How to Minimize Income Taxes upon the Sale of your Company

by Shina Culberson and Carol Frank

This month’s column will feature some sage advice from a business colleague of mine, Shina Culberson. Shina is the CEO of Quist Valuation, a premier valuation firm specializing in valuing companies for tax, sale, and financial reporting requirements.

When you started your pet business, you likely had other issues on your mind than choosing the best corporate entity form for an eventual sale of your company. Given the high multiples that are being paid for pet companies, many entrepreneurs are now thinking about an exit. However, tax entity choice (C or S corporation) is critically important. Why? Because selling your company’s assets inside the wrong entity can cost up to an extra 40 percent of your sale price in taxes: an unacceptable prospect for most owners! Operating as a C corporation during start up and growth years allows you to take advantage of lower tax rates but when it comes time to sell your corporate assets, you will pay taxes at the corporate level and then again at the individual level.

Let’s look at an example of how this double tax whammy affects a fictional owner:

After careful analysis, Chuck Ramsey decided that he needed $3 million from the sale of his business (Pet Products Plus). Given that Ramsey’s investment banker valued his pet company at about $4 million, Chuck’s goal was realistic. Chuck anticipated 25 percent capital gains tax (20 percent federal because Chuck is in a high-income tax bracket and 5 percent state) and was ready to sell.

When we reviewed PPP’s financial statement, we noted that there were not a lot of hard assets (meaning most of the purchase price would be paid for goodwill — an asset without any basis) and that PPP was organized as a C corporation. We suggested to Chuck that this entity choice would prove to be a major stumbling block because most buyers would want to buy the assets of PPP — not the stock. As a C corporation, his tax bill would be closer to $2 million.

Chuck was shocked as we explained that the IRS would tax PPP at the corporate level on the difference between the $4 million paid for the assets and the value of the assets. At most, PPP’s basis was $1 million so that tax would be assessed on a gain of $3 million. Because the effective tax rate is approximately 39 percent, the tax paid by PPP would exceed $1 million. When Chuck then personally received the remaining $3 million from PPP, the IRS would impose a capital gains tax on Chuck’s gain. Assuming a 25 percent capital gains rate, Chuck would pay about $750,000 because he had very little basis in the stock. The net proceeds to Chuck were not $3 million but just over $2 million.

If Chuck had operated PPP as an S Corporation or other “flow through” tax entity, the tax bite would have been much different. How can you avoid this tax disaster when you sell your company? Some C corporation owners insist upon a stock-only sale. A great theory, but well over 60 percent of all M&A transactions last year were asset sales, especially for small companies. Restricting your pool of buyers to those willing to purchase stock will significantly limit the number of possible acquirers. And, those buyers who are willing to purchase stock may likely pay less (given the inherent risks — most importantly the wholesale assumption of liabilities that accompanies a purchase of stock) than an asset buyer. The net effect of insisting on a stock sale for a small business will be fewer buyers offering less money – not a very appealing or competitive situation.

Converting your company from a C corporation to an S corporation is an option but one that the IRS scrutinizes quite closely. So closely, in fact, that it requires 5 years to pass before it allows your company’s assets S corporation tax treatment. If you don’t have 5 years left in you, converting now to an S corporation may still offer great tax benefits. In addition, the sooner you convert to an S corporation, the greater the likelihood of tax saving. We always recommend consulting with a knowledgeable tax advisor to discuss in more detail.

Shina Culberson: As the President of Quist, Shina Culberson brings over two decades of financial and valuation experience to her leadership and guidance of the firm. Known for her direct style and laser focus, Ms. Culberson specializes in business and securities valuation engagements for corporate finance, financial reporting and tax purposes. Ms. Culberson graduated with a bachelor’s degree in Economics from Claremont McKenna College, holds the CFA designation and is a member of the Society of Analysts in Denver.

