The Pet Industry

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

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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.

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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.

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Cat GPS Tracking: The Wave of the Future or a Passing Fad?

I recently had the pleasure of meeting a pet industry entrepreneur who has a passion for ensuring cat owners never experience the emotional pain of permanently losing their cat. Lisa Tamayo is the CEO of a new pet technology company, SCollar. Lisa and her husband built and sold a technology company several years ago, so they are no strangers to either starting a new business or how to incorporate technology into a new product. While SCollar is one of the many entrants into the race to breakthrough to the front of the pet technology pack, there are many tech-oriented products for dogs, but few for cats. According to the most recent APPA National Pet Owner’s Survey, 27% of cat owners have an electronic tracking device for their cat, an increase of 50 % since 2012. However, the majority of these tracking devices are implanted microchips. A collar with GPS is still quite a new concept and currently just 2% of cat owners have one, a number that is likely to grow over the next several years as more products are introduced to the pet market.

I was curious how a GPS system for cats worked and how it could keep cats from being lost forever. Lisa was kind enough to share her significant wisdom and insight into all things Cat GPS and below are snippets from our conversation.

Cats are elusive creatures. Whether a cat stays indoors exclusively or roams about the neighborhood, cats like to find small, tight places to tuck themselves into and sleep. Which is pretty inconvenient when you want to find them. There are times when a good shake of the food bag will do the trick, but not always. You call and you call and nothing happens. That little hitch in your throat stays there until he finally appears, sauntering over to rub against your legs while you contemplate yet another futile cat lecture. Time to talk about the next wave of Cat GPS Tracking.

If kitty goes outside, you would like to know where he hangs out. And if he doesn’t come when called, you need a way to find him. New technology is finally making both of these things possible. Currently your furry friends can be tracked with Cat GPS using cellular signals or Radio Frequency signals. But… what does that actually mean? A Cat GPS Tracker, really?

GPS CAT TRACKING WITH CELLULAR:

GPS with cellular offers more accurate tracking and can show kitty’s location in real time on a mobile app. There are several companies with cellular GPS trackers on the market, but most are too big for cats and small dogs. All of the currently available GPS Cat cellular trackers attach to a cat’s regular collar. GPS Cat cellular trackers are more expensive – ranging from $100 to $200 and require a cellular subscription costing between $5 and $15 per month. The best cellular GPS options for cats are Paw Tracker, Nuzzle, Pawtrack, and Pod.

The GOOD: GPS with cellular allows for real time tracking of a cat.
The BAD: Pet owners incur a monthly subscription cost.

GPS CAT TRACKING WITH RADIO FREQUENCY:

Radio Frequency (RF) tracking has been around for years and functions in a similar fashion to a walkie talkie. Most RF trackers attach to a cat’s collar, although newer companies are introducing RF tracking integrated into the collar. Some RF trackers require a remote to help pet owners find kitty, while others have introduced tracking on a mobile app. Social GPS, combing the signals of other users, is a tool some RF trackers employ to help locate a lost cat. Trackers using RF have a “line of sight” range of up to 500 meters but the range around a neighborhood is much smaller because the signal is blocked by obstacles like houses and trees. Prices range from $20-$100. The best options currently available for cats are TabCat, Pawscout and Scollar.

The GOOD: GPS with Radio Frequency is a more affordable option for tracking.
The BAD: The distance covered in a neighborhood is usually limited.

WHAT TO LOOK FOR IN A CAT GPS TRACKER

A Head Start: The best tracker will show the pet owner where the cat has been to give an idea where to start looking. The most feared scenario is the one where the cat is missing and the pet owner has no idea where to look. All of the tracking devices listed point the pet owner in the right direction, just with varying degrees of effort. Older RF trackers use remotes, while newer technology uses the map based interface on a mobile app.

A Good Match: Match cat tracking requirements with cat movement patterns. The best type of tracker depends on the cat and the living arrangement. If the cat spends a lot of time outside and disappears for long periods, a GPS Cat Tracker with cellular is likely the best option. If kitty doesn’t go outside very much and spends most of her time close to home, a GPS Cat Tracker with Radio Frequency is likely the best option.

Multiple Uses: Look for a cat tracking system that includes other functions to help manage the cat. The pet wearable universe is rapidly growing and changing and newer technology does more than just track cats (and dogs). Trackers that light up at night, have sound for communication, monitor activity, and manage regular reminders for feeding and medications help with overall kitty care. A cat tracker with multiple uses also makes it easier to justify spending the money on the technology.

