Implications Of Recent Tax Law Developments On Private Equity Mergers And Acquisitions

Lynne E Fowler and Chris Burke for Kilpatrick Townsend write: As it has always been, Federal income tax issues drive many of the structures of private equity funds and portfolio company investments. In addition, as we all know, the Administration and Congress continue to change the tax landscape. Most recently, The American Taxpayer Relief Act of 2012 (the "Fiscal Cliff Bill") that Congress passed in January resulted in numerous changes to the Internal Revenue Code and permanent extensions of various aspects of the "Bush tax cuts." This summary discusses certain of these recent trends and changes in the tax law and their implications for private equity and M&A transactions.

Using Partnerships for Portfolio Companies

One trend in private equity is an increased willingness for PE transactions to invest in a portfolio company taxable as a partnership. The partnership tax structure allows for a single level of tax, as described below. From a state law perspective, the portfolio company typically will be a limited liability company.¹

Using a portfolio company taxable as a partnership offers many opportunities for tax savings. However, the flow through treatment offered by a partnership presents specific issues that the private equity investor needs to address.

Flow through treatment generally - In an entity taxable as a partnership, the owners are taxed on the company's income at the time it is earned, not when this income is distributed. The character of the earned income passes through up to the owners as well. The owners will increase or decrease the tax basis in their interest in the company for their share of the company's income or loss each year.

The investor-owner will not be taxed on cash distribution he or she receives unless that distribution exceeds his or her basis in his or her interest in the entity. In addition to increases or decreases to the tax basis for the amount of income earned, the investor-owner's basis in his or her interest will increase or decrease for his or her share of contributions and distributions.

Leveraged recapitalizations - The partnership tax rules provide more flexibility in a leveraged recapitalization of the company, which might allow for deferral of taxation. In a leveraged recapitalization transaction, the portfolio company borrows money from a third party lender and distributes proceeds of the loan to the existing owners. Under partnership tax rules, the owners' basis in their interest is increased by their share of the partnership's liabilities.

As discussed above, partners are not taxed on distributions of cash until the amount exceeds their basis in their interest. Thus, the partnership generally can distribute the proceeds from the loan to the investors without a current tax effect.

Compare this result to a leveraged recapitalization transaction involving a portfolio company taxable as a corporation. In that case, the distribution of the loan proceeds would be a dividend at the time of distribution (or possibly a capital gain) subject to the 20% Federal income tax rate for high income individuals.

Section 754 elections - A partner's purchase of an interest in the partnership from another partner generally doesn't cause an increase in the basis of partnership assets to take into account the gain recognized by a selling partner. This means that the investor would not get the benefit of additional depreciation or amortization of the partnership's assets.

The partnership tax rules do provide for an elective fix to this issue. The partnership may make what is commonly called a Section 754 election, named for the Internal Revenue Code section that authorizes the election. This election will allow for the contributing investor to receive a step-up in the basis of his or her share of the partnership assets which may result in additional depreciation and amortization deduction for that investor. This election is available for minority purchases of partnership equity. Thus, the Section 754 election is more readily available than the analogous 338(h)(10) election for purchases of S corporations, which require a purchase of 80% of the stock of the S corporation.

Reverse 704(c) allocations - A contribution of cash by a new investor for equity in a partnership portfolio company does not result in step-up in basis of the partnership assets. Thus, similar to a purchase of an interest, the contributing partner would not get the benefit of additional depreciation or amortization of partnership assets that accompanies such a step up.

Certain allocations of items of income or loss of the partnership provide a similar depreciation result to the basis step-up for new investors. These allocations are referred to as reverse 704(c) allocations. When an investor contributes cash, the capital accounts (book accounts) of the company are revalued to reflect their fair market value at the time of the contribution. This revaluation may result in a "book-tax difference" for the existing partners in the basis of the assets reflecting the built-in gain or loss of the assets. In order to ensure that this built-in tax gain or loss is allocated to the existing partners and not the new investor, the tax rules provide that items of income, gain, loss or deduction must be allocated such that the gain or loss is born by the existing partners. For example, the new investor may be allocated additional depreciation while the existing partners are allocated additional income to offset this book-tax difference.