Carol Frank of Boulder, CO, is the founder of four companies in the pet industry and a Managing Director with MHT Partners, a premier middle-market investment bank, where she specializes in M&A in the pet sector. She is also a principal at BirdsEye Consulting, the pet industry’s premier consulting group. BirdsEye advises in the areas of M&A, strategy, and licensing. She can be reached at birdseye@carolfrank.com

By |The Pet Industry|Comments Off on How to Minimize Income Taxes upon the Sale of your Company

An interview with Krista Morgan, CEO of Online Lending Platform P2Bi

P2Bi: An online lending platform for growing companies

Recently, I learned about an interesting new resource for pet companies who need access to growth capital. It’s called P2Binvestor (P2Bi), and it provides online access to lines of credit through a hybrid technology and marketplace model. Given my work with rapidly growing pet companies, I am always on the lookout for non-traditional methods of raising capital. I was fascinated by what I learned about P2Bi, so I asked to interview their founder/CEO, Krista Morgan.

1. Where did the idea for P2Bi originate?
I spent six years living in London— one of the first places financial technology and crowdfunding really began—and was exposed to the online lending industry very early on. At the time, my dad was working for a factoring company in Denver, and it occurred to us that factoring was one of the areas where financial technology could make a huge impact and disrupt what was a very old industry running on antiquated, cumbersome technology. After the market crash in 2008, banks had significantly decreased their loans to businesses and there was—and still is—a lack of capital available to entrepreneurs. So in 2012 we took the idea of factoring and created a hybrid ABL/factoring product funded by a crowd of investors. It provides customers a simple to understand, scalable line of credit and our crowd the still has the legal protection of factoring.

2. How is P2Bi different from a traditional lending institution? From an online lending platform like Lending Club?
The unique thing about P2Bi is really our technology and the way we have structured our access to capital. Because we have this crowd of investors, we’re able to deploy a lot of capital very quickly—much faster and in much larger sums than other online lenders in the space. At the same time, a lot of the companies we serve are growing rapidly and that volatility is too difficult to manage for a lot of traditional lending institutions. Banks simply don’t have the technology needed to serve these high-growth businesses. We are also the only online platform that provides multi-million dollar lines of credit in a very automated way.

3. Who is your “sweet spot” in terms of client companies?
The customers who we see benefit the most from our line of credit are high-growth product companies like consumer packaged good businesses in the natural foods or consumer electronics space with $1-10M in revenue. We also work with many B2B service companies in consulting, professional services, and logistics.

4. Do you have a success story to share about a P2Bi customer?
We have seen a lot of success stories in the past year. Two of our clients were included on Inc 5000s list of fastest-growing companies. One of our favorite success stories to share is an ice cream company out of Brooklyn called Phin & Phebes. They make delicious ice cream and have created a really fun, unique brand. Using our line of credit, they were able to move their production to a centrally located copacker and expand distribution. You can now find them in major retailers across the U.S.—a long way away from the farmer’s markets in NYC where they originally began selling their product.

5. Has P2Bi worked with any pet companies?
We have a company in our portfolio called Pipeline Pet Products that makes a few different USDA certified organic, natural pet snacks such as Green Bark Gummies. They’re actually about to launch a brand-new product called Terra Ultra that is a Free-Range Chicken pet snack that contains no corn, no soy, and no wheat.

6. What can an investor expect from a relationship with P2Bi?
Our investors enjoy a fast and easy investing experience using our proprietary technology as well as very competitive rates, diversification opportunities in a variety of industries, and an average of 30-90-day liquidity. We also have strict underwriting criteria and default rates that are lower than the factoring industry standard. Our investors are extremely active on the platform, and there is never a lack of capital in our crowd to fund our clients.

7. In your opinion, can you identify 3 or 4 qualities that make a small business successful?
I think success is measured for everyone differently, but at the end of the day if you’ve built the company you set out to and had some fun along the way, I’d call that a success. Entrepreneurship is a tough road, and while large exits are definitely a big plus—and probably why a lot of us launch these crazy companies—success really comes during the challenges and breakthrough moments you experience along the way. I’d say if you’ve built a team that you’re proud of, got your hands dirty in something that interests you or a problem you really wanted to solve, and got through all of it with only a minor tequila problem—that is success.

8. How does a pet company go about applying for a P2Bi loan?
Our typical loan size is between $200,00 up to $5 million. Our loans are backed by the applicant’s A/R and Inventory.  Go to Apply.p2bi.com and fill out the application and then someone with P2Bi will follow up within a few hours.

9. Anything else you would like to share with our readers?
I highly value diversity and have built a company that is 50% women on our wider team, on our leadership team and in our board room. I believe we make better decisions as a company because we assume less and listen more and value differing opinions and ideas.

