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Roundtable Discussion: The Middle-Market Landscape in New York City

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It’s a great time to be running a middle-market firm for many companies in New York City. The Tax Cuts and Jobs Act is ushering in a substantial corporate tax cut that is expected to make U.S. companies more competitive with rivals from around the world. That would make a difference for many firms in New York City and other major cities, given the high overhead that comes with operating in a prime location.

Meanwhile, valuations are on the upswing for middle-market companies. As a result, it’s a good time for owners who want to cash out to start thinking about their exit strategy.

Nonetheless, there are some challenges ahead. Middle-market firms need to stay on their toes to prevent cybersecurity breaches. In the wake of high-profile data breaches, CEOs and boards are expected to have the right systems in place to protect sensitive client data.

To gain insight into how leaders at middle-market firms can get in front of these and other developments, Crain’s Custom Studio spoke with a brain trust of experts from the accounting and advisory world who work frequently with middle-market firms:

Michael Fanelli, CPA, a partner in the transaction advisory services practice at RSM US LLP and the leader of the New York transaction and advisory services team
Michael Laveman, CPA, a tax partner with EisnerAmper
Greg Wank, CPA, CGMA, an accounting and advisory partner at Anchin, Block & Anchin LLP

Crain's: How will tax reform impact business for middle-market companies?

Michael Laveman: Overall, large corporate entities should see the biggest impact as the combination of a drop from a 35% federal corporate tax rate to a 21% federal corporate tax rate will likely result in share buybacks, investment in capital expenditures, R&D spending and M&A activity. Most owners of pass-through entities will also benefit as a result of the new 20% deduction against qualified business income, which will lower the effective tax rate to below 30%, down from 39.6%. This will enable pass-through owners to invest back into their businesses.

Greg Wank: The Tax Cuts and Jobs Act is the largest tax bill since 1986 and will substantially impact middle-market companies and their owners in 2018 and beyond. The bill significantly reduces the income tax rate for corporations and eliminates the corporate alternative minimum tax (AMT). It also significantly increases individual AMT and estate tax exemptions. And it makes major changes related to the taxation of foreign income.

It’s not all good news for the middle-market, however. The Tax Cuts and Jobs Act also eliminates or limits many tax deductions, and much of the tax relief is only temporary. Additionally, the significant changes to employer deductions for business-related meals and entertainment could impact how businesses entertain and socialize with clients, employees and contacts. Overall, for privately-held, middle-market companies, there are a variety of changes that must be analyzed to determine the true impact on the business.

Michael Fanelli: The choice of entity for which a middle-market business operates should also be considered, which also requires a discussion around succession planning and the owner’s annual cash flow needs in order to know what entity would be best to operate from a tax cash flow perspective over time. Focusing on capital needs and efficiently using the new enhanced capital expenditure provisions will be important, as will modeling out whether the new limits on the use of interest expense and net operating losses to determine any impact on the business. Considering which elements of tax reform the state tax authorities follow will be another important part of planning under tax reform.

Crain's: Based on tax reform, how can middle-market firms minimize their effective tax rate?

Michael Fanelli: Qualifying a business for the new 20% qualified business income deduction if a pass-through entity or taking advantage of the new 21% corporate tax rate could help middle-market firms reduce their effective tax rate and provide for more earnings to be reinvested into the business and/or its employees and owners.

Greg Wank: The Tax Cuts and Jobs Act substantially reduces the federal income tax rate on C corporations to 21%. This could have an impact on entity choice for middle-market firms going forward, as well as warrant an assessment of the merits to revoking an existing S-corp. election. There is a substantial new incentive to invest in property and equipment via a 100% deduction of certain capital expenditures.

Michael Laveman: Many factors come into play in making the decision to switch from a pass-through structure to a corporate structure, including the type of business involved, where the company is located and how much money can be reinvested into the business as opposed to distributed to shareholders/equity holders. Interest expense deductibility is another area that businesses should focus on. Business interest expense deductions are now limited, so financing arrangements should also be reviewed.

Crain's: If a firm is considering a potential exit strategy in 2018, what will its leaders need to do to prepare their business for that event?

Michael Fanelli: Preparing your family-owned or owner-operated middle-market business can be a daunting task. We suggest business owners prepare as early as possible for this event. Preparation should not be performed alone, as hiring expert advisers (tax, legal, investment banking, accounting, etc.) becomes critical to driving the highest sales value of your company, while allowing you to continue to manage your business. Other key aspects include (but are not limited to) clear articulation of your vision. Where can the business grow to in say, three, five, or seven years? Also, try to mitigate the risk of keeping the key business management in your head. Making yourself redundant and grooming a supporting management team can become critical.