Applicable partnership tax rules provide three methods for making these allocations, the traditional method, the curative method and the remedial method. The traditional method favors the existing partners. The remedial method favors the new investor. The curative method often is in between the other two.

UBTI and Blockers - Many, if not most, private equity funds have tax-exempt investors. Tax-exempt investors have their own set of concerns when determining where to invest. Their primary concern is that the investment does not result in taxable income to them. With certain exceptions, income that is not related to the tax-exempt investor's exempt purpose is generally taxable as unrelated business income (commonly referred to as unrelated business taxable income, "UBTI"). If the tax-exempt investors invest in a company taxable as a partnership then it may receive UBTI because the character of the income earned by the portfolio companies passes through to the investor.

As stated above, there are certain exceptions to what constitutes UBTI, one such exception is dividend income. Thus, the solution to the UBTI problem for direct investment in the portfolio company is to insert a corporation between the tax-exempt and the portfolio company. This blocker entity would be taxable on its share of the portfolio company's income and could make dividend distributions to the tax-exempt investor which would not constitute UBTI.

ECI and Blockers - Similar to tax-exempt investors, foreign investors have their own concerns when choosing where to invest. With US private equity, the concern for the foreign investor is that they do not want to be subject to reporting or tax obligations in the US. As with the tax-exempt investor, direct investment by the foreign investor would result in the foreign investor being taxed subject to tax in the US. Under the rules dealing with foreign persons, the foreign investor would be treated as if he or she is engaged in the, US in the business of the partnership and the partnership income would be effectively connected to a US trade or business (commonly referred to as effective connected income, "ECI"). This would result in US taxation of the foreign person on the ECI.

Similar to the tax-exempt investor, a common solution is to insert a blocker corporation between the foreign investor and the portfolio company. While the dividend income paid to the foreign investor is still subject to tax in the US at a flat rate of 30%, the tax is collected through withholding by the blocker corporation; therefore, the foreign person is not required to file returns in the US unless they wish to seek a refund of the tax. The US also has numerous bilateral tax treaties that might lower the 30% withholding rate or eliminate it entirely if the foreign person meets certain requirements.

New Rate Structure

Recent acts by Congress resulted in changes to both the individual and capital gains rates.

Long-Term Capital Gains - Prior to 2013, the maximum Federal income tax rate on long-term capital gains was 15%. One of the key questions in the fiscal cliff negotiations was whether the long-term capital gain rate would revert to 28% as proscribed by the sunset provisions of the Bush tax cuts. The Fiscal Cliff Bill set the long-term capital gains rate for individual taxpayers at a rate of 15% generally for individuals whose taxable income is less than $400,000 ($450,000 for married filing jointly) and at 20% for those individuals whose taxable income is more than $400,000.

Qualified Dividends - Prior to 2013, certain qualifying corporate dividends were taxable at the same 15% rates as long-term capital gains tax rates. The sunset provisions of the Bush tax cuts provided for all dividends to be taxable at the same rate as ordinary income (generally 39.6%). The Fiscal Cliff Bill maintained the applicable tax for qualified dividends to be the same as long-term capital gains (see above).

Individual rates - The Fiscal Cliff Bill also extends the existing lower individual tax rates that were part of the Bush tax cuts with one major change. The act created a new 39.6% bracket. This new bracket will apply to the amount of taxable income (for 2013) that exceeds $400,000 for single individuals, $425,000 for heads-of-household, $450,000 for marrieds-filing-jointly, and $225,000 for marrieds filing separately. For tax years after 2013, these highest bracket threshold amounts are adjusted for inflation.

Impact on Private Equity and M&A- The good news is that while long-term capital gains rate increased, they remain at relatively low historical levels, so deal flow should not be impacted. Also, the maintenance of the equivalent rate between qualified dividends and long-term capital gain rates make leveraged recapitalization transactions tax efficient for target shareholders looking for liquidity.

Carried Interests

The use by fund managers of carried interests in the fund remains a hot topic of debate in Washington. Many critics maintain that the carried interest gives fund managers an inappropriate long-term capital gains tax rate for income from services rendered.

If properly structured, the receipt of a carried interest has no tax effect because the interest is deemed a zero value. Instead, as the partnership earns income the fund manager holding the carried interest is taxable on his or her share of the profits and losses.