Carol Frank of Boulder, CO, is the founder of four companies in the pet industry and a Managing Director with MHT Partners, a national middle-market investment bank, where she specializes in pet sector mergers and acquisitions. She is also a principal at BirdsEye Consulting, the pet industry’s premier consulting group. BirdsEye advises in the areas of M&A, strategy, and licensing. She can be reached at birdseye@carolfrank.com.

By |Business Advice|Comments Off on An interview with Krista Morgan, CEO of Online Lending Platform P2Bi

Trends in Pet Industry M&A: An Insider’s Perspective

by Craig Lawson

In advance of our “Ask a Pet Industry M&A Expert” consultation sessions at Global Pet, we thought our readers and GPE attendees would find it helpful to gain additional insight into the current pet industry M&A landscape.

As active advisors in the pet mergers and acquisitions arena, we’re struck by a couple of dynamics and emerging trends at play.

In terms of the consumables space, acquisition activity and consolidation amongst larger players (e.g. Nestle Purina, Mars, J.M. Smucker, etc.) have abated, after a period of robust activity. Somewhat stepping in to fill this void are second and third tier players, oftentimes private equity backed and as such, significantly smaller than the larger aforementioned firms. In terms of subsectors of the consumable space, treats continue to be highly prized, with food (highly consolidated and generally less profitable) much less so. Regardless of treat or food designation, owned manufacturing capacity is often seen as a plus (versus a pure contract manufactured model) . Natural, grain-free, made-in-the USA are all are labels that generate significant buyer interest. Further, many pet parents are increasingly purchasing alternative pet food, treats, and food topping forms such as freeze dried, dehydrated, and raw. Not surprisingly, a presence in the pet specialty channel is typically prized, whereas a presence in Food/Drug/Mass (where shelf space is limited and expensive to obtain), somewhat less so.

On the pet durable side, acquirers continue to focus on the same fundamental business attributes that has resulted in successful sales of several high-end pet durables companies over the years. Premium price points, strong intellectual property, and lack of customer concentration (with a strong presence nonetheless in big box pet specialty) all resonate with the buyer universe. We’ve also noticed a discernible trend towards an affinity for traction in the rapidly growing e-Commerce space. E-commerce is a rapidly growing channel (~ 15%/year) while brick-and-mortar broadly speaking is growing at ~2-3%/year.

According to Packaged Facts, e-Commerce represents over 4% of total pet industry sales and the channel is expected to grow between 10%-15%/year through 2018 (vs. 5%/year for the industry as a whole). Millennials, the fastest-growing segment of all pet owners, have grown up with e-Commerce and are the most prodigious users of the channel as well. A strong and growing presence on Amazon, Chewy.com and other rapidly growing e-Commerce sites is increasingly seen as not only a nice to have, but a need to have, amongst discerning buyers.

Noteworthy as well, whereas in the past, certainly consumables, and to a lesser extent durables, were top of mind for acquisition oriented players, pet services certainly appear to have garnered a larger share of mind and activity for both private equity and strategic buyers (look no further than the Mars acquisition of VCA). While veterinary clinics have long been a staple of groups focused on pet services, we are seeing more interest and activity with respect to pet insurance, daycare and pet hotels, and wearables-analytics, among others.

The increased focus on services is driven by the fact that service businesses require low levels of invested capital, are crucial to the continued humanization of pets, and equally important, are oftentimes viewed as a less expensive way for investors to enter the pet sector.

If you would like to discuss your particular pet sector or company in more detail at Global Pet Expo, my colleague Carol Frank and I are offering complimentary 30 minute private sessions to go over and any all questions you may have about selling your company, acquiring a company, or raising growth capital. Click HERE to learn more.

Craig Lawson is a Founder and Managing Director at MHT Partners, a middle market investment bank that serves as the preeminent advisor to innovative, niche market leaders with offices in San Francisco, Dallas, Boston and Boulder. Craig leads MHT’s Consumer Growth practice (including Pet) and brings over 20 years of experience, including dedicated public and private company M&A deals spanning buy-side and sell-side transactions, LBOs, capital raises, going private transactions, joint ventures, cross border transactions, and fairness opinions.

