Welcome, guest blogger Arun Prakash! Arun is a Vice President with Virgo Capital, a private equity firm based in Austin, Texas, focused on acquiring small software and technology-enabled services companies. More information on Virgo Capital can be found at www.virgocapital.com.
As someone who regularly discusses buying and selling of companies with their respective owners and advisors, I often hear, usually around this time of year, about a desire to get a transaction done by December 31. The reason is quite intuitive – to avoid gains in the subsequent year when there could be tax rate increases levied by the government, especially in presidential or midterm election years, such as 2012.
The fears are not unfounded. Typically, with Democrats in control, we assume that tax rates will go up, and the opposite will happen with Republicans in control. But it isn’t so cut and dry when it comes to the capital gains tax rate, which is most relevant for those who wish to sell their business. For example, in 2008, with Democrats in control of the executive and legislative branches, the relevant rate remained unchanged at 15%, as the administration didn’t want to adversely affect the struggling economy. Going back to 1997, with a Democrat in the White House and a Republican-led Congress, the rate went down, from 28% to 20%. The Republican president Ronald Reagan presided over both a decrease of the rate in 1982 (from 28% to 20%) and an increase, in 1987, back to 28%.
As we stand today, the rate is set to return to 20% in 2013 with the expiration of the Bush-era tax cuts, but now that the 2012 election is over, President Obama and Congress are attempting to work together on a compromise to avoid that fate. Given the situation, business owners are in the right mind to consider selling their business today to save 5% on the tax bill, but at what cost? If your business is doing well and you are bullish on its prospects, you most certainly wouldn’t sell today as the tax savings wouldn’t be worth your estimate of your company’s future value. Further, getting a good deal done takes time, and if you haven’t already started the process and lined up two or three buyers with bona fide offers, you probably won’t close the deal by the end of the year, or you will overstrain yourself and your team trying to do so. Finally, the tax rate increase may not even happen, as we saw in 2010 when there was a bipartisan compromise to extend the Bush-era tax cuts through the end of 2012.
The data certainly supports the hypothesis that more sales occur when a tax increase looms. The Wall Street Journal recently reported that in the fourth quarter of 2010 there were 928 sales of middle market companies ($10 million to $250 million in purchase price) compared to 548 sales in Q4 of 2009. We will likely see the same phenomenon this year, but that doesn’t mean a sale is right for every owner or every business.