Greg Wank: Focusing on margins and profitability are important when considering an exit, but incentivizing key employees and leaders to remain for the long term can be just as important. Many exits are contingent on the continued growth and success of the company, and exiting executives with nontransferable intelligence and intellectual capital can seriously damage a transaction amount. Right sizing expenses, investing in marketing and business growth, building strong internal controls, and developing better processes can all be key factors in building business value.

Crain's: What are some of the differences between selling a middle-market business to a private equity firm vs. a corporate strategic buyer?

Michael Fanelli: In the current M&A marketplace, private equity firms and corporate strategic buyers are looking more and more similar. However, there are still differences worth noting. Typically, a private equity firm is going to have a shorter-term investment horizon (many times three to five years), while corporates may invest for the long-term. Private equity firms bring significant financial acumen to the business, which may include higher leverage. However, often they also bring operating partners with years of operational experience in one’s industry.

In many instances, private equity firms look to back existing management teams and will invest a majority (say, 80%) in the business, while allowing management to keep 20% equity in the business. This provides for a “second bite of the apple” scenario where many times the original seller can make just as much or more on the sale of the remaining 20% equity interest. Corporates typically seek to acquire 100% of the business.

Greg Wank: An owner of a middle-market company has to weigh existing options and future goals for the business. If it is a pure exit, with no intention of continuing at the company, the highest bidder usually wins. But for founders or owners who want to remain active in the business and continue to benefit from company success, it is imperative to weigh the differences in a transaction. A private equity firm may have a three-to-five-year plan to build and grow the company, while a corporate strategic buyer may see the business as a long-term growth driver. In some cases, tremendous investments will be made to accelerate growth and expansion, while others want to increase velocity. The ultimate exit needs to tie to a founder/owner’s goals and to the company’s mission.

Crain's: M&A valuations remain at some of the highest levels of all time. What are some variables that could impact this going forward?

Greg Wank: The economy is strong and in some industries, including consumer products, we are seeing the highest multiples ever in deals. In key strategic expansion areas, valuations and multiples will continue to grow and owners will realize tremendous value. As an example, if Coca-Cola decides to expand in a snacking category, it has the size and pocketbook to go acquire a brand. It doesn’t have to invest in R&D and spend years trying to perfect a product. With this in mind, the competition gets stiffer and strategic buyers compete private equity, venture capital, and other acquirers. That drives offers and competition, increasing valuations and multiples even further.

Michael Fanelli: The current average earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple has been hovering in the 10-12x range; however, this varies widely depending upon industry and size of the company. Consistently high valuations have been primarily driven by low-interest rates, and a supply-demand issue, with a tremendous amount of capital chasing too few quality businesses.

For this to change, interest rates would have to increase significantly, more businesses would need to come to market compared to years past, limited partner investors would need to move away from investing in the private equity asset class, or a catastrophic global event would need to occur. Otherwise, with the availability of relatively cheap debt, high supply of capital to invest and low number of business for sale, valuations will likely remain high.

Crain's: How has the CFO role at a middle-market firm changed over the past year? Where do you see it in, say, five years?

Greg Wank: CFOs need to think beyond the day-to-day financial picture of a middle-market company. They have to be a financial executive and leader at their firm, driving ideas for growth and expansion, thinking big, and becoming more of a financial visionary for the company. You are seeing more CFOs ascend to larger operational roles as they assume more responsibility in the executive suite. The evolution of CFOs as leaders will continue, and we are excited to see them drive value in the C-suite.

Michael Laveman: The CFO role has gone far beyond just being responsible for financial reporting and tax compliance. Many CFOs are now actively engaged in a wider range of company issues, including regulatory issues, internal controls, technology, investor relations and many others. Although many companies have internal or outsourced personnel to assist them in these areas, more often than not, the CFO is very involved. As the worlds of robotics, artificial intelligence and blockchain continue to advance, it is likely that five years from now the CFO will play a leading role in managing these, and perhaps other, areas of a company’s business.

Michael Fanelli: The role and importance of the CFO are being impacted significantly by today’s digital world as they become evangelists for driving technology, data, and analytics throughout an organization. In their role as strategic leaders, CFOs need to build their companies by focusing on five pillars of success within financial operations: people, processes, technology, reporting and analytics, and controls. Process-led technology enablement will empower progressive finance chiefs to take the reins as business performance leaders and effectively drive organizational performance.