By |The Pet Industry|Comments Off on Trends in Pet Industry M&A: An Insider’s Perspective

Interested in Acquiring a Pet Company? The Top Five Things You Need to Know

Growing through acquisitions is becoming increasingly popular as business owners see the value in increasing revenue without having to significantly increase overhead. In investment bank speak, this is known as creating “synergies.” In other words, if you buy a pet company whose products would sell into your existing customers and sales channels, you are effectively buying their gross margin and maybe a small amount of overhead. But costs such as rent, accounting or other professional fees, administrative staff, and even sales expenses would be all but eliminated as you fold the business into your infrastructure. If this sounds appealing, then perhaps you are interested in becoming a “strategic buyer.”

What does a strategic buyer need to know before pulling the trigger and pursuing an acquisition? Here are a few key lessons that I’ve learned over years of helping pet companies grow through acquisitions:

Similar products will result in the greatest cost savings. If you manufacture dog treats and you acquire a toy company, not only will the manufacturing processes be completely different, but likely the category buyers you call on will be different as well. This is why a durables company (toys, collars, leashes, beds, etc) usually looks to acquire another durables company and that a consumable company (treats/food/supplements) realizes the great synergies when acquiring a fellow consumable company. Think Petmate’s acquisition of Precision Pet Products and Nestle Purina’s acquisitions of Zukes and Merrick.

Find out EARLY ON about the Target’s valuation expectations. Several years ago, I consulted with a well-known pet company to help them grow through acquisitions. We identified a list of over 100 companies (aka Targets) that met their criteria. One of the most eye-opening aspects of this project was the importance of fleshing out the Target’s valuation expectations early in the process because 75+% of the time, my client’s valuation expectation did not align with the Target’s valuation expectation. My client was more than willing to pay fair market value for the business, but unless the Target company’s owner was ready and eager to sell, they often will expect a price above (and in some cases WAY above!) market value. Ferreting out the Target’s price expectation early in the conversation will prevent a great deal of wasted time and resources.

Ensure the Target is truly interested in an exit. I’ve heard countless stories of buyers working on a deal for months and months, only to have the seller change their mind at the last minute. While there is no way to guarantee this won’t happen, having probing and meaningful conversations at the beginning of the process will mitigate the risk of the Target changing their mind at the 11th hour. Once you’ve identified a willing Target, learn as much as you can about their valuation expectations, their reason for wanting to sell, and what they plan to do post-sale.

Sloppy accounting records will result in major difficulties for the buyer.  It never ceases to amaze me the number of multi-million-dollar pet companies who do not have professional accounting records. I’ve experienced deals that fell apart because the seller was not able to produce accurate books that the buyer could use to evaluate the business. Questions to ask at the onset: What system is used to keep their accounting records? Do they have a professional accountant prepare monthly or quarterly financial statements? How far back do they go? If they don’t have at least three years of professionally prepared financial statements, sales, inventory, A/R, and A/P data, you may never be able to determine the true value of the business.

Spend more time than you initially think necessary evaluating the Target’s customer relationships. In many cases, the most appealing aspect of a potential acquisition is the key customer relationships. Have you been trying to get into Petco or Petsmart but have been unsuccessful? Perhaps you are strong in pet specialty and have a plan to expand into the FDM (food/drug/mass) channel but don’t have experience in entering that market. Acquiring an existing business that is strong in the channels you are not could result in the placement of your current products into the new sales channel. But before paying a strong market multiple for this company, make sure that the relationship they have with the coveted customer(s) is solid and stable. I’ve seen deals fall apart at the last minute because a large customer dropped the Target’s product line before the deal closed. How do you diligence a customer relationship? The ideal situation is to speak to the category buyer(s) at the retailer(s) in question. Many acquirers will put this requirement into the Letter of Intent (LOI) as one of the last steps in the due diligence process before closing. If the Target will not allow this, look at the month-by-month sales to the customer for the last 12-24 months and look for any patterns of decline. Go into the retailer in question and talk to the sales people about the product line. Carefully review any existing contracts.

It probably won’t surprise you that I strongly recommend you hire an experienced team of M&A advisors to help you through the acquisition process. Your team should include an investment banker, an M&A attorney, and an accountant. The right team will more than pay for themselves by preventing you from paying too much for the Target, from putting yourself at legal and financial risk, and by ensuring that the books/records of the Target are accurate.