The character of the income allocated to the fund manager is the same as the character of income received by the fund. Because most of the income earned by a private equity fund consists of long-term capital gains or qualifying dividends, the fund manager's share of income will generally be subject to the lower Federal income tax rate applicable to those types of income.

As has been widely reported, the taxation of carried interests has been a hot button in Congress for several years now. Congress has considered several proposals to do away with this perceived loophole, but none of the proposals have gained any significant momentum. Most recently, President Obama has included a new proposal to tax income attributable to carried interests as ordinary income as part of his solution to avert the so called sequester. While it remains to be seen whether this proposal will become part of any legislation in the near future, it seems clear that the debate is not going away any time soon.

Medicare Tax

On March 30, 2010, President Obama signed into law the Health Care and Education Reconciliation Act of 2010 which added Section 1411 to the Code and the IRS has issued proposed regulations interpreting the application of the section. This section requires certain individuals, estates and trusts to pay a 3.8% Medicare surtax on "net investment income". This surtax applies for taxable years beginning after December 31, 2012. Net investment income can be broken into three distinct groups of income, as follows:

• Gross dividends, interest, royalties, annuities, and rents, other than those derived in the ordinary course of a trade or business that is not either a passive activity or the trade or business of trading in financial instruments,
• Other gross income derived from a passive activity or the business of trading in financial instruments, and
• Net income attributable to the disposition of property other than property held in a trade or business that is not listed in bullet two.

The income may be reduced in each of the above cases by allowed deductions that are properly allocable to the gross income.

Impact on Private Equity M&A - The Medicare surtax applies to those who receive dividends or recognize capital gains in liquidity events. This increase reduces the after tax proceeds available to exiting shareholders and managers.

In addition, fund managers should be cognizant that the Medicare surtax will add to the tax costs of the capital gain and dividend income allocated to the managers with respect to their carried interest. Thus, notwithstanding the lack of any Congressional action on carried interests specifically, fund managers will pay more tax with respect to their income from carried interests starting in 2013.

Ten Facts about Capital Gains and Losses

The term “capital asset” for tax purposes applies to almost everything you own and use for personal or investment purposes. A capital gain or loss occurs when you sell a capital asset.

Here are 10 facts from the IRS on capital gains and losses:

1. Almost everything you own and use for personal purposes, pleasure or investment is a capital asset. Capital assets include your home, household furnishings, and stocks and bonds that you hold as investments.

2. A capital gain or loss is the difference between your basis of an asset and the amount you receive when you sell it. Your basis is usually what you paid for the asset.

3. You must include all capital gains in your income.

4. You may deduct capital losses on the sale of investment property. You cannot deduct losses on the sale of personal-use property.

5. Capital gains and losses are long-term or short-term, depending on how long you hold on to the property. If you hold the property more than one year, your capital gain or loss is long-term. If you hold it one year or less, the gain or loss is short-term.

6. If your long-term gains exceed your long-term losses, the difference between the two is a net long-term capital gain. If your net long-term capital gain is more than your net short-term capital loss, you have a 'net capital gain.’ 

7. The tax rates that apply to net capital gains are generally lower than the tax rates that apply to other types of income. The maximum capital gains rate for most people in 2012 is 15 percent. For lower-income individuals, the rate may be 0 percent on some or all of their net capital gains. Rates of 25 or 28 percent can also apply to special types of net capital gains.

8. If your capital losses are greater than your capital gains, you can deduct the difference between the two on your tax return. The annual limit on this deduction is $3,000, or $1,500 if you are married filing separately.

9. If your total net capital loss is more than the limit you can deduct, you can carry over the losses you are not able to deduct to next year’s tax return. You will treat those losses as if they occurred that year.

10. Form 8949, Sales and Other Dispositions of Capital Assets, will help you calculate capital gains and losses. You will carry over the subtotals from this form to Schedule D, Capital Gains and Losses. If you e-file your tax return, the software will do this for you.

For more information about capital gains and losses, see the Schedule D instructions or Publication 550, Investment Income and Expenses. They are both available at IRS.gov or by calling 800-TAX-FORM

IRS Tax IRS Amnesty for Employers of Household Help

Arden Dale for the Wall St. Journal writes: Employing a nanny or other household workers can open a can of worms with the Internal Revenue Service, but the agency wants to make it easier for someone who mishandles taxes for their hired help to put things right.

