Who profits from a capital gains cut?

A lower capital gains tax might entice more owners to sell the business—to family or to outside buyers.

By Lloyd Greif

The American public is in for a cut in the capital gains tax if the broad outlines of a budget record reached in May by Congress and the Clinton Administration hold. Thanks to a strong economy, a Republican-controlled Congress, and an Administration that increasingly recognizes the importance of small business to the nation’s welfare, the capital gains tax could be reduced this year from the current top rate of 28 percent to a maximum of 19.8 percent.

A lower capital gains tax would have a tremendous effect on owners and investors, creating an ability to retain more money from the sale of appreciated assets, securities, and shares in a business. Most significantly, it would prompt more family business owners to sell their companies—whether to outsiders or insiders.

Owners who sell a business would benefit in one of two ways: paying less tax on a sale, or selling at a higher price.

Say Paul Andrews had wanted to get $10 million for his manufacturing business, which he was planning to sell to his two sons. At the 28 percent capital gains tax rate, he would have had to sell the company for $14 million to net $10 million. But at a tax rate of 20 percent, Andrews would have to sell at only $12.5 million to net $10 million. This makes the sale much more possible. The sons would have to raise or finance only $12.5 million instead of $14 million; they would be taking on less debt, and putting themselves and the family business at less risk.

Alternatively, Paul could sell the business for the same price—$14 million—and net $11.2 million instead of $10 million, at a 20 percent tax rate. In this scenario, the sons would pay the same amount for the business, but Paul would take away an extra $1.2 million, or 12 percent.

Either way, the family benefits overall. The only question is who will reap the added benefit—and what that person will do with it.


More sales likely

Whether or not a family business owner is ready to sell, he or she should prepare to think about it, because the greatest short-term effect of a reduction in capital gains taxes would be renewed vigor in the merger and acquisition market. Your business could become the next beneficiary—or target.

The last time there was a big cut in capital gains was in 1981, under President Ronald Reagan, when the tax was lowered from 28 percent to 20 percent. It is far from a coincidence that the following two years marked the beginning of the M&A boom that imprinted the 1980s with the label, “The Decade of Greed.”

The same cut today would touch off another flurry, though not to the same extent. That’s because we are already in a strong M&A market. Still, activity would surely pick up, particularly in the middle market (where many family firms are found), as aging entrepreneurs find the allure of higher net proceeds too strong to resist.

It is already a “sellers market” in 1997, so lower capital gains taxes would be akin to pouring gasoline on a fire. Sellers who were on the fence might finally decide to jump into the game, changing the current dynamics of the M&A market in two significant ways.

First, there would be a shift from stock-based buyers to cash-based buyers. With the stock market at all-time highs, public companies are using their high-priced stock to make acquisitions, enabling them to pay a higher price than the cash-based buyers who are their competitors. Many owners of closely held businesses have been perfectly happy to take the freely tradable securities in payment for their otherwise illiquid asset. And the transaction allows them to defer payment of taxes until they decide to sell the stock.

However, a lower capital gains tax would make ownership of public stock less attractive, due to lesser tax savings on the sale of the stock. In relative terms, this would make the negatives of owning stock more prominent, including the lack of control over how the buyer’s business is run, and vulnerability to the cycles of the stock market. The pendulum might then swing back toward cash-based buyers—the masters of the leveraged buyout who led the pack in the “Go-Go Eighties.”

The second effect of a cut in the tax rate would be a return to more of a buyer’s market. The ability to make more money or save taxes would encourage some owners to accelerate their timetable for selling the business. As sellers flood the market looking for greater rewards, the current equilibrium between buyers and sellers would change. The influx of new businesses for sale could cause prices to back off a bit, and the momentum would shift back to a buyer’s market. Offsetting this trend to some extent would be the influx of new investors lured by the prospects of higher net after-tax returns.


Watch for red herrings

So is a capital gains tax cut more of a bane or boon for family business owners? It can go either way. Buyers are in the business of purchasing companies as cheaply as possible. That means they will use every trick in the book to convince owners that their businesses are worth less than they think. Beware of suitors who, after the enactment of lower capital gains rates, try to capture the benefits for themselves in the form of a lower purchase price. Sellers should try to make the tax cut a windfall for them, in the form of higher after-tax proceeds.

The point is that smart owners should remember that the tax benefits of a sale are only a minor reason for doing the deal. Really, capital gains taxes are irrelevant to the fair market value of a company, and that’s what the seller should get. Company values are denominated in terms of multiples of earnings, cash flow, sales—whatever the appropriate measure in a given industry. How much the shareholders net is impacted by many factors, from the amount of debt on the company’s balance sheet, to transaction costs, to the bonuses that accrue to non-shareholder managers.

Sellers should also remember that what’s good for the goose is good for the gander. When a buyer makes the red-herring argument that the seller should take less because he’ll be saving taxes and therefore netting the same amount, the seller should quickly counter that the suitor will reap the same tax benefit when he sells in the future.

In short, the sale of a business should be based on its market value, not on arguments about tax savings. While a reduction in capital gains can sweeten the pot, the proper strategic handling of a sale will generate the most income for the seller.

A family that operates one of the largest mortuary and cemetery businesses in the country found out how this can work. The owners had approached four strategic buyers and invited them to submit offers. The highest offer they received was $122 million, based on conventional industry yardsticks for valuing the company. They then retained our firm to try to negotiate a higher price. We assessed each buyer’s strategic needs and financial capabilities, and implemented separate marketing campaigns that emphasized unique aspects of the seller’s business that would be most appealing to each. We then played one bidder off against another, creating an auction environment. By getting the buyers to see more clearly the synergies between the companies, we enhanced the desirability and urgency of the deal. As a result, the same buyer who had bid $122 million ended up paying $250 million—in cash.

For sales within a family, a lower capital gains tax will put more dollars in the older generation’s pockets, or save money for next-generation buyers. For families looking to sell to the outside market, the most significant effect will be the heightened promise of quicker sales for greater dollars. This should keep enough buyers in the market to make auctions a routine fixture of mergers and acquisitions for some time to come.


Lloyd Greif is president and CEO of Greif & Co., a Los Angeles investment banking firm that specializes in arranging mergers, acquisitions, and corporate financial transactions for middle-market companies, including many family businesses.