Carol Frank of Boulder, CO, is the founder of four companies in the pet industry and a Managing Director – Business Development with MHT Partners, a national middle-market investment bank, where she specializes in pet sector mergers and acquisitions. She is also a principal at BirdsEye Consulting, the pet industry’s premier consulting group. BirdsEye advises in the areas of M&A, strategy, and licensing. She can be reached at birdseye@carolfrank.com.

By |Business Advice, The Pet Industry|Comments Off on Interested in Acquiring a Pet Company? The Top Five Things You Need to Know

DRIVING UP THE VALUE OF YOUR COMPANY: The Top Five Value Drivers

Do you want to find ways to ensure your pet company is more valuable 12, 24, or 36 months from now then it is today? This is done through “Value Drivers” that increase the transferable value a buyer will eventually pay for your company. Generally, these value drivers increase cash flow both during and after the original owner’s tenure.

Determining how to increase transferable value is the owner’s job. But once owners and their advisors determine which of the value drivers (listed below) must be strengthened, everyone in the company should be involved. Owners cannot do it alone. If they could, by definition they wouldn’t be creating transferable value because once they departed, the value drivers would disappear. Based on my years of experience as a pet company M&A advisor, these top five drivers will give you the most bang for your buck with respect to increasing the value of your company:

  1. Stable, motivated, strong management team who is willing to stay on after an acquisition
  2. Sustainable revenue, resistant to “commoditization” through unique products or IP.
  3. A competitive advantage.
  4. A documented and proven growth strategy.
  5. A solid, diversified customer base.

A brief word about each:

  1. A stable, motivated management team that stays after owner leaves. If you plan to take any exit path other than liquidation, capable management is indispensable. Having the “best in class” management is the surest way to become a “best in class” company.
  2. A solid, diversified customer base. Buyers typically look for a customer base in which no single client accounts for more than 10-15 percent of total sales. A diversified customer base helps insulate a company from the loss of any single customer.
  3. Sustainable revenue. Buyers look for revenue streams that continue despite fluctuations in the economy. They also prefer those that are resistant to “commoditization”, which can be avoided if your company has strong patents or other forms of IP.
  4. A Competitive Advantage. To paraphrase Michael Porter of Harvard University’s Business School, competitive advantage is the product or service that a company offers–either better or more cheaply–over time than does its competitors. Your company’s competitive advantage is the reason your customers buy from you instead of from your competitors.
  5. A documented and proven growth strategy. In my experience as an investment banker, the first thing buyers want to know about a potential acquisition are the specific ideas/plans the company has on how to significantly grow the business over the coming years. Valuation multiples in the pet industry are still quite high, but those multiples cannot be achieved if the seller does not have a solid, defendable growth strategy that includes innovative, unique products or services in the pipeline. Even if you expect to retire tomorrow, it makes sense to have a written plan describing future growth and how that growth will be achieved based on industry dynamics, increased demand for the company’s products, new product lines, market plans, growth through acquisition, and expansion through augmenting territory, product lines, manufacturing capacity, etc. It is this detailed growth plan, properly communicated, that helps to attract buyers. Buyers will give credence to your current growth plan if previous plans have attained their goals.

Creating the plan to increase transferable value in your company is your job. No one else cares nearly as much and no one else will reap as great a reward. Executing the strategy to increase value, however, is everyone’s job. If you don’t already have top managers and skilled advisors ready and willing to provide ideas and implement value drivers, I suggest that you recruit them immediately.

Remember that this list contains only the top “generic” value drivers. There are many others that carry a great deal of weight, depending on what your company does. Your best course of action is to hire a professional advisor or CFO that can help you execute a plan to attain your maximum valuation.

Carol Frank of Boulder, CO, is the founder of four companies in the pet industry and a Managing Director with MHT Midspan, a premier middle-market investment bank, where she specializes in M&A in the pet sector. She is also a principal at BirdsEye Consulting, the pet industry’s premier consulting group. BirdsEye advises in the areas of M&A, strategy, and licensing. She can be reached at birdseye@carolfrank.com.

By |Business Advice|Comments Off on DRIVING UP THE VALUE OF YOUR COMPANY: The Top Five Value Drivers