The current tax preparation season is a time when questions often surface about how employers of household help have handled--or not--the withholding requirements and other tax issues, financial advisers say. This year, the IRS is allowing more people to enter a special program that eases penalties for those who haven't been following the rules--but only until June 30.

A lot of people either aren't familiar with the rules or don't want to be bothered to jump through all the hoops. They may pay a nanny under the table or treat the worker as an independent contractor. That can prompt an audit and lead to penalties.

In some extreme cases the so-called nanny tax issue has even derailed some presidential cabinet nominees. The most famous case is that of Zoe Baird, whose nomination for attorney general in 1993 was pulled after it was disclosed she and her husband failed to pay payroll taxes for two household workers. The matter helped raise awareness of the issue--which the media quickly dubbed "nannygate."

ome advisers, like Murray Stoltz, president of Vermont-based firm Manchester Capital Management LLC, say knowing about clients' hired help is part of their job. "Our dialogue with the client is close enough that we know this is part of their financial and home world," he says.

Other advisers acknowledge that clients sometimes keep employees secret--or simply don't think to mention them.

Adviser Renee Kwok underscores the need for correct reporting whenever she learns a client has a nanny. "But our role is not to be a policeman or whistleblower for the IRS either," adds Ms. Kwok, president of TFC Financial Management in Boston.

As she recently did with a doctor client, who has four children under the age of four and a nanny to care for them, Ms. Kwok often recommends outsourcing employment to a payroll expert who fully understands the sometimes complicated rules.

The IRS, revising a program it started in 2011, has made it easier for those who haven't been following the rules. It lets employers reclassify workers they had been treating as non-employees or independent contractors. It foregoes interest and penalties, as well as most tax due for previous years, for employers who have been issuing Forms 1099. Those who paid workers under the table in some years may also be eligible but would have to pay more tax and some penalties.

Employers with all kinds of workers, not just household help, are affected by the program. In the past, taxpayers who misreported could only get a settlement if they had been audited, according to IRS spokesman Eric Smith. "This means you don't have to wait to hear from us," he says.

Stephanie Breedlove, who is co-founder of a household tax and payroll company in Austin, Texas, recalls how one family came to her this year: A nanny they employed had tried to use a national tax preparation company to file her taxes as an independent contractor. That tax preparer refused, insisting she go back to her employers and have them report on her properly.

This scenario may become more common as the IRS steps up efforts to get employers to follow the rules--which call for the withholding and paying of Social Security and Medicare taxes if a worker is paid $1,800 or more for 2013.

A further complication: There are separate and, often different, federal and state employment requirements. Some states insist employers pay workers' compensation and unemployment insurance, for example.

The IRS requires quarterly wage reporting, as well as annual filing of Form W-2 and Schedule H. Throughout the year, the employer withholds Social Security and Medicare taxes, along with any applicable state taxes, from the worker's paycheck.

A couple that sought accountant Brian Schultz's help decided to look elsewhere when he told them about the tax rules, he recalls. A veterinarian and his wife with a day-time babysitter, they seemed surprised to hear they would have to file a W-2 form and payroll taxes.

"They weren't excited about it," and they left, says Mr. Schultz, who works closely with a wealth management team at accounting firm Plante Moran PLLC in Southfield, Mich.

Comment

• Valerie Donovan Wrote:

The reason that trickle down theory didn't work is that the government wants to catch every drop that trickles These low wage earners pay little tax but have a drastic positive impact on the lives of the people they work for. They make productive people more productive which more than offsetting any unreported wages the IRS is griping about.. If they simply eliminated payroll tax and filing requirements for domestic labour more people would be employed, there would be alot less stressed out parents, and fewer people would be on public assistance. Domestics could be required to be payed through a special bank account, which insures they have an ssn and are eligible to work. Make it simple and every one wins.

Tax Claims: Good Investment (Maybe)?

