By Matt Becker and Dan Shea
April 28, 2011
With the recent economic challenges forcing many businesses to focus principally on operational and efficiency issues, it is hard for many business owners to step back and take note of the broader trends emerging in capital markets. This is especially difficult in the industrial sector of our economy, where businesses were most impacted by the recession. Many are surprised to learn how healthy the capital markets appear in recent quarters and that the near and medium term outlook is even more promising. Whether you are looking to finance growth or buy or sell your company, it strongly benefits business owners to be prepared as capital markets continue to advance.
Increasing Value through Capital Structure
First and foremost, the capital structure of a business impacts its value and ability to attract funding regardless of the form of the funding. While many companies are structured as taxable C-Corporations, this is an inefficient designation in that it creates a second layer of taxation - one born by the company and the other by the shareholders when capital is redeployed from the enterprise. In such an arrangement, extra tax means less capital is available for reinvestment and it ultimately lessens a company’s valuation.
From a tax perspective, the most efficient way to structure your company is as either an S-corporation or a limited liability company (LLC). These are known as “pass-through” structures under which income taxes are only paid by the owners - taxation at the company level is avoided. Worth noting, S-corporations generally only allow for one class of stock while LLCs provide vast flexibility in terms of varied ownership rights and special profit allocations thereby providing the most tax efficient structure of all.
Fortunately, businesses can be converted from one structure to another, and adopt the structure that best suits the circumstances. The time to convert is when the valuation of the business is at its lowest. This is when the taxable value is at its lowest as well thereby ensuring that the negative tax consequences of the conversion are minimized.
Company sale transactions rose by nearly 60 percent in 2010, according to recent reports. The industrial company portion of this overall trend grew similarly, by 54 percent. Higher levels of activity seem to be continuing as we enter the second quarter of 2011. Executive teams, disciplined by the recession, are making strategic decisions positioning themselves for future growth. Lenders have seen this too, and are more assuredly pursuing new accounts and expanding existing client relationships. Libor-based spreads are at near record lows as banks seek to grow their loans outstanding. The news may be particularly advantageous for industrial companies, where manufacturing assets are more plentiful and serve as highly tangible collateral against loans.
The availability of debt capital is helping to fuel the growth of companies and is also supporting more merger, divestiture, and acquisition activity. Those seeking to fund acquisitions through debt are enjoying the lower cost of capital that debt provides (relative to equity) given the low Libor-spreads. This is especially true for industrial entities with strong credit.
The Future of Capital Markets
Surveys indicate an increased willingness, if not need, to consider capital markets transactions in the near and medium-term in an effort to sustain shareholder value increases. It remains wise for owners to consider structural changes to their businesses, such as converting from a C-corporation to an LLC, thereby minimizing the tax consequences of doing business as the markets continue to advance.
Dan Shea has a dual role as a managing director with BDO Capital Advisors while managing business development activities for BDO Valuation Advisors, and Matt Becker is a tax partner at the Grand Rapids office of BDO.