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As a general rule, a higher tax rate reduces a company’s cash flow, hence it reduces the value of a company, and vice versa. However, the effects are not always that simple. Without wishing to enter into the politics of the proposed changes to the Hungarian tax regime, these changes are dramatic, and provide the opportunity for a most interesting case study on how changes in tax regime may affect the valuation of companies.
In a nutshell, the Hungarian government has levied a “Special Tax” on banks and on major companies in the energy and telecommunications sectors, as well as on supermarkets, depriving all of these organizations of a substantial portion of their profits over the next three years. In the meantime, the government intends to reduce the tax rate on individuals to a flat rate of 16 percent (perhaps even lower). The corporate tax rate will also be reduced to 16 percent.
All of those companies facing a tax decrease to the new flat tax would of course see an increase in their valuation. This usually happens according to some kind of multiplier effect- that is to say, a €1 increase in cash flow may create an increase in company value of approximately five or six euros.
Conversely, prima facie, those banks, supermarkets, energy and telecommunication companies facing the “Special Tax” would see fairly dramatic declines in value, with a similar multiplier effect.
However, the situation is not that simple: the increase in consumer purchasing power (thanks to reduced individual tax rates) should help promote additional spending on telecommunications services, gasoline, and groceries, which may fully or partially offset the effect of the Special Tax. Much depends on whether consumers decide to save or spend the tax windfall. Presumably banks may also need to write off fewer bad loans if consumers have additional disposable income. So the long-term effect on valuation is highly uncertain.
Markets abhor uncertainty. For anyone who now wishes to sell or raise financing today for a company affected by the Special Tax, there are major uncertainties ahead, which may make any transaction or financing extremely difficult:
Investors and financiers will also find it very difficult to forecast whether consumers will save or spend the tax windfall, hence it will be difficult to forecast revenues of the companies affected by the Special Tax.
- It will also be impossible to forecast how much of the tax companies will be able to pass on to their customers. (If the entire tax could be passed on, there would arguably be no impact on valuation).
- Investors and financiers may fear that the Special Tax will be extended beyond the three-year period currently intended by the government.
- It is still too early to predict what effects this taxation program will have on investor confidence.
- It is still too early to predict whether the Special Tax will be sufficient to plug the fiscal gap. After all, multinationals have an amazing aptitude for tax planning, in order to find legal ways to avoid taxes. Furthermore, it remains to be seen whether the government announces structural reforms. If the fiscal gap is not plugged, the government may be forced to resort to additional measures.
It is probable only a minority of owners of telecom companies, energy companies, and supermarket chains may be contemplating a transaction over the next few years. For most owners of these companies, the possibility of reduced cash flow will be more significant than a diminished valuation. There may however be a few such owners contemplating exit, who may be tempted to postpone transactions until after the uncertainties have been resolved, as investors will tend to value such companies based on conservative (one might say pessimistic) scenarios.
Overall, however, for the vast majority of companies not affected by the Special Tax, valuations and the environment for transactions is likely to improve.
As the Warsaw Stock Exchange (WSE) is currently working towards going public, it is worth reflecting on its preeminence in the Central European corporate finance world. In November 2010, the WSE is itself going to be listed on the WSE. The Polish government is selling 63.82 percent of the outstanding shares, but still plans to keep 52 percent of voting rights. With a price range of zł.36-43 per share, the WSE is valued at zł.1.5-1.8 billion (€382-456 million).
With a total market capitalization of some zł.715.8 billion (€174 billion) – 30 percent more than that of the Vienna exchange, and five times the market capitalization of the Budapest Stock Exchange –, the WSE was the third-largest stock exchange in emerging Europe, after Moscow and Istanbul, at the end of 2009.
The WSE has expanded the fastest in the region, more than doubling the number of traded companies and almost tripling daily turnover in the past decade. Over the past five years, there have been over 200 Initial Public Offerings (IPOs) on the main floor of the WSE. In 2009, a year of global doom and gloom internationally (but when GDP in Poland powered forward with a 1.8 percent annual growth rate), 38 IPOs raised approximately €1.6 billion on the WSE and the alternative exchange for small companies, NewConnect. This is a remarkable achievement and today there are a total of 364 Polish and 23 non-Polish entities listed on the WSE, including MOL, CEZ, UniCredit, Astarta, Immoeast, and the Orco Group.
Cheap equity has been one of the growth drivers of the WSE. For many years, the Polish government has required that Polish pension funds invest their funds into Polish equities. Given that the supply of Polish equities has been limited, this means that their prices have been driven up considerably (e.g. enterprise value has often exceeded 20 to 25 times EBITDA for companies listed on the WSE). This has been a boon to Polish entrepreneurs, who have strengthened their balance sheets with the cheap equity raised on WSE IPOs. (This may, however, raise the question of whether Polish pension funds are sufficiently diversified in their equity holdings. It also raises the question of whether all of these small companies should be on a stock exchange, as they may not be in a position to meet growth expectations and, given their low capitalization, may find it difficult to maintain a following among analysts and shareholders, causing their share prices to languish over time.)
