Article written by:
Wade Kozich, CPA, CEPA
Senior Director
You see various exit options being promoted as “the best” depending on the promoter’s focus. I believe that to help someone properly and with integrity, you must start with a blank chalkboard and fully vet all options. My intent here is to try to describe the various options a business owner has in creating liquidity in plain, straight talk.
Every business is distinct and every transition is unique and must be addressed as such. Finding the right path, requires knowledge, planning and detailed execution. You have to do the homework. It all starts with the goals of the owner(s)/stakeholder(s) and looking out for THEIR best interests.
Let’s start with these interesting facts:
- The average age of a Baby Boomer today is 63 years old.
- 76% of Baby Boomer-owned businesses will transition in the next 10 years.
- 80 to 90% of those Baby Boomers’ wealth is tied up in their businesses.
- 100% of all businesses will eventually transition…one way or another. The truth, though, is that very few will transition in a highly successful manner.
Option #1: Outright sale of your business to a Strategic-type Buyer
- This is often the best path when you want to maximize current liquidity and eliminate your risks associated with the business.
- A sale to a Strategic buyer is often best when the owner is ready to pack it up, retire and stop worrying about the business and wants to sell 100%.
- It is commonly thought that an outright sale maximizes the sale price due to inherent synergies between the buyer and the seller.
Option #2: Sale of all or part of your business to a Private Equity-type buyer
While this has many of the same attributes as a sale to a Strategic Buyer, a sale to a Private Equity buyer can render a similar sale price but also allows the owner/seller to maintain a stake in the business and get that “second bite of the apple”. Typically, a seller to a Private Equity Buyer will roll something like 20% of the sale price and usually will get more value over the long term as a sale to a Strategic Buyer.
Quite often this second bite of the apple can amount to more than the first bite.
To qualify to be a seller to Private Equity, the owner should plan on sticking around for a while, at least during a transition period. Having a second, strong person on board to run the business is a major plus if the seller/owner wants to become a passive owner.
Observation: In our world, I would say at least 80% or more of our deals fit into one of these two categories with the deals being split equally between Strategic Buyers and Private Equity buyers. Also, keep in mind that a Strategic Buyer for your business may itself also be owned by a Private Equity firm. Private Equity ownership in companies is much more pervasive than most people realize because they are usually not that visible.
Option #3: Sale to an ESOP
An ESOP can be a great option for certain business owners. In fact, ESOPs can sometimes be an ideal solution that accomplishes most or all of a business owner’s objectives. We are proud ESOP advocates and we work with over 100 ESOP companies each year. My personal view, however, is that certain firms who focus solely on ESOPs are overselling ESOPs. Oftentimes, an ESOP is not the best fit.
Boiling it down to its essence, with an ESOP, you are basically selling your company to the employees in a leveraged transaction, and, in most cases, getting your proceeds over a 5-7 year period. To finance an ESOP transaction, the company must take on leverage either through bank debt or by the seller providing the debt.
The biggest benefits of selling to an ESOP include: (a) maintain corporate culture as an independent company, (b) provide a valuable benefit to existing and future employees, (c) receive fair market value, (d) transition ownership when there might not be another logical buyer, (e) likelihood of improved company performance, and (f) certain tax advantages, which can be substantial.
In 1974 when the government first established ESOPs, they wanted to promote employee ownership, and consequently, provided very substantial tax breaks. These tax breaks come in three primary ways:
- An owner selling stock in a C-Corporation can generally defer gain on the sale of that stock if proceeds are then reinvested in domestic stocks.
- If the Corporation is, or switches to, an S-Corporation status post-deal, then to the extent that the ESOP owns the S-Corporation stock, the company basically becomes an income tax-free entity because an ESOP is a retirement plan, and consequently, pays no income tax.
- Depending on the structure of the transaction, the entire amount of the ESOP loan may be able to be repaid with pretax dollars (as opposed to traditional financing in which only interest is deductible).
What I see as the drawbacks to ESOPs:
- You will usually not get the highest value because the purchase price is not to be higher than “fair market value”, so valuations do not provide for potential strategic synergies that can be realized by a sale to a strategic buyer. We had one company where the owner thought the company was worth $25 million, and we ended up selling it for $46 million by running an investment banking process.
- You can eliminate or severely restrict your future financial upside from the business by selling the company for a fixed price. I have seen ESOP deals here in town where the owners got no money on day one from the transaction and they froze their upside. In many cases, this may not make sense.
- You will typically need to wait to get your money over a 5-7 year period. Consequently, the continued success of the business is required to get you paid, and this will keep you worried about how the business is doing. If you want to walk away from the business entirely, an ESOP is often not the best option because you would be dependent on the people running the company to get your money.
Observation: While I do not have a current statistic on this, my guess is that less than 10%, and maybe less than 5%, of owner liquidity events are accomplished through ESOPs.
Option #4: Leveraged Recap
A leveraged recap can work well when an owner does not want to sell yet, but wants to get liquidity from the business. In this type of transaction, the company borrows from someone, usually a bank, and distributes the proceeds to the owner. Depending on the tax status of the company and its owner, some of these amounts distributed may be taken out tax free. Basically, with a leveraged recap, the owner is mimicking what a private equity firm would do with the business if they had bought it. A leveraged recap will work best for the owner who is very confident in the future of their business, does not mind taking on debt, and sees a big potential upside, consequently seeing high value in retaining their ownership. This can be an effective way for an owner to transfer wealth from the company to their personal balance sheet.
Observation: While a very small percentage of owner liquidity events are accomplished through leveraged recaps, they can be very effective and beneficial and should not be overlooked.
Option #5: Management or Partner Buy Out
These can be very good options, but are also relatively uncommon.
The problem with these, while they sound good at first, is that management typically has little money so they argue for a lower buyout price and favorable terms and must usually borrow the money, sometimes requiring the seller to carry the debt.
Also, if management is not financially sophisticated and not properly represented, it can be difficult to complete these transactions.
Observation: These can fit well where the buyer pool for a business is limited and where management is very strong. In smaller deals, management may be able to take advantage of SBA financing which fits many of these transactions very well.
Option #5: IPO
For the most part, the IPO market has been replaced by the private equity market which has created a very efficient market for most strong, private companies. The cost of going public along with the ongoing compliance costs of going public make it prohibitive for all but very large companies.
Observation: In the last five years, I can think of only one of our clients that has gone public.
Option #6: Family Transfer
While a decent percentage of businesses transition this way, I do not view this as a liquidity option. I view this more as an estate planning tool. Any liquidity created by these would be similar to the dynamics of a management buyout or leveraged recap described earlier.
Observation: While these sound good from a legacy feel-good perspective, they are often done for the wrong business reasons. I have stories where a client owner refused $40 million 25 years ago from a strategic buyer, but instead chose to sell the business to Johnny for a song, only to have Johnny run the business into the ground. Sometimes these work out well and family businesses can be a wonderful thing, but I strongly encourage anyone to go into these with eyes wide open.
Option #7 Orderly Liquidation
You see this every once in a while when the asset value of a business exceeds the going concern value of the business. This can happen as a result of the business not being successful or when you have a business that has just wound down in a natural fashion and liquidation is the only viable option left.
Summary
All of these options must be considered and are not mutually exclusive. In fact, we have had one client utilize nearly every one of these liquidity options over a 40-year period including an IPO. Even amongst these options, there can be many variations, so do not assume anything until you fully explore your options.
