Cherry Tree & Associates | Twin Cities, Minnesota | December 2018

Tax Reform Impact on Growth Companies
Federal tax reform legislation lowered U.S. corporate income tax rates to 21% beginning in 2018.  For larger and fully taxable corporations, the impact is direct in terms of increasing after-tax cash flows available for expansion, dividend, repurchase or acquisition activities.  For growth businesses, the impact of tax reform is more nuanced since these companies often generate little or no taxable income while working to maximize revenue growth rates. In addition, many growth businesses are organized as pass through entities, so they pay no taxes themselves and instead pass through income or losses to their underlying owners.   

In aggregate, we see five primary impacts of tax reform on growth businesses:

  1. More owner interest in M&A transactions
  2. Increased acquisition demand by corporate buyers
  3. Decreased premium for high growth rates
  4. Pass through deduction will benefit many owners
  5. Macroeconomic volatility due to increased federal deficits
More Owner Interest in M&A Transactions
During the 2018 year, S&P 500 companies have on average recorded after tax profit increases in excess of prior years, related in substantial part to lower federal tax rates. Internal valuations of privately-held growth businesses will rise as their larger, slower growth, fully taxable industry comparable companies grow in terms of after tax profits and relative stock market valuation.  These higher internal private company valuations that originate from routine valuation exercises may tend to cause founders and investors in growth businesses to consider an exit sooner rather than later.
Increased Acquisition Demand by Corporate Buyers
Corporate development departments will allocate some portion of their increased after tax cash flow to acquisitions of all types including growth companies.   This increased demand by corporations for acquisitions should further stimulate the interest of owners of growth companies in acquisition conversations. We believe this combination of demand and supply circumstances to be favorable to the number of M&A transactions that will occur over the next 12 months among growth companies.
Decreased Premium for High Growth Rates
Private equity and growth equity investors may shift their investment interest in favor of companies that generate more cash flow and taxable income in the short term since the tax hit for taxable income in the short term is less than in the past.  The logical tendency for growth equity investors to value higher growth rate companies as compared to lower growth rate companies won’t go away of course, but the differential between higher and lower growth rate company valuations should be moderated by the change in tax rates.
Pass Through Deduction Will Benefit Many Owners
In addition to the federal corporate tax rate change, tax reform legislation includes a 20% exclusion from taxable income for non-compensation income paid to owners of qualifying pass through entities including Sub S corporations and limited liability companies.  This means that owners of certain pass through companies, there may be a significant decrease in their personal federal tax due. The impacts of this portion of tax reform is still murky as tax accountants and attorneys sort out the best method to assure legal favorable treatment, but certainly there will be some movement in terms of the propensity of a growth company to expand level of employment, invest in capital equipment and make tuck-in acquisitions since less cash will be utilized to make cash distributions to owners related to their pass through personal income tax obligations.
  
Macroeconomic Volatility Due to Higher Federal Deficits
Federal budget deficits will inevitably be higher due to lower revenue from corporate taxes and without significant adjustment in other tax rates to compensate.  In fact, the U.S. Treasury Department reported earlier this month that the federal deficit increased 17% to $779 billion in the fiscal year ended September 30, 2018. The unprecedented decision by our federal government to increase the already stunningly high federal budget deficit level during a period of economic expansion puts our economy into uncharted territory.   With deficit spending this high late in the economic cycle, there will be less room for future moves to counter-balance macroeconomic downturns with fiscal policy, making our next down cycle potentially more painful than otherwise would have been the case.

John Bergstrom is a Managing Director of the Cherry Tree & Associates investment bank and has been an advisor to growth businesses over his thirty-year career working as investment banker, venture capitalist, entrepreneur and corporate advisor. Perspective North is a column offered to Cherry Tree clients, contacts, friends and associates to promote discussion and good business decision-making.

Prepared by:
John Bergstrom
Managing Director
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Cherry Tree & Associates is a p rivate investment banking firm based in the Twin Cities focused on representing mid-market companies in their merger & acquisition and financing transactions
Important Disclosures

The information included in this publication has been obtained from public sources and is not based upon private or confidential Cherry Tree information. Cherry Tree gathers its data from sources it considers reliable. However, it does not guarantee the accuracy or completeness of the information provided within this publication. Any opinions presented reflect the current judgment of the author and are not necessarily the opinion of the Cherry Tree firm. Readers should consult their attorney, tax advisor or other expert for advice on how matters discussed in this publication relate to their individual circumstances. Officers, directors, partners of Cherry Tree and Cherry Tree proprietary investment funds may have positions in the securities of any companies that are discussed and certain affiliates of Cherry Tree may recommend to specific clients the purchase and sale of securities discussed in the publication. This publication does not constitute a recommendation with respect to the securities of any company discussed herein, and it should not be construed as such. Cherry Tree or its affiliates may from time to time provide investment banking or related services to these companies. Like all Cherry Tree employees, the author of this publication may receive compensation that is affected by overall firm profitability. We undertake no obligation to update any information in this publication.