Listing on the WSE is also simple for non-Polish companies. After Poland’s accession to the EU, listing a foreign company on the WSE is as simple as listing a domestic company. Poland has adopted the EU single-passport rule, which states that any company registered in any EU member country may make its debut on either the WSE main floor or the NewConnect market without applying for consent from the Polish Financial Supervision Authority. In keeping with the single passport rule, the prospectus of the candidate company may be approved by the capital market regulator in any EU country. The prospectus does not even need to be translated into Polish in its entirety: an English-language version is sufficient.
The WSE has been a phenomenon. Over the past decade, it has been a fantastic advantage to those companies which have been able to raise capital on favourable terms. The IPO reflects the fact that the WSE itself has become big business. However, it will be interesting to see how the next decade plays out, with widespread consolidation of Central European stock exchanges expected. For how long will the EU continue to allow rules forcing Polish pension funds to invest in local equities, and for the Polish government to control the WSE with a type of “golden share” ownership?
Most small- to mid-sized businesses have no need for a holding company. It may be sufficient for the company owner(s) to personally own shares or a quota directly in the company in question. This article will look at a number of instances where a holding company might nevertheless be advisable. I will look at three types of reasons for setting up a holding company: (a) corporate governance; (b) financial; and (c) taxation. I will then conclude with a few ideas on things to watch when setting up a holding company.
1. Corporate governance
I am currently advising the owner of a group of companies who has numerous corporate entities which are held by him personally. He exerts his control directly over each company, and his personal control is really the only institutional link among the various corporate entities. At some point in the evolution of this group of companies, they will require a common management team to provide coherent leadership. This could be achieved by interposing a holding company that provides direction to the operating entities.
If a strategic or financial investor were to invest in such a group of companies, they would likely insist on a holding entity, as it would not be practical to appoint board members to each entity, and then somehow try to coordinate so many entities. It is much simpler to provide coordinated governance for a group of companies at the level of a holding company.
2. Financial reasons
It is usually easier to obtain both debt and equity financing when you have a holding entity (e.g. usually with consolidated statements). Such an entity is usually larger and more diversified than any single subsidiary, and therefore has less risk. This should result in lower costs of capital. It may also save transaction costs (for example, one loan for the group, rather than separate loans for each of the operating companies).
3. Taxation reasons
Significant tax advantages may be achieved by interposing a holding company. Dividends may flow tax free or at lower tax rates than if an owner were paying taxes to himself or herself personally. In certain jurisdictions, the sale of subsidiaries may be free of any capital gains tax. Therefore, the jurisdiction in which the holding company is incorporated is of paramount importance— it generally pays to incorporate a holding company in a jurisdiction that has tax treaties with all the countries in which the subsidiaries operate. This helps avoid double taxation. It is extremely important to obtain advice from tax experts for the purposes of tax planning (which is perfectly legal) and make sure you are not entering the realm of tax evasion (which is illegal).
In short, the reasons for creating a holding company may be quite compelling. It is very important to ensure that when a business owner sets up a holding entity, and transfers ownership of operating companies from personal ownership to the holding entity, that this does not trigger a taxable event, or if it does, that the tax implications are manageable. If you are contemplating building a business empire that spans many companies, it may be advisable to create the holding structure as soon as possible to avoid the potential tax liability upon such transfers.
A data room is used by a company seeking debt or equity financing. Prior to making a binding offer, the investor or banker will usually want to see all contracts, title documents, tax returns, and other relevant documents. These may either be provided in a physical data room (i.e. a room filled with filing cabinets containing documents, which may be viewed by the investor and their advisers), or a virtual data room, which provides web-based access to the same information. Investors may then view the information from the comfort of their offices or homes, saving travel expenses as well. For larger data room exercises, the travel and accommodation costs for dozens of staff and advisers can be substantial.
This article first discusses some of the positive arguments for using a virtual data room, followed by a critique of the disadvantages when compared to a physical data room. I conclude with some comments on which type of data room might be more appropriate in different circumstances.
Reasons for using a virtual data room
A physical data room ties up considerable physical space (e.g. at least a fair-sized board room), usually for several weeks, as each investor will need to have several days' access to a physical data room (and sometimes considerably more). Hence, access to a physical data room needs to be carefully coordinated and, in the interests of ensuring that various potential investors do not become aware of each others’ identity, every physical data room exercise must be fully terminated prior to commencing the process with the next investor. This considerably lengthens the amount of time required. Also, the process requires at least one full-time person – either a staff member of the company seeking financing or its advisor – to be present throughout the period during which the data room is open.
Because a virtual data room is online, it requires no physical space. Online investigations by different investors may therefore occur simultaneously. Furthermore, the company seeking financing does not need to tie up a staff member (or someone from its advisor) for many days or weeks in a physical data room. If one adds new documents to a physical room, one has to provide access again to all bidders; whereas in a virtual data room it is possible to add documents, simultaneously advantaging all bidders.
