Solving The Middle Market M&A Riddle In A High-Tax State
California is the most-conspicuously entrepreneurial state in the U.S., with Silicon Valley in the north the world’s technology start-up epicenter, and Southern California home to defense and entertainment juggernauts that spawn growth companies at a furious rate.
And yet, no state taxes the sale of a business so heavily: on top of the 20% top federal capital gains rate, California levies its own 13.3% top rate, such that an even third of a founder’s ownership stake can be due to the governments after a sale.
Therefore, nowhere is it more important for founder/owner/CEOs of middle market companies to develop a sophisticated estate plan and to think in after-tax dollars when considering an exit strategy. And yet, so few do so, falling prey to the cliché of the entrepreneur who’s too busy running the business to plan for his or her own financial success.
“I would say that the percentage of business owners who have an effective estate plan in place is between 0% and 2%,” says David Emmes, president of BNY Mellon’s Western U.S. region wealth management business. That lack of planning, David explains, leaves the business owner vulnerable to high taxation when an opportunity to sell presents itself. “They get a signed letter of intent and then it’s too late to maximize after-tax proceeds,” he says.
I’ve invited David and his colleague Grace Russak, who works directly with middle market business owners from BNY Mellon’s Century City office, into this discussion because timing has become critical on these issues – for all middle market business owners, and especially so in California. Some background: the financial crash of 2009 forced many business owners to delay their exits. Valuations plunged. And business problems demanded intense management attention. For the most part, the health of middle market companies has recovered nicely. But only in recent months have valuations approached pre-crash levels in private business transactions.
To boil it down: an advantageous opportunity to sell has finally presented itself. But, economic cycles being what they are, the window won’t likely be open for long. With that challenge (and opportunity) in mind, I recently persuaded a former Bank of America colleague, Matt Dalany, to join Verit Advisors to intensify our concentration on California and the West Coast.
Matt’s assessment, viewing current conditions against his three decades in the California market, confirms what our BNY Mellon friends are telling us: “There’s enormous pent-up demand among business founders – men and women who started companies 30 years ago, or more – to exit. But they’ve been so busy turning around their operations, and recovering from the crash, and for the most part they haven’t developed a plan for themselves or for their business to be sold.”
What’s the cost of not having a plan? Grace Russak at BNY Mellon advised an unfortunate client post-crash. The client’s husband had been the personal license holder to operate a food business associated with a major, international brand. He died suddenly, in his mid-50s. The license couldn’t be transferred to his wife, and this necessitated a sale of the business, near the bottom of the economic cycle. Also: the owner had paid for an effective estate plan, but hadn’t implemented it.
“It was just so difficult for the client,” Grace recalls. “On top of her grief, she faced enormous financial issues.” The sale price was far below today’s valuations. And the tax bite was close to 40%.
At the other end of the spectrum, Grace advised a client, the owner of a construction company, who was extremely tax-averse and motivated to plan well ahead. He sold his C-Corporation to its workers in an Employee Stock Ownership Plan, or ESOP. Doing, so, the owner was eligible to reinvest the proceeds in qualifying securities – stocks and some bonds – and defer, potentially forever, capital gains taxes. (That’s a unique element of ESOP transactions too few business owners know about until it’s too late.)
The sale was pre-crash and the owner took back some paper to facilitate the transaction. Trouble? There could have been. Many construction companies failed after 2009. This one prospered, however, Grace notes. And in out-performing its peers, it fits a well-documented pattern of ESOP productivity; worker-owners behave differently and their companies tend to perform better than similar companies operating with different ownership formats. The former owner’s paper was entirely repaid and his company is thriving.
Grace and David at BNY Mellon advise entrepreneurs on managing their wealth, which often is recognized after the sale of a business. As I’ve written in the past, a good investment banker can help steer you to the right buyer with a superior price, perhaps a 25% increase over mean values. But a good estate plan can add upwards of 50% economic value (in my home state, Illinois, for instance, combined federal and state estate taxes can take roughly half the value of a business) and superior alignment with personal goals for family, estate and charities. Imagine – especially in high-tax California – if you did both?