Capital Gains & Business Owners

Why is it a better time to sell now vs. the future?

Let’s assume you are a business owner and your company is generating $1M EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and has $300,000 in Depreciation. Today, your company could sell to a Private Equity Group (“PEG”) at a multiple of 5x EBITDA. This produces gross pre-tax proceeds for you of $5 million, or $4.25 million after taxes at today’s 15% long term capital gains tax rate.

For the PEG who typically likes 30%+ returns on their equity, this investment just barely makes their return hurdle. As a happy and healthy business owner with have a few good years left, maybe you think it might be a good idea to wait to sell his business?

(The math for your buyer, the PEG is as follows: They will borrow $4.3 million from their local bank and invest $0.7 million of equity capital. Given the $700,000 in Free Cash Flow produced by the your company and the $344,000 in interest that the bank collects, your buyer is left with $356,000 before taxes. Assuming this PEG pays taxes to the Federal and State governments at a combined rate of 34%, they are left with $235,000. Thus, a 30% required return on investment.)

Let us fast forward 3 years and assume you decided to wait to sell his business. The new Congress has raised the Long Term Capital Gains Tax Rate back to 28%. You’ve done a good running your company and through your hard work, your EBITDA has grown 10% per year. As the economy has recovered, interest rates have risen 2% for long term borrowings and even more for short term debt. Your EBITDA is approaching $1.35 million. You do the math at 5x EBITDA to see for how much you can sell your business for? The gross pre-tax proceeds come to $6.75 million while your net after-tax monies now exceed $4.86 million! Unfortunately, that money you’ll get is not higher after-taxes given the 30% growth in EBITDA, as you’ll still be left with 12.5% more in your bank account.

As now you’re getting near retirement age, you approach the same Intermediary to talk to the PEG’s about buying your business. Unfortunately, the PEG’s will tell you that they cannot pay you more than 3.75x your Company’s EBITDA for a total of $5.06 million for your Company.

You ask how this could be given the PEG’s interest in acquiring your company at 5x EBITDA just a few years earlier? The PEG will now explain to you how they must now pay 10% on their borrowings. In order to be left with the same $356,000 in pre-tax income on his $0.7 million investment, they cannot borrow more than $4.35 million. As the banks require acquirers to put in a minimum amount of equity into any purchase, if they pay more for the business, they will need to put in more equity.

Given your Company’s EBITDA, they will not earn his 30%+ returns if he pays more than $5 million for the business. On the other hand, you are now left with only $5 million in gross proceeds, not the $6.75 million you expected. On top of this, you now must pay taxes at a 28% tax rate on the sale of your company. This leaves you with only $3.6 million in net proceeds or 15% less than you could have had in your bank account by selling 3 years earlier. In fact, for you to receive the same net proceeds as three years earlier given the rise in taxes and in interest rates, your Company needs to grow its EBITDA by over 57% or at a 16.3% compound rate over this time period.

With family owned companies facing this math, you’re going to see more sales prior to the next Congress. You’ll also see CEOs that are close to retirement and possess large equity stakes in their businesses to making similar moves before the window of opportunity closes. In addition to this depressing math, you should note that in five years, there will be more businesses for sale than any time in the history of the United States. It is staggering to see how many business owners are baby-boomers in consideration to the correlation turning 65.

It might be better to sell your business now vs. in the future. What do you think?