Another big advantage of a virtual data room is that most enabling software has a different password for each user, in order to preserve confidentiality. This also has the advantage of allowing the company to monitor which investors are expending the most effort on the data room. For example, if an investor has not spent much time in a virtual data room, it remains open as to how much reliance one should place on an offer coming from such an investor, or at least it should be easier to resist requests for subsequent access to the virtual data room if it is clear that they did not take sufficient advantage of their earlier access privileges.
.Disadvantages of a virtual data room
The big disadvantage of a virtual data room is that investors with access to the data room may walk off with sensitive information. While participants in a virtual data room typically sign a document in which they agree not to copy information from the data room, in practice this is very difficult to enforce. While the software may contain options to prevent printing or saving documents, it is almost impossible to verify that an investor with access to a virtual data room is not using screen save features, photographing the screen, or copying the content of the screen by hand. I am not aware of any provider of virtual data room software that provides a 100 percent guarantee that it is impossible to copy the contents of the data room.
Another disadvantage of a virtual data room is that it either assumes that documents are available electronically or it means considerable effort must be expended on scanning and organizing data.
Concluding comments
From the above analysis, it is evident that physical and virtual data rooms are appropriate in different circumstances, depending on confidentiality requirements, the level of trust among the parties, the availability of space and human resources, the availability of information electronically, etc. One option that I have found to be a workable compromise is to have a virtual data room for less confidential information, and a physical data room for the most confidential information.
Any business owner who has children will usually consider transferring the business to one or more of those children as an eventual exit option. (I will use the expression “child” or “children” even though the offspring may be fully adult). This article will look at the issue of intergenerational transfer from the perspectives of timing and competence, then examine the issue of what can be done to improve the likelihood of success. Finally, I will talk about some of the common financial implications of intergenerational transfers.
Timing issues
When my 16-year-old son (my only child) expressed enthusiasm about taking over my corporate finance business, I said to him: “Ok, let’s see how this would work out as far as timing. You have four more years of high school, followed by about six years of university (undergraduate and MBA), followed by eight-ten years of work experience. That means you could be ready to take over the business in about 20 years time. A lot of uncertainty there! Will you still want to take over the business in 20 years? Will I remain healthy enough to run the business for the next 20 years? In my case, an intergenerational transfer would be a very long-term strategy indeed. And a somewhat risky strategy as well: unless there was some back-up plan, the likelihood of my being in good enough health to manage a grueling business into my seventies is certainly not 100 percent.
You should therefore think through the timing issues very carefully.
Issues of competence
Would you want to transfer both the ownership and the management of your company to your offspring? If you have professional management in place, the transfer of ownership may be easier (although overseeing or eventually replacing management is fraught with difficulty as well).
In most cases, owners transfer both ownership and management to their offspring. Parents often do not realize that skills that they have accumulated over many years, sometimes decades, are not that easy to transfer to children within just a few short years.
Have you made a full and honest inventory of the competencies required in the CEO position, or whatever leadership position you wish your child to assume? Sometimes the competencies required can be quite daunting, ranging from professional qualifications to people management skills, and from excellent salesmanship to business development skills within the industry. A proven track record is always better than theoretical competencies.
Improve the likelihood of success
A psychologist that my firm has worked with very closely in the past specializes in the area of intergenerational transfers. While he cannot predict the probability that a child will succeed in following in a parent’s footsteps, he can predict, with close to 100 percent accuracy, when a child is likely to not be successful. This can be invaluable information. Why set your child up for failure? (Not to mention the financial implications, if you are expecting payments over time from your child for transferring the business).
You might also consider rotating your child through several positions within the firm before they take on leadership or ownership of the firm. Have him or her learn the business from the bottom up—marketing and sales, production, finance, etc. This will allow your child to move up the learning curve; it may then be less of a leap to the CEO/owner function. It will also allow you to gauge whether your child is capable of taking the leap, and which staff would relate well to your child. Be careful: employing children usually creates some tricky dynamics with staff, especially if the child is promoted very rapidly. You may also consider making your child CEO and minority owner, while you remain chairman and majority owner. A gradual transition allows corrective action, if required.
Taking over a business from a successful (and often domineering) parent is an intensely personal affair, and not an easy task. Family politics or intergenerational issues may also create enormous difficulties. A successful transfer requires as much effort from the parent as from the child (and sometimes restraint!)
Financial implications
An intergenerational transfer is typically driven by the fact that one or more members of the family feel strongly that the business should remain within the family. This objective often has drawbacks from a financial perspective:
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Intergenerational transfers seldom result in the type of valuation that might be expected from a fully competitive sale process. Hence, if the owner is looking to maximize proceeds from such a transaction, he or she is likely to be disappointed.
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Because children seldom have the liquidity necessary to purchase your business, transactions are often structured in such a way that compensation to the owner is deferred, either by way of a promissory note or an “earn-out” type transaction. In either case, if the next generation of owners drives the business into the ground or does not meet expectations, satisfying the payment obligations or expectations could be a major issue.
Conclusions
There is only a small subset of businesses where intergenerational transfer is the most appropriate exit mechanism for owners. If you decide that you would like to investigate intergenerational transfers more closely, tax and estate planning should also be part of your strategy.
