Is Rollins really selling? My take (taxes, taxes, taxes) and what it means to you

Earlier this month (June 2020) I was sitting at my computer doing what every deprived sports fan has been doing during the sports vacuum caused by COVID-19. I was day trading. In addition to the fast-moving stocks I watch, I always keep an eye on pest control industry players because stock price is one of the many factors we use to gauge the market and determine maximum value for our M&A clients.

In the mid-afternoon, Rollins stock popped to an all-time high and within a few minutes dropped 5 percent. Fortunes made and fortunes lost, all in a few minutes. With my curiosity piqued, I started to do a little research on what just happened, and over the news wire I found this:

“Rollins Considering ‘Strategic Options,’ Including Potential Sale”

Now why would the Rollins family want to sell this fantastic empire? Well, I can’t confirm the story and I couldn’t even imagine what this would look like. When contacted, a company official said, “The company has a policy of not commenting on market rumors one way or the other.”

Why would the Rollins family sell?

So, we know nothing about the potential sale. But there are a few things we do know. If the Rollins family, or any insider, tried to sell large blocks of stock on the New York Stock Exchange, alarms would go out and the investment community would smell a rat and the stock would plummet. A company with a $14 billion valuation, with more than half owned by the Rollins family, would immediately drop in value. So how would the family take some chips off the table without alarming investors? They would hire an investment banking firm to find institutional investors interested in taking an interest in the firm and sell a block of ownership outside of the public markets. With this type of strategy, we’d most likely see very little, if any, value degradation. This is how it would be done.

But why? Why would the Rollins family even consider selling shares? One reason would be to diversify their family fortune into other assets, thereby reducing their exposure to specific asset valuation risk. Another is there is tremendous risk in the overall economy due to business cycles and recent events. A major risk as I see it is that when all the government stimulus currently being pumped into the economy dries up, we go into a deep recession, and that scenario would have a negative impact on the stock market, and therefore the Rollins stock price drops.

Diversification in this case helps to mitigate valuation risk as the market falls and provides many options with respect to family estate planning. Sounds plausible, right? But with the government pumping trillions of dollars into the economy, who is going to pay for it? Without getting political here, we all will! — through increased taxes. It doesn’t matter who wins the election in November, taxes are going up. In fact, Joe Biden already has proposed eliminating capital gains taxes for anyone making more than $1 million. Sound like a lot of money, right? But in the year of sale, many pest management professionals will far exceed that million dollars.

What’s happening to capital gains taxes?

Currently, the difference between the federal long-term capital gains rates (20 percent) and maximum marginal ordinary rates (37 percent) is 17 percent. What if long-term capital gains are eliminated, as suggested by Biden, and maximum ordinary income rates are increased to 40 percent — just 3 percent higher than current? The increase in taxes that the Rollins family or anyone else, including you, if you sell your company, would be 20 percent of the purchase price. For example, let’s assume the Rollins family diversifies by selling $2 billion worth of stock (not even half their interest). Today, at a 20 percent capital gains rate, their federal taxes would be $400 million. If they sell under the tax increase scenario above at 40 percent, they would pay $800 million in taxes. That’s a $400 million (100 percent) increase in taxes!

You see, if we sell at a high valuation at a very favorable tax rate, we leave the blackjack table with all the chips. If we stay and keep playing, we give back a lot of our winnings. If you take nothing else from this article understand this: We have no control over either the valuation risk if the economy tanks or the tax risk, which is almost certain. And in my opinion, my friends, this is the reason Rollins is or should be considering taking some chips off the table.

How does this affect pest control M&A deals?

You may be thinking, “Interesting stuff, Dan, but how does this affect me?” Well, it affects you the same way. If values decline due to the economy (or any other reason for that matter), that is valuation risk. Once the nation was introduced to COVID-19, the two largest strategic buyers of pest control firms left the market (Rentokil and Anticimex). While they will be back soon, expect valuations to be down from the top of the market. That said, there are still deals to be done now, but they are subject to valuation risk.

The second shoe that will fall, in my opinion, is the risk of rising tax rates. The two combined risks will affect after-tax proceeds of deals in the future, likely starting after election season.

Let’s look at how this could play out with a pest management professional M&A deal that we did just before the COVID-19 crisis:

Scenario 1 – actual terms of the deal

a. My client did about $5 million in annual revenue

b. His revenue breakdown included 80 percent recurring revenue

c. Adjusted cashflow (EBITDA) was about 20 percent

d. Sales price was $14.2 million, so a valuation of 2.84 times revenue

With federal capital gains tax at 20 percent and state income tax at 7 percent, taxes paid were $3,834,000. After-tax proceeds were $10,366,000.

Scenario 2 – same deal with following assumptions:

a. The market values drops by 30 percent

b. Capital gains tax is eliminated for income over $1 million

c. Ordinary income maximum marginal tax rate increases to 40 percent

d. New sales price (30 percent less): $9,940,000

e. Federal taxes paid at 40 percent and state income tax at 7 percent, taxes paid would be $4,671,800 and after-tax proceeds would be $5,268,200.

The difference in after-tax proceeds between Scenario 1 and Scenario 2 is $5,097,800 to the downside — just about 49% less.

Is this realistic? It depends on to what degree the valuations fall and how much taxes rise. But let’s say that I overestimated the downside by half. That’s still a total after-tax proceed degradation of more tha $2.5 million.

Questions you should be asking yourself now include:

1). How much after-tax proceeds do you lose by waiting to sell if the economy falters and if tax rates increase?

2). How much do you have to grow your business just to get back to even using the lower valuations and higher tax rates?

3). Would now be the right time to sell given 1). and 2). above?

As you can see, if you’re thinking of taking advantage of the bull market that the pest control industry has experienced over the last several years, you may want to look at your options now.

Why contact PCO M&A Specialists?

If that means testing the waters and offering your company for sale, we will get you the highest after-tax proceeds, while minimizing your legal exposure when it comes to contract time. No one in the industry offers the fire power we do. We have the inside data on which industry buyers and private equity firms are paying the most in which areas of the country and which attributes they are looking for the most.

Our on-staff computer specialists are experts in Pestpac, Pest Routes, ServSuite and Real Green Systems. They can extract value from your CRM that other brokers in the industry may not even know exists.  With several CPAs, MBA analysts and a Certified Valuation analyst all under one roof, no one will get you a better deal. We don’t brag, make outlandish predictions or fictitiously hype our expertise like other industry brokers do. We just rely on our success and experience in getting our clients the highest after-tax proceeds on deals we facilitate.

Author: Dan Gordon