Managing Success

For me as a guy who interfaces with many converters on a regular basis and is privy to a lot of financial information, 2020 was probably the most profitable year for converters since I got involved with the industry almost 30 years ago. It certainly didn’t start out that way, and when COVID-19 hit the economy hard in early 2020, many of you experienced some rocky months. But just about everyone obtained PPP loans, which more than covered the down months and the trials and tribulations of running a fairly labor-intensive manufacturing operation during a pandemic. Even without the effect of the forgiven PPP loan on the income statement, many converters were showing profits in the rarified air of 15%-plus on the bottom line, many of you were in the 10% to 15% range, and almost everyone had a good year.

With two price increases already implemented (and a third one looming), it seems that price increases are good for everyone’s bottom line, and my observation from watching the business closely for quite a long time is that converters pick up margin when the price of paper goes up. The economists point to a dramatic increase in nonstore retail sales during the second half of 2020 and cite the government stimulus programs for a big overall uptick in consumer spending. Panic buying during the early stages of the pandemic has also been cited as a factor in all of this, but the bottom line is that everyone is busy—so much so that paper supply has become tight, lead times for orders have lengthened dramatically, and everyone is working hard to take care of their good customers. The price for packaging has all of a sudden become less of an issue with the customers than the availability. Integrated companies are sending more and more orders to independent companies, and large independent companies are sending more and more orders to smaller independent companies.

The last half of 2020 and the first four months of 2021 have been a veritable panacea for both integrated and independent companies. So the question that needs to be asked is, “What should you be doing with this success?” In the last edition of BoxScore, I argued for using it to invest in your business to help ensure its long-term future. High-speed converting, with its increased output relative to plant employee head counts and more consistent and precise boxes with better print and a lower average cost per unit, will certainly help you be more competitive. I still believe that this is the right course of action for most of you, but let’s look beyond this and talk about the market and other external forces that need to be considered to help you come up with a more comprehensive plan.

• With the integrated-based companies so busy, they are exporting much less paper.
• Pricing for paper in almost all of the export markets has improved dramatically, so many of these contracts that used to generate little or no profit are not nearly as bad now.
• Because of this, it is unlikely that the prices that they are willing to pay for your business are going to be as high right now as they were for the past decade, when most of the integrated producers were trying to become more integrated.
• If you embrace the concept of utilizing your current success to invest in the future, then it is likely that your balance sheet will reflect lower cash balances and higher debt balances.
• Company valuations are most likely on the rise due to the increased profitability, but remember that valuations are reduced dollar for dollar for increased debt and reduced cash balances.
• Also keep in mind that most valuations use an average of a couple of years in the calculations.

Let’s digress from these thoughts and spend a few minutes discussing the current political climate in Washington, D.C. President Joe Biden wants to institute a massive investment in infrastructure and pay for it with increased income and estate taxes. No one knows exactly how this will play out and whether the changes will be made retroactive to the beginning of the year (yes, they can do this and have done it in the past). What he is proposing for successful business owners is absolutely frightening. The following are a few of the key provisions in his proposal:

• Increase in capital gains tax for taxpayers with over $1 million in taxable income from 20% to ordinary income rates (which he proposes to make 39.6%).
• Reduce the estate exemption amount to Obama-era levels of $3.5 million ($7 million for a husband and wife).
• Eliminate the step-up in basis to fair market value for assets passing through an estate.

So, if you have a company (or own real property or any other investments) that is worth $20 million, instead of being able to pass it to your children tax-free with a full step-up in basis, you now will have an estate tax on $13 million and no step-up in basis. If you sell the company (assuming you have little or no basis), you will incur $8 million in taxes instead of $4 million.

If you wish to preserve some or all of the current roughly $23.5 million in estate exemption and the 20% tax rate on capital gains, you may need to move very quickly, because once the new laws are enacted, you will be stuck. While no one knows exactly how this political process will play out, it is a safe bet that tax rates are going up and favorable estate rules will be diminished. So here is what you need to consider in the very near future:

• Consider obtaining current appraisals for all of your key assets. The valuation will probably be as low right now as it can be, assuming your business profits are accelerating and you are taking on new debt to pay for equipment and systems.
• Meet with your tax and estate planning experts to develop a plan to transfer assets out of your estate in the very near future. A strategy encompassing some combination of gifts, outright sale, installment sale, sale to a defective trust, or transfer to a trust should be drawn up.
• Trusts need time to be formed, recapitalizations involving nonvoting stock can take time to effectuate, and deeds on real property often cannot be changed overnight.
• Valuation and estate-planning experts are going to be very busy in the near future, and you may not be able to get to them quickly.

Significant change is on the way, and if you are going to manage your current success properly, you need to get ahead of all of this and start the process immediately.

Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or mitch@klinghernadler.com.