Alternatives for Transferring a Company
By Edward W. Towers, RFC and CBI
Merger and Acquisition activity is really heating up. The article titled “Small and Mid-market Activity Rose in ‘04” in the February 2005 issue of Inc. Magazine stated, “Both the volume of deals and their value rose sharply, according to Mergerstat, an M&A research firm based in Santa Monica, California.” Transferring or exiting a company is a major decision for the small or mid-market business owner. Frequently it is the biggest financial decision of his life and commonly at least three-fourths of the family’s net worth is tied up in the value of the family business. Preparing an exit plan is important. In developing an exit plan, the owner should consider the many alternatives for transferring the company.
In the same article, Inc. Magazine also put forth “Equity valuations surged ahead by sixty-eight percent”. The article went on to state that the latest figures mark a return to the level of activity seen prior to the dot-com meltdown. Dan Gallagher of CBS Market Watch wrote an article December 31, 2004, titled “M&A jumps to $1.95 trillion for 2004. December surge pumps deal activity to four-year high”.
With EBITDA multiples for midsize companies hitting 7.3 times, many owners are considering their options. This article will only briefly discuss the eight most common transfer or exit alternatives.
Merger. This is a reorganization by joining an existing company. IRS regulations define A-G reorganizations that may qualify for tax deferred status. A reverse triangular merger is a common approach in mergers. You frequently hear of mergers between large companies as being a “merger of equals”. This usually is a misnomer. As in most cases, one company is effectively getting control. It is common for a financial buyer to attempt to do a “roll up”, which is to merge with a number of firms in the same business to take a dominant position. The owner may receive stock in the surviving company or newco, possibly along with some cash. The existing management team may stay, and resources are combined. Larger public companies effectively acquire a company by having the smaller firm merge into the surviving legal entity.
Planned succession. In this situation, the owner passes on the ownership to a family member. Usually this is a child, but sometimes it is a younger sibling. This process is not as easy as you might think. The successor needs to be identified and qualified, but they also have to accept that many times the potential successor just doesn’t have the same level of interest in Mom and Dad’s dream. The successor must be trained and there is a question of how well the owner’s know-how can be transferred. Plus the owner knows a lot more than he realizes. Planned succession has the benefits in the continuity of management and additional estate planning options. Ownership can be phased in over time.
ESOP (Employee Stock Ownership Plan). This is a tax qualified employee benefit plan that gives employees a larger ownership in their company. An ESOP is governed by the Employee Retirement Income Security Act of 1974 (ERISA). There are over 10,000 ESOPs in the U.S. with 90% of them being privately held companies. An ESOP may provide liquidity for the company with thinly traded stock and allow the owner to transfer control where there may be no outside parties interested. It also allows the current owner to keep control in the hands of management. If the ESOP borrows funds to buy out the current owner, the company may possibly deduct both principal and interest payments. In a leveraged ESOP, the company establishes an ESOP trust.
Sell a minority interest and recapitalize. Because this alternative is not disposing of majority control, it is not ultimately a transfer solution. The primary reason for a minority interest recap is for wealth diversification. To finance a minority interest recap, a capital firm will use mezzanine securities, preferred stock, and subordinated debt. A mezzanine security is a hybrid between equity and senior debt. Like equity, a mezzanine security is unsecured and long term in duration and like senior debt they are loans that earn interest. A minority interest recap offers owners the opportunity to “have their cake and eat it too” as they can take some money out of the company and still keep majority control. The minority investor should be someone who is trusted, collegial, and ideally a partner who has advantages with suppliers and/or customers. Usually the minority shares are discounted from the value of the majority position.
Shareholder or management buyout. A management buyout occurs when one or more of the management employees buy part or all of the ownership of the company. It is almost always leveraged. Usually they are designed by existing management. Some or all of the stock is bought by one or more people who will be actively involved in the management of the company. A common feature of a management buyout is an equity sponsor who invests along with management to buy the company. Management buyouts constitute nearly fifty percent of all M&A transactions today.
Initial Public Offering (IPO). An IPO happens when a private firm initially raises cash by going public with its stock. The $70 billion raised in 2004 by IPO’s was the highest in the last four years and 200 % more than 2003. This years IPO’s through February of 2005 raised an all time high amount of money for early in the year. The fact that IPO’s are back in style again is important because Private Equity Groups (PEG) and Venture Capital (VC) firms frequently utilize IPO’s as their exit strategy to get a good return on their investments from the companies they have acquired and built up.