Crain's: How much do middle-market companies need to worry about cybersecurity? What are the leading-edge issues when it comes to data security and privacy?

Michael Laveman: Middle-market companies should be very focused on cybersecurity. Many high-profile companies have disclosed significant data breaches over the past few years, and many of them have had some level of protection in place that did not prevent these events from happening. Companies should either have an internal resource or an outsourced solution that addresses areas such as hardware, software, staff training, vulnerability testing and beyond.

Greg Wank: Proper security training and enterprise security assessments are absolutely necessary in today’s marketplace. We see tremendous investments in information security services and think it will only continue to grow as more breaches are made public.

Crains: How can middle-market companies take advantage of artificial intelligence and blockchain?

Greg Wank: AI and Blockchain have the potential to revolutionize the way we do business. Quicker, more efficient processes can be built, and technology is allowing us to create things we never imagined before. We see significant changes on the horizon with technology revolutionizing every industry. With disruption like this comes opportunity. The amazing thing is that it is accessible for middle-market companies, and this can aid their path to growth.

Michael Laveman: Each day, artificial intelligence is becoming a more commercially available tool that businesses can actually use. For instance, our firm has partnered with IBM’s Watson to assist us with “smart auditing.” We have been able to teach the AI technology a set of rules whereby it can then review documents and provide output for us to review. And, based on our input, the technology actually learns. This has enabled us to spend less time on routine areas and greater focus on value-added analysis. Businesses with generally labor-intensive, manually driven processes are good candidates to consider the implementation of AI.

Crain's: How can middle-market companies access tax credits and incentives in 2018?

Michael Fanelli: The numerous tax credit and incentive programs that are available to middle-market companies throughout the U.S. can include credits and incentives for capital investment, job creation and technology development. These benefits can vary by state and by industry, and are administered by state or city economic development agencies, many of which have specialists that help rapidly growing companies access these benefits. We assist companies in identifying applicable programs and working through the application and negotiation process with these agencies.

Implementing these programs frequently requires the evaluation of expansion options in more than one state, so often it is necessary to negotiate these benefits simultaneously across jurisdictions. Ensuring that the program is negotiated and applied before the company finds the lease or begins the expansion is essential. Surprisingly, many smaller and middle-market companies do not take advantage of these programs because of misconception that the programs are geared toward large companies only.

Greg Wank: There are significant tax credits and incentives that can be leveraged in 2018. If a middle-market company is considering a relocation, negotiations with state, city and local officials can lead to significant incentives for them. Hiring people, expanding into new locations, and investing in R&D are all ways that a company can benefit. The R&D credit has been an unbelievable incentive for many of our clients, in a variety of industries. That access to capital allows tremendous reinvestment into their businesses.

Crain's: Are there any incentives firms should be aware of with respect to investing in capital and real estate?

Michael Laveman: Companies should be aware of the new rules related to the expensing of certain business assets. Both bonus depreciation rules and Section 179 rules were favorably changed in the new tax act. For periods between 9/27/17 and 1/1/23, businesses can deduct 100% of qualified business assets. In addition, the annual Section 179 deduction has been raised to $1 million with higher phaseout amounts.

It’s important to remember that planning around asset purchases—along with other new rules, such as net operating losses—may need to be considered in determining which of the new asset expensing rules would be beneficial and, if so, to what degree. Another important consideration is that the purchase of used property will now be eligible for bonus depreciation.

Michael Fanelli: Most states have some type of incentive to support companies that are investing in capital and/or real estate. Depending on the state, these programs may be limited to specific industries and may be limited to specific locations with each state. Typically, incentives of this type can help companies reduce or eliminate their property taxes, sales taxes and/or income taxes related to a capital or real estate investment. These types of benefits must generally be negotiated for and applied for prior to making the underlying investment.

For example, a technology or software development company in New York can take advantage of the Excelsior Tax Credit Program with as few as five new jobs created and some capital investment. In New Jersey, manufacturers can take advantage of the New Jersey Grow Tax Credit Program with as few as 10 jobs. You can also negotiate a reduction in real estate taxes with the relevant jurisdiction where your facility is located.

Greg Wank: Many real estate investment vehicles are favored under the new tax law, thereby increasing their potential after-tax rates of return. As stated earlier, the cost recovery for capital investments in your business has been accelerated under the new tax law as well. As the overall tax rate environment drops, company executives have to weigh the net returns on investing in people and property in their business compared to returning capital to its stakeholders.

Mr. Laveman specializes in complex tax advisory and planning services for the financial services sector. He works with start-ups and well-established clients, including hedge funds, private equity funds, venture capital funds and more.

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