Vicki Harding for Pepper Hamilton LLP writes: Does the purchaser of a tax sale certificate hold a "tax claim" for purposes of Section 511 of the Bankruptcy Code?  In Kopec the answer to that question meant the difference between interest on the claim of 18% versus 4%. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) included several amendments to the Bankruptcy Code that were favorable to tax authorities, including Section 511, which provides:

If any provision of this title requires the payment of interest on a tax claim or on an administrative expense tax, or the payment of interest to enable a creditor to receive the present value of the allowed amount of a tax claim, the rate of interest shall be the rate determined under applicable non bankruptcy law.

Typically under state law ad valorem real property taxes are secured by a super priority lien on the taxed property.  Historically, debtors argued that those taxes should be treated like any other secured claim, which meant that they could be paid over time as long as the payments had a net present value equal to the value of the claim.

Even in times when interest rates were not the miniscule rates of today, the rate used to calculate present value of a claim was almost always substantially less than the statutory interest rate for property taxes.  As a result, a debtor could pay considerably less for delinquent property tax claims than it would have been required to pay outside of bankruptcy.

Today Section 511 clearly precludes this treatment for tax claims asserted by governmental authorities.  However, most states have a delinquent tax system that provides for some sort of sale of the tax lien or property.  The question addressed by Kopec is whether the tax purchaser holds a "tax claim" within the meaning of Section 511 so that it is entitled to non-bankruptcy interest.

The answer turns on the status of the tax purchaser under applicable state law.  The Kopec court reviewed a Fifth Circuit case holding that a tax lien holder had a "tax claim" for purposes of Section 511 under Texas law, since the transferee was subrogated to the rights of the governmental entity.  Although that debtor argued that the tax claim was extinguished and replaced with a new obligation, the Fifth Circuit questioned whether the tax lien could be transferred if the tax debt was extinguished.

Another bankruptcy case discussed by the Kopec court concluded that a tax sale purchaser in Ohio held a tax claim for purposes of Section 511.  Among other things, that decision noted the use of the term "creditor" as opposed to "governmental unit" in Section 511, suggesting that it was intended to be broader than just tax authorities and would include a third party tax sale purchaser.  A third opinion discussed by the court reached the same conclusion under New York law.

Kopec was governed by New Jersey law.  The court noted that there were two prior bankruptcy decisions applying New Jersey law.  In re Princeton Office Park, L.P., 423 B.R. 795 (Bankr. D. N.J. 2010) held that the purchaser did not hold a tax claim because the underlying taxes were paid in full at the conclusion of the tax sale.  Thus, the purchaser acquired a statutory lien, but not a tax claim.  ThePrinceton Office Park decision was followed by a second bankruptcy court.

The Kopec court disagreed because (1) the governmental tax claim was not extinguished at the end of the sale based on its statutory analysis, (2) if the tax debt is extinguished, then there would be no basis for the lien continuing, and (3) the language in Section 511 suggests broader coverage, since it uses "tax claim" instead of "tax" (as used in the administrative expense section) and "creditor" as opposed to "governmental unit."

Consequently, the court found that the holder of a tax sale certificate under New Jersey law had a "tax claim,"  and thus was entitled to the statutory interest rate of 18%.  The court also noted that the Third Circuit is considering the Princeton Office Park decision on appeal.  (It certified a question to the New Jersey Supreme Court in 2011, which accepted the question in mid-2012, but has not provided any response as of early 2013.)

This case is a good illustration of several continuing themes:  (1) state law is frequently determinative of issues in bankruptcy; (2) often you can find a bankruptcy case to support either side of an argument, and (3) a bankruptcy court does not view itself as bound by decisions of other bankruptcy courts in its jurisdiction.

Collecting Retroactive Transit Tax Break Befuddles Commuters Burdens Employers

Ashlea Ebeling for Forbes writes: It turns out the retroactive commuter transit parity tax break Congress passed in January as part of the American Taxpayer Relief Act for 2012 is bittersweet. Depending on how you submitted your transit expenses to your employer, you might not get the tax savings. And for most of those who will benefit, they’re stuck waiting to file their tax returns as employers churn out corrected W-2s to make needed adjustments to gross income (my husband’s employer said to expect a W-2c by March 15). It gets even more complicated—in some cases employees may also be eligible for a refund on FICA taxes.

“One of these days Congress will wake up to the fact that there’s a need for lead time when it comes to tax legislation,” says Saul Brenner, a tax partner and CPA at Berdon LLP in New York.

