Commentary: Why the ‘fiscal cliff’ is driving startup M&A

President Barack Obama was reelected on November 6th, and since November 7th my phone has not stopped ringing.

Every entrepreneur, investment banker and venture capitalist is calling to sell their companies — all at once. My inbox is inundated with NDA’s and company overviews on businesses of all kinds.  The terms are all the same: “I need a cash deal and I need to close prior to year end.” 

On further digging, they are all willing to take a pretty significant discount to close by year end.

What’s going on? One word: TAXES!

As Washington is debating whether or not we are going over the “fiscal cliff,” one thing is for sure: taxes are going up for the wealthy in 2013, particularly in California.  Many entrepreneurs and business owners are looking to sell their businesses before any significant tax increases take effect next year.

Four potential tax increases are driving this behavior:

  1. ObamaCare:  The Affordable Care Act, also known as ObamaCare, will represent a 3.8 percent increase in taxes for wealthy individuals (people making more than $250,000 per year). Also, depending on how small businesses implement the policy, there is an additional risk of reduced profits for people intensive businesses, due to requirements to provide health care.
  2. Long-Term Capital Gains:  A long-term capital gain is profit made on an investment that you have held for more than 12 months.  In 2013, the capital gains tax rate is proposed to go up from 15 percent to 20 percent on wealthy individuals.  So if you are a small business owner or a significant shareholder in a business, you are going to make at least 5 percent less from the sale of your stock on January 1, 2013 vs. December 31, 2012.
  3. Dividends:  Dividends are cash distributions that a company pays to shareholders.  Small business owners often put their life savings into their business and would like to get cash out without selling shares in the company.  Small business owners can take cash out of their company through dividends. Historically, dividends have been taxed as ordinary income to discourage owners and investors from using dividends for cash distributions.  Under George W. Bush in 2003, the tax rate on qualified dividends was dropped to 15 percent.  In 2013, the tax rate on dividends is proposed to go back to the ordinary income rate (which could be as high as 39.6 percent in 2013).  Many public companies are executing large one time dividends in 2012 ahead of any changes in tax rates.  Just this week, Costco announced a one-time dividend of $3 billion to shareholders.
  4. Prop 30:  Proposition 30 was passed in California to properly fund public education and public safety, given the fiscal challenges the state is facing.   Prop 30 increases taxes on individuals earning more than $250,000 per year by one percent to three precent for the next seven years.  (Prop 30 will be retroactive back to January 1, 2012, so should not be a concern for most, but I have heard Prop 30 mentioned by entrepreneurs and bankers alike as a reason for selling).

All this has led to small businesses looking to sell ahead of any tax changes that could potentially go into effect in January 2013.

Here in Seattle, we already see evidence of larger cash-rich companies gobbling up companies to take advantage of the situation.

For example, Zillow has acquired three companies in the last 30 days.

Large, local securities transactions like the $1 billion financing of WaveDivision Holdings and the $85 million financing of Zulily could also be driven by favorable tax treatment for early investors and founders wanting to sell shares. (The Wall Street Journal reports that follow-on stock sales are up 72 percent in November 2012 versus last year because of the tax increases in 2013).

BUT the real question is “does an increase in the tax rate matter or change the behavior of an entrepreneur?”

Warren Buffett wrote a compelling piece in the New York Times this week arguing for a minimum tax on the wealthy, and that tax rates really do not affect anyone’s wealth accumulation over the long-term.  Buffett believes that the Bush era tax cuts really just made the rich that much richer.

He elegantly ended his New York Times piece with:

“In the meantime, maybe you’ll run into someone with a terrific investment idea, who won’t go forward with it because of the tax he would owe when it succeeds. Send him my way. Let me unburden him.”

Similarly, if you are an entrepreneur who is just starting out or an entrepreneur with a business that has a lot of gas left in the tank, all this discussion on tax rates is irrelevant.  Your choices in life are — work for a corporate giant or strike out on your own to blaze your own trail.  A 5 percent increase in long-term capital gains won’t change that decision.  Or at least it shouldn’t.

If your startup is so successful that a potential tax increase is driving you to sell your company, CONGRATULATIONS!

Nikesh (Niki) Parekh is the CEO of ActiveRain — a professional blogging platform and social network in real estate — and EVP of Product at Market Leader — an online marketing solutions firm for real estate professionals.   You can follow his ActiveRain blog here, or follow him on Twitter at @nparekh00.

  • skeptic

    Why do we trust/care what this guy’s insight is on M&A deal flow is? Is he a VC? Is he a banker? Is he a lawyer? Active angel investor? You didn’t do a great job of qualifying why we should care about his analysis (which I am skeptical of anyways).

    A way to make this better would be to ask other people who have insight into deal flow to confirm they are seeing the same thing and let us know if it has been corroborated.

    • http://twitter.com/nparekh00 Nikesh Parekh

      Hi Skeptic, I have led corporate development for two publicly traded companies, worked in venture capital at Second Avenue & Madrona, worked in private equity and investment banking. I have not seen this amount of deal flow in small period of time. Feel free to ask around. Here is a Wall Street Journal article on topic: http://online.wsj.com/article/SB10001424127887324020804578149541072261444.html

  • Mike Mathieu

    I just bought a company where the “fiscal cliff” was one of the reasons the seller mentioned for wanting to sell. Happy to buy more great companies before the end of the year…

    • johnhcook

      Mike,

      I’d be interested in learning more about the deal, especially if it is tech related.

  • VG

    Niki – Definitely agree. As investors in private technology companies, we are seeing tax implications driving increased dialogue regarding liquidity both in terms of outright sale of a company, as well as sale of secondary shares by individuals (employees, former employees, etc.). Also agree that new taxes are unlikely to dampen entrepreneurial activity. MSFT, Intel, etc. were all founded when taxes were higher.

  • Mark Illing

    My concern with these companies is that their behavior sounds more like owners of a pump and dump company rather than companies being built for the long term. Do you really want to invest with someone worried so about the short term? If you buy, certainly evaluate if these are the leaders you want going forward.

    • http://twitter.com/nparekh00 Nikesh Parekh

      Hi Mark, that is a real risk and problem. It is highly unlikely that anyone would wake up on Nov 7, decide to sell their company, and actually get a deal done in less than 60 days. Plus, anyone selling to save 10% is likely not seeing the big picture for their business.