The 2010 year is a unique time to be making important business decisions, be they operating, financial, or ownership related.  We are living in an uncertain world.  Business owners must carefully consider the current uncertainties in order to position their companies (and themselves) optimally for the future.  In this article, we focus on the current economic, transaction, and tax environments that business owners should consider in their decision-making.

The Economic Environment

With very few exceptions, the operating environment across industries continues to be very challenging.  The overall economy shrank around 2.5% during 2009 as measured by the change in GDP.  While our economy appears to have avoided a doomsday scenario of continued, accelerated declines (at least to date), and GDP actually increased during the third and fourth quarter of 2009 (5.7% during quarter four based on the most recent official data available), we continue to see high levels of uncertainty regarding any recovery.

Through discussions with business owners and executives across all sorts of industries, we continue to hear the same two questions:

• Exactly how long will the economy take to normalize?
• What is the “new normal” that we are normalizing to?

For many industries, pre-2008 performance levels will likely not be achieved again in the short-term. Those management teams that understand the realities of the current economic environment will be the ones that will position their companies for both short-term and long-term success.

The Transaction Environment

In line with the general economic environment, merger and acquisition (“M&A”) activity during 2009 decreased substantially compared to the last several years.  Based on broad market data published by MergerStat, total M&A transactions for 2009 measured 6,751, compared to totals of 10,559 and 8,048 for 2007 and 2008, respectively.

From an anecdotal perspective, our experience at Mercer Capital during 2009 suggests that the middle and lower ends of the M&A market were similarly diminished in 2009.  Some deals did get done, but the overall quality of the companies being transacted was generally lower.  As with the general economic activity, transaction activity did appear to show some signs of life, however meager, during the last quarter of 2009.

The reason for the reduced transaction activity is obvious.  With the weak economic conditions (and general lack of capital availability), valuations have continued to decline relative to what might have been a reasonable valuation expectation just a few years ago.  At these lower valuations, there are fewer sellers, especially sellers of quality companies.

As ownership groups make decisions regarding business transactions (either the sale of their business or the possible acquisition of other businesses), they must understand the market from just a few years ago is no longer directly relevant. The price that could have been gotten three years ago is not the appropriate benchmark from which to make investment decisions.  Such a backward view of the market could result in a business owner missing a viable opportunity for liquidity; an opportunity that may be very attractive relative to what will be available in the future.

The Tax Environment

Usually, the one part of the financial environment that is certain is taxes.  While there is no question that there will continue to be a tax burden, the level and form of taxes is currently in flux.  Consider the following:

As of January 1, 2010, there is no estate tax.  The 2001 tax bill which set a schedule to phase-out the estate tax has reached its final year.  While expectations were that the estate tax issue would have been resolved for the long-term before this year, that did not happen.  Currently, at least three scenarios seem possible:

• An estate tax bill is passed during 2010, likely with compromises on the level of exemptions and rate, and made retroactive to January 1, 2010.  There has been much discussion regarding the constitutionality of such a retroactive feature, so any bill with this feature would likely end up being debated in the court system for several years.
• An estate tax bill is passed during 2010, again with compromises on the level of exemptions and rate, and is not made retroactive to the beginning of the year.  This would create an almost arbitrary mid-year date upon which the tax will be changed.
• No “new” estate tax bill is passed during 2010, meaning that the 2001 bill phases out and we return to the pre-2001 terms of the estate tax.  This would result in much lower exemptions and a higher actual tax rate.

In 2011, dividends, which are currently taxed at a federal rate of 15%, will revert to being taxed as ordinary income at an individual’s highest marginal tax rate.  At the same time, the tax rate applicable to capital gains will increase from 15% to 20%.

Government expenditures currently far exceed government revenues and this is likely to continue well into the future.  While a political discussion of spending and tax policy is not our intent, this is an important fact in considering what future tax burdens might be.

What will happen with the specific tax issues outlined above (not to mention the broader question of regular income tax rates) is not clear.  There is likely to be an estate tax by 2011 (at the latest) and the rate on dividend and capital gains is likely to increase in the future.

Business owners must have flexibility in their ownership and liquidity plans to deal with the different possibilities.

Conclusion

We face several uncertainties in 2010.  However, as the legendary coach John Wooden once said, “Do not let what you cannot do interfere with what you can do.”  We cannot predict the future, but we can look for opportunities amid the uncertainties in the current economic, transaction, and tax environments.  If Mercer Capital can assist you, please contact us at 901.685.2120.

Reprinted from Mercer Capital’s Value Added (TM), Vol. 22, No. 1 (2010)

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