The bottom line is this: if you ran all your transit expenses through your employer’s transit plan, bifurcating the total between $125 a month pretax salary deferrals (the old limit before the law change) and the rest as after-tax salary deferrals, then you get the tax savings on the difference between $125 a month and the new higher limit of $240 a month (that’s on par with the parking benefit). But if your employer capped the amount you could put away at $125 a month or you paid out of pocket for any additional commuting expenses above the $125 a month, then you’re out of luck.

Brenner has been busy explaining the retroactive transit tax conundrum to employer clients and to his own employees, who fell in both camps. He even talked to the lawyer who drafted the Internal Revenue Service notice to inform employers (i.e. their accountants) how to handle this Congress-induced mess. Apparently employers are only obligated to help employees who submitted all their expenses through a plan.

Jim Terminiello, marketing manager at Berdon, is in this tax-favored group. He takes New Jerseytransit at $160 a month and ran the full expense through his employer plan, so his wages were adjusted for the extra $35 a month, reducing his adjusted gross income for 2012 by $420. “For the people who aren’t in Jim’s boat, it’s unfair,” Brenner says. “I told them, ‘Write your Congressman.’”

That’s what Michael Devaney, a disgruntled commuter who rides the Long Island Railroad into New York City and then takes the subway downtown where he’s a settlements analyst for ConEd, did. (He hasn’t heard back from Sen. Charles Schumer who championed the original transit parity law). “The idea is for people to have more in their pocket, but it’s not happening,” says Devaney. “If you live in an area like New York City, the transit costs are so high, you’re losing out on something really significant.”

For commuters like Devaney who can’t get the retroactive break and whose expenses top $240 a month, they lost out on about $550 in tax savings (an extra $1,380 in pretax salary deferrals at a combined rate of 40%). That’s two months of commuting expenses, Devaney notes.

An estimated 2.7 million families gain from the transit break. It’s not clear just how many won’t get it for 2012 because of the way the fix is being administered. “All the stars have to be aligned,” sighs Ruth Wimer, an employee benefits lawyer with McDermott Will & Emery in Washington, D.C.

As to the second part of the fix, getting a refund for extra FICA (Social Securityand Medicare taxes) paid in, the Internal Revenue Service says employers have an obligation to repay employees their share of these taxes. Employers then file amended 941 quarterly returns (employers get a refund too).

“It’s a big pain in the neck,” says Wimer. All employees getting the first fix to adjusted gross income should also get the 1.45% Medicare tax back ($20 per employee), but only employees below the Social Security wage base of $110,100 will get the 4.2% Social Security tax back.

The transit parity break goes through year-end 2013, with the limit raised to cover up to $245 a month of expenses.

Xero market cap hits a cool $1 billion (New Zealand)

(from New Zealand, Chris Keall for National Business Review writes - with the always fun comments at the bottom) Just eight months after NBR asked, "is Xero worth a cool half billion?", Rod Dury's online accounting software company has hit a $1 billion market cap. (New Zealand).  In late trading, Xero shares were up 5.04% to $8.55 - lifting the company's value to $1,001,958, or a $70 million increase on the day.   In a February 7 update, Xero said it had more than 23,000 customers to its client list since September and says it is on track to double last year's $19.3 million in annual revenue.

The Wellington-based company has more than 135,000 customers and monthly recurring revenue of almost $4 million, it says in a statement. That implies annual sales of some $48 million.

Xero 12-month NZX performance (S&P Capital IQ. Click to zoom).

Xero CEO Rod Drury has long maintained it is better to push for growth than profit at this phase of Xero's existence.

Over the same period, cash has increased from $38 million to $85 million - primarily thanks to December capital raising round that sawy Peter Thiel-backed Valar Ventures of San Francisco invested $24 million and Massachusetts-based Matrix Capital Management invest $58 million. They also bought collectively $22 million of existing shares from Xero's three largest shareholders: Mr Drury, co-founder Hamish Edwards and director Craig Winkler.

Xero NZX performance since 2008 IPO (S&P Capital IQ. Click to zoom).

Despite Mr Drury offloading some of his holding during the December round (it now stands at 18.3%), he and his fellow managers and employees still have a lot of skin in the game.

