The anticipated capital gains increase is prompting some business owners who might otherwise have stayed at the helm to explore a sale of their company. And the time is ripe, as venture capital and private equity funds are stirring to get back in the acquisition mode.
For many business owners looking to sell their business, a sale to a private equity or venture capital firm has advantages, according to Verenda Graham, national private equity tax leader at Top 100 Firm BDO USA.
“They see private equity as an alternative to selling to individual owners or strategic buyers, or going public,” she said. “They may have started out as a mom and pop but have grown to significant size and want to retire. If they don’t have a younger generation to take over, it can be hard to find a strategic buyer that aligns with their goals, and an IPO would be more complex. But a sale to private equity involves a fairly short acquisition period. It’s a very viable option for an exit strategy.”
One of the considerations on the minds of private equity and venture capital fund managers is the prospect for increased taxes down the road, according to Graham. “And surprisingly, the potential for increased digital tax on products and services is concerning private equity and venture capital fund managers more than a possible capital gains tax increase, the impact of the interest expense deduction calculation or changes to carried interest regulations,” she said. Graham cited the BDO Private Capital Pulse Survey — Spring 2021, which included these key findings:
- Increased taxation of digital products/services was managers’ No. 1 concern when it comes to potential tax changes, with 58.5% worrying about it.
- Capital gains tax changes came in second, at 50.5%.
- The impact of the interest expense deduction calculator being based on EBIT (earnings before interest and taxes) versus EBITDA (earnings before interest, taxes, depreciation and amortization) is the top potential tax change for half (50%) of survey respondents.
- Tax strategy was cited as the top post-M&A challenge over the next 12 months for more than a quarter (26.5%) of PE and VC respondents.
“My take on this is that the concern of fund managers is not so much on the amount of tax as it is on the uncertainty of how digital taxes will work,” said Graham. “Capital gains and carried interest are concrete situations that can be planned for and modeled. There’s less ambiguity as to where they will land — they’ll either stay the same or increase.”
“The same is true of carried interest,” she continued. “Biden has proposed eliminating the special treatment of carried interest but we know what the impact of that would be. But there’s a concern about digital taxes as to how they will be handled on a global basis. With digital taxes on products and services, there’s no real way to model based on current proposals. “
While waiting for the OECD to arrive at a digital tax agreement, countries in Europe have put in their own temporary solutions because they want the revenue that digital tax will bring, Graham observed.
“A large number of jurisdictions define digital tax in different ways,” she said. “PE and VC funds will have to develop ways to get their arms around something that is less certain than capital gains. They will need to examine factors such as physical presence and economic nexus, especially involving tech companies. This is a huge area as it relates to due diligence and its impact on exit strategies.”
The Private Capital Pulse survey polled 100 venture capital and 100 private equity middle-market fund managers in the U.S.