Many of the IPO’s now are spin-offs from large public companies that want to sell off assets that are not critical to their main business. Small firms might shy away from an IPO because of new rules that have raised the expense of going public. IPO’s were dominated by tech companies during the dot com boom, but now only represent twenty percent of the companies executing IPO’s. Besides raising cash, another reason to do an IPO is to reward the company’s founders and employees. There is usually a “lockup period” whereby insiders are not able to sell their stock for at least 180 days.
Charitable Remainder Trust. This is a device recognized by tax law for the owner to retain interest from income from an asset while gifting the remainder to a charity. One form is a Charitable Remainder Annuity Trust (CRAT) whereby the owner receives a fixed annuity income of at least five percent of the original value of the assets transferred into the CRAT, payable at least yearly. Usually it is for life. Another form is a Charitable Remainder Unitrust (CRUT) which is similar to a CRAT except the yearly income depends on a fixed percentage of the current fair market value of the assets in the CRUT (re-determined yearly). The owner of a growing company that pays a low dividend can contribute stock to a CRUT and get a big stream of income during retirement years when the stock can pay larger dividends.
CRATS and CRUTS are commonly used as a tool of estate planning lawyers. A CRAT would be preferred by an owner who desires the certainty of fixed income, even in a declining business environment. A CRUT appeals to an owner willing to risk irregular income for the opportunity to receive higher income payments in the future. A CRUT is used as a hedge against inflation. With either of these methods, instead of giving the donation directly to the charity, the owner places the donated assets within an irrevocable trust, that names the charity as the ultimate beneficiary. The trust is dissolved at the end of the prescribed time period, and the charity receives all of the assets remaining. The big advantage to either form of charitable remainder trust is the ability to remove assets from the owner’s estate and consequently reduce the owner’s estate tax liability.
Outright sale. This exit alternative allows for the owner’s goals, objectives, and timetable to be met. By proper positioning, the owner can create an attractive acquisition candidate. It is best to use a Certified Business Intermediary (CBI) to identify the potential buyers, prepare a marketing plan, and develop a comprehensive Descriptive Offering Report. See the International Business Brokers Association (IBBA) website at HYPERLINK “http://www.IBBA.org” www.IBBA.org for a list of CBI’s in your area. A valuation of the company should be prepared. The best way to realize the net worth of a company is to use the sale for retirement planning purposes.
Buyers can be either strategic or financial. A strategic buyer is usually in the industry in some fashion. The acquisition may give the buyer either vertical or horizontal integration synergies. The interest of a financial buyer is driven by the balance sheet while the interest of a strategic buyer is usually driven by pro formas.
A common financial buyer is a Private Equity Group (PEG) – aka Private Investment Group. A PEG raises a fund for acquiring mid market companies. Most plan to “flip” the acquired companies in three to five years at a fine return for their high net worth investors in the fund. They frequently use a mix of consideration of cash, seller financing, employment contract, covenant to not compete, and earn out. Seller financing is where the previous owner takes a note secured by assets of the newco. An earn out is a type of consideration whereby the previous owner takes some risk that the newco will be able to deliver the EBITDA, and if it does he gets a percentage of the “earn out”. It can be indexed or “all or nothing”. The earnout is usually laddered with a term of three to five years. An earnout is a good vehicle to bridge a gap in value between the buyer and seller. PEGs have been stockpiling cash since the dot-com implosion, not so affectionately called the “dot bomb”. There is as much as $88 billion now in capital available ready to be invested today. “They’ve raised $50 billion this year, more than the $42 billion raised in all of 2004, said Danielle Fugazy, editor of Buyouts, a Thomson Financial Research publishing report.
The fact is that every business owner will exit their company, one way or another. It is best to do a transfer with an exit plan, considering the timing, and with a market valuation. For an owner to evaluate the various exit alternatives, it is advisable to use a Certified Business Intermediary (CBI) to recommend and implement a specific strategy. Why? Their background, training, and education is quite a valuable asset in this process.
EBITDA is a self-defined expression of cash flow. EBITDA = Earnings Before Interest Tax Depreciation and Amortization. Thomson Financial Securities Data Corp. in The Deal, February 13, 2005, for transactions between $25 million and $200 million. International Business Brokers Association (IBBA) Newsletter of March 5, 2005. “Information Week”, January 10, 2005, article titled “IPO’s Are Back”. “Investors Business Daily”, January 10, 2005, p.A20 “Back in Business”. “Investors Business Daily”, May 6, 2005, p. A1 titled “Private Equity Firms Bigger and Bolder, Make Fat Profits”.