(out of New ZeaChris Keal for National Business Review writes: Xero has about 3000 shareholders and 48% of its shares are held by directors and staff, according to the January 31 filing.

Following Xero's half-year result, Forsyth Barr reiterated its hold rating, and put a 12-month price target of $6.32.

"On normal valuation metrics Xero appears fully priced," the company said in an update.

"However, at this stage the share price is still not so high as to be pricing in unreachable targets. Our analysis suggests it is pricing in Xero reaching around 1.1 million customers in approximately five
years."

By any conventional metric, Xero's valuation is off the charts. But major December cash injection shows the stock's appeal to sophisticated tech investors, ForBarr says.

Some are no doubt hoping for a trade sale, as with Mr Drury's previous two start-ups.

The Xero boss says he's in it for the long haul, but is also not above pointing out tasty trade sales, as in this tweet:

Rod Drury @roddrury

Another $B+ enterprise SaaS exithttp://www.zdnet.com/cisco-acquires-meraki-for-1-2-billion-to-move-in-on-mid-market-cloud-customers-7000007612/?s_cid=e550 … White hot space

7:09 PM - 19 Nov 12

Mr Drury kept things low key when approached by NBR OLINE for comment this afternoon.

"It's a cool milestone but still lots of work to do," he said.

-

Comments and questions

16

#1 by Hot air 8 hours ago

Doesn't the rate at which a bubble inflates accelerate dramatically just before it bursts?

#2 by Anonymous 8 hours ago

Congrats

#3 by Michael Shrubsall 7 hours ago

Interesting to compare with another company with $1 billion market cap being Chorus. Chorus has annualised npat of $168 million, annualised operating cashflow of $368 million, dividend payout 60% of npat which equals 12.5% dividend yield. Has a bit of a monopoly as well.

by Chris Keall (verified) 7 hours ago in reply to Michael Shrubsall

But not that informative for those who want to take a punt on Xero.

It's the classic value vs growth scenario.

Chorus has stable earnings and strong dividends, but (shenanigans over wholesale copper pricing aside) its next few years of revenue and growth prospects are quite tightly proscribed by its major contracts (the UFB and RBI) and its work with telcos and ISPs.

Xero is shooting for major growth in new markets like the US, UK and Australia. But whether it achieves profitability and world domination and/or gets sold for a truckload is still an open question - and much harder to put a price on.

by Hot air 5 hours ago in reply to Chris Keall

It will need to be sold for several truckloads.

by Lance Wiggs (verified) 7 hours ago in reply to Michael Shrubsall

and little growth prospects aside from putting their prices up. And folks are already baulking at connection/ongoing costs for UFB.

Xero on the other hand has millions of potential customers, and a steadily widening path to get to them.

#4 by asocialservice 7 hours ago

Ok, I give up... this defies so much logic and normal metrics or analysis that it is beyond me... Well done Rod and team (I think...).

#5 by Harvey Specter 7 hours ago

Well done Rod.

#6 by The Doctor 7 hours ago

Rod will be able to take more money out now

#7 by @lancewiggs 7 hours ago

told you so….

by Anonymous 7 hours ago in reply to @lancewiggs

Famous last words. if the bubble bursts watch all the people saying to YOU the same thing...!! I will be one of them.

#8 by Lance Wiggs (verified) 7 hours ago

<-- that was a reply to Chris Keall on Twitter, which references a comment I made to him at the $500m stage that Xero was clearly on a path to go through a billion.

For the record I would still advocate holding Xero shares for a very long time. There are still ridiculous levels of scope for customer growth, and Xero are consistently managing their growth very well.

Well done Rod and the whole team (currently and formerly) at Xero

by Anon 6 hours ago in reply to Lance Wiggs

Ahh, the classic. I told you, so cop out - telling people to hold for a long time so that if/when the bubble bursts you can't be wrong then, either.

You don't fool me.

by Hot air 5 hours ago in reply to Lance Wiggs

Come on Lance! Even before this latest surge the price assumed revenues will rise by squillions of percent and profits will be colossal.

#9 by Anon 6 hours ago

Seen it all before. Wonder who's going to get burnt?

#10 by Looks like bursting soon 4 hours ago

We are getting all this "its a new pardigm" guff here....