a member of our team reach out to you.