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.

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Pet Industry Outlook 2016: The News Just Keeps Getting Better!

The economy may be so-so; the stock market may be shaky; retail sales may be sluggish, at best. The $60 billion-plus pet industry, however, is expected to continue its long, strong, growth streak this year. Brian Beaulieu, an economist, recently told the Pet Industry Leadership Conference that growth in pet expenditures started significantly outpacing all retail sales in 2004 and is currently growing about 50 percent faster than the retail sector as a whole. “We will be enjoying growth in 2016, 2017, 2018,” he said, adding that he believes the industry is recession-proof. Longer-term, the future is bright, too. “There will be 100 million more Americans in 50 years,” he said. “And many of them will want pets.” Pet-loving Millennials, in particular, are mitigating fears about an aging population leaving the market, as Baby Boomers downsize or retire and become unable or unwilling to take care of animals. Bob Vetere, president of the APPA, believes this younger demographic backfill should keep the industry healthy for at least three to five years, as the Boomers age out. (Fun fact: 20 percent of Millennials who own a dog are likely to dress them up for Halloween, as opposed to only 13 percent of Baby Boomers.) Dogs, especially, are becoming more popular. David Sprinkle of Packaged Facts notes that the number of Americans who own dogs rose to 40 percent from 35 percent between 2007 and 2015; about 32 percent of the population has children. Yes, that means Americans today are more apt to have a dog than a child.

Besides the sector’s growth and “millennializing”, here are five other pet-related trends that will be big in 2016:

Acquisitions

The pet space continues to attract strategic and private equity investors; deal volume will likely continue apace this year, following a robust 2015. One area that has been picking up is the phenomenon of big fish buying little fish. And now we are seeing large, non-pet players entering the fray. Such was the case when J.M. Smuckers Company acquired Big Heart Pet Brands last year. No matter how many deals are completed, however, more small fish always appear. In fact, about 200 to 250 new businesses join the APPA each year; currently, membership is about 1,250 companies, up from 620 in 2002.

Technology

GPS and activity-oriented tags and collars will remain popular and evolve further. But Millennials, like some Boomers, perhaps, also place a premium on devices that help them make sure their pets are doing well when their owners are away. Remote cameras, speakerphones, timed doggie doors, or eating and watering contraptions are all hits with techie pet owners. Imagine watching on your cell phone your pup at home, and if the animal is causing mischief or making a mess, just call a cell phone-like device on its collar and bark, “Stop!”

Online Shopping

Traditional shopping channels for pet prdoucts—pet superstores, grocery stores, veternarian offices and wholesale clubs—are doing well. But shopping online has shown the most growth in the past five years; some 8.2 percent of pet-owning households bought pet products online in 2015. Be prepared, too, for more grooming items marketed as upscale or luxury versions of pet staples both online and in brick-and-mortar stores, all part of what has become known as “premiumization”.

Services

Growth will remain strong, too, in the pet services sector. With pet owners becoming more and more time-pressed, they will seek out more and more businesses that provide boarding, grooming, pet-sitting, dog-walking even poop-scooping. A new trend to watch: meal delivery for pets.

 Nutrition and Health

In the pet food space, frozen and refrigerated dog food sales were up by 28 percent last year; cat treats were up 13.3 percent, proving, possibly, that convenience and indulgence are still key factors in selecting pet food products. But many pet owners also care about the quality of his or her animal friend’s food. Labels, such as natural, premium, organic, eco-friendly and sustainable move products in the sector, even if few seem to know the difference between the terms, if and when they exist. This “humanization”, as well as “premiumization”, of products and consumer desires goes beyond food, too. Eco-friendly products and those labeled as environmentally safe will attract buyers. The increased demand also is pushing down prices for what often had been very expensive products. For more information on this, visit the Pet Industry Sustainability Coalition website. Meanwhile, vet visits are no longer just for getting annual shots and examinations. Hip and other transplants are becoming more common, just as they are in their human owners. One cause may be that about half of all dog and cat owners own a senior pet, and half of all pets are overweight or obese, reports the Association for Pet Obesity Prevention. Could genomic research and DNA testing on pets become common in the near future? Don’t laugh—a couple in the United Kingdom recently paid $100,000 to clone their deceased dog, proving, I guess, that cats aren’t the only pets that can have, potentially, nine lives.

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

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