ELITE ADVISOR BEST PRACTICES
Buying a Business with Pretax Dollars
An ESOP can afford to pay your clients more for their business than any other business entity. Here’s what advisors need to know.
By Josh Patrick
- When your clients buy a business, make sure they factor in the tax cost of a transaction.
- If you work in the business market, learn how ESOPs can be used as tools to make acquisitions become accretive more easily.
- ESOPs can be attractive to sellers because of employee relations issues that happen when a business is sold.
Learning about employee stock ownership plans (ESOPs) will benefit your practice and your business owner clients.
My recent post in the New York Times’ “You’re the Boss” column was about selling a business for an outrageous price. The final three potential buyers were all businesses that did well over $1 billion a year in gross sales. The winning bidder in the auction was a business that generated over $2 billion in sales. This made it relatively easy for the company to write a check in excess of $44 million.
One of the beliefs that Clayton Capital Partners and I share is that to get an outrageous price, you must sell to a buyer whose sales are at least 100 times greater than yours. In these situations it’s easy for the buyer to add several million dollars to its offer price. It’s one of the things that happened in the particular acquisition described here.
At the same time, any buyer will want to get a good return on their investment. That’s why they’re buying the business in the first place. In this example, the other two suitors that didn’t win the bidding were both public companies. Had they won, their return would have likely been found in the stock value of the business.
The price that all three suitors were offering to pay was in the range of 10 to 11 times earnings. If a public company had won the auction, its return would have been immediate because of the arbitrage value in its stock.
That’s because the purchase price was $43 million for the business. If the buyer’s stock was trading at 15 times earnings, the business would add approximately $60 million to the stock value, thus giving the buyer an immediate return of $17 million on the purchase. At the same time, getting a cash return on the business would be very difficult.
The problem with buying a business with after-tax dollars
The electrical distributor in the example above was acquired as a stock sale for $43 million. This means that a buyer used after-tax dollars to pay for the business. In the case of a taxpaying entity that had a 40 percent tax rate, the real cost for buying the electrical distributor would be about $71 million:
Net purchase price $43 million
Taxes at 40% $28 million
After-tax price $71 million
The reason is that before you can use your money to buy stock, you have to pay taxes. With a 40 percent tax rate, a buyer would have to pay $28 million in taxes on profits of $71 million. No wonder it’s so hard for business purchases to be accretive.
If the acquirer was a taxpaying entity, an increase of even 50 percent of EBITDA to $6 million per year would mean a real cash return on investment of only 8.5 percent. That’s hardly a healthy return, considering the risk of actually being able to improve the EBITDA by 50 percent post-acquisition. No wonder it’s rare that a business acquisition is accretive to the buyer.
Another way to buy a business
In the case of the acquisition described above, the winner was an S Corporation ESOP. Because the winning bidder was a company owned by an ESOP trust, and because trusts don’t pay current income taxes, all profits flow through to the ESOP for tax purposes. This means there are no federal income taxes paid on the company’s profits.
The buying company was able to acquire the electrical distributor by using pretax dollars. This meant that instead of having to come up with $71 million, the buyer was able to pay just $43 million for the business.
This translates to a 9.3 percent return on investment with no improvement in operations. If our buyer improved EBITDA by 50 percent, it would get a return of almost 14 percent instead of the 8.5 percent return by the taxable entity. This obviously provides a much larger margin of safety for the acquisition. It’s one of the major advantages of an S Corporation ESOP when the ESOP is used to buy another company.
An ESOP was more attractive to the sellers
The seller in this case was a company that cared about its employees. They cared so much they were ready to scuttle the deal when the buyer started to renegotiate the way the seller’s employees were going to be treated post-closing.
The eventual buyer not only decided to stop renegotiating the deal, it made all employees of the acquired company fully vested members of the buyer’s ESOP. In addition, the buyer agreed to make a 15 percent annual contribution to the ESOP retirement of all of the acquired company’s employees.
This gave the ESOP company a significant advantage over the other two finalists in the bidding. The ESOP company ended up paying much less in after-tax dollars and could offer an employee benefit that was significant. Neither of the two fully taxed companies in the bidding could do this.
The real ESOP advantage
The reduced price for the acquisition was just one advantage. The other advantage was the strong financial performance that ESOPs tend to have in general. According to research done by the National Center for Employee Ownership, ESOPs generally outperform other companies that are fully taxable. Many believe that’s because employees of ESOP companies have a vested interest in the success of the company and they pay more attention to company performance. This leads to the outsize financial performance of many ESOP companies.
It’s not hard to believe that this particular acquisition would bring a cash-on-cash return of 15 percent or more to this acquisition. And since this return would accrue to the retirement accounts of participants/employees of the ESOP, this deal was good not only for the sellers and the buying company; it was good for all employees of both the acquirer and seller.
It’s also one of the reasons I love ESOPs. Too often, ESOP companies don’t take advantage of their tax status in the acquisition market. With some creative thinking like this particular buyer showed, deals can be put together in which buyers, sellers and employees of both companies come out as winners.
Do you think this benefit is good enough for you to learn about ESOPs and how they might be an attractive option for your clients? Contact us for more information or to share comments.