In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss internal and external exit options for you and your family business and summarize the possible buyers for your family enterprise.
We regularly encounter family business owners contemplating the dilemma of ownership transition. After years (maybe even decades) of cultivating the business through hard work, determination, and perhaps a bit of luck, many families believe now is a sensible time to exit.
Tax changes are looming, pandemic and post-pandemic winners see solutions to a myriad of operational challenges, and valuations remain favorable in most industries. However, a seller’s timing, the readiness of the business, and the readiness of the marketplace may not be aligned without careful preparation and real-time market awareness from your family business board of directors. Families often fail to realize that their preparation, their tolerance for post-deal involvement, their health and ability to remain active, and their needs for liquidity will influence the breadth and priorities of their options and will influence who the potential buyers might be and how they might target the business. Proactivity (or backfilling for the lack thereof) will also influence the design and costs of the process for effective representation.
Under ideal circumstances, your family will begin planning for ownership transition well before the need for an actual ownership transfer arises. One of the first steps in planning for an eventual exit is to understand who the potential buyers might be and the different characteristics of these buyers. In this article, we discuss some exit options and summarize some of the specifics of certain types of buyers and what that could mean for transaction structure and economic outcomes.
Internal Ownership Transition
Potential buyers in an internal transition generally include the next generation of the owner’s family or key employees of the company (or a mix thereof). When done carefully, an internal transition can be desirable in order to protect both the existing employees and the culture of the business. These transactions generally occur two ways: through a direct sale from the exiting owner to the next generation or through the establishment of an Employee Stock Ownership Plan (ESOP). While these transactions may not yield the pricing or turnkey liquidity that selling to an outside buyer might, they can provide comfort to the current generation of family owners regarding their legacy and the continuing prospects of the business as an independent going concern.
Sale or Transfer to Next Generation
For many family businesses, transitioning ownership and leadership to the next generation of family members is the primary exit consideration. For other families, a sale to the non-family management team makes more sense. In either event, the value of the shares being transferred is critical.
Whether transferring ownership to the next generation of family members or to the non-family management team, the value of the shares being transferred is critical
For sale transactions, the question of how the transaction will be financed is equally important. Internal transactions are often achieved by share redemptions in installments and/or through a leveraged buyout process. Often, the seller will provide financing using one of many potential structures. Seller financing carries the risk of the buyer’s inability to pay, which often requires the seller to reinsert themselves into active leadership. Many may view seller financing as desirable in order to control the terms and costs of the arrangements and to benefit from the interest and other terms of the financing.
As noted, a seller’s liquidity requirements and the underlying fundamental borrowing capacity of the business play a big part in determining how much third party capital can be employed. Many sellers want their buyers, family or otherwise, to have real skin in the game by way of at least partial external financing.
If the next generation of family members and/or employees are not well situated to achieve a buyout as a concentrated ownership group, then the feasibility of a more formal collective buyer group may be a good alternative. The following is a brief overview of Employee Stock Ownership Plans, which can serve as an alternative to a concentrated internal transition.
Establishing an Employee Stock Ownership Plan
“ESOPs” are a proven vehicle of ownership transfer. They can provide for either an incremental or a turnkey ownership transfer. They also facilitate the opportunity for legacy owners to continue contributing to the stability and success of the business while allowing employees to reap the rewards and benefits of capital ownership. Assessing the feasibility of an ESOP requires the advisory support of experienced financial and legal professionals who help ensure best practices are implemented and compliance awareness governs the transaction. To that end, family businesses contemplating an ESOP need to be keenly aware of the importance of following a well designed process that satisfies the requirements of the Department of Labor and adheres to governing rules and regulations.
As a qualified retirement plan subject to regulations set forth by ERISA, ESOPs are regulated using strict guidelines for process, fairness, and administration. Accordingly, the entire life cycle of a contemplated ESOP needs to be studied in a process generally referred to as an ESOP Feasibility Study. Valuation, financing, plan design, plan administration, future repurchase obligations, and many other concerns must be assessed before venturing down the ESOP path.
Establishing an ESOP includes creating an ESOP trust, which, using one of many possible transaction structures, becomes the ultimate owner of some or all the stock of the sponsoring ESOP company. ESOPs are unique in being the only qualified retirement plans allowed to use debt to purchase the shares of the employer corporation. Once an ESOP is in place, the qualifying employee participants are allocated interests in the trust annually according to the Plan’s design. As employees cycle through their employment tenure, they trigger milestone events that allow for the effective sale of their accumulated ownership positions, providing a nest egg for retirement. During their tenure of employment, the employee’s account is mostly concentrated in company stock, the valuation of which determines the amount they receive when nearing and eventually reaching retirement age. The stock accumulated during active employment is converted to cash and the Plan shares are either redeemed or recycled to perpetuate the ESOP.
There are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different ways
There are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different ways. Sellers in ESOP installations must understand the necessary complexities and nuances of a well-run ESOP transaction. Sellers lacking the patience and gumption for an ESOP process or those who require turnkey liquidity in their ownership exit should consider an alternative liquidity strategy.
In general, the ability to sell your family business to an external party yields the highest proceeds. If you have succeeded in creating a sustainable business model with favorable prospects for growth, your business assets may generate interest from both strategic and financial buyers, the pros and cons of which are listed in the following sections.
A strategic buyer is usually a complementary or competitive industry player within your markets or looking to enter your markets. These buyers can be generally characterized as either vertical or horizontal in nature. Such buyers are interested in the natural economies of scale that result from expanded market area and/or from specific synergies that create the opportunity for market and financial accretion (think 1 + 1 = 3).
There is a good chance that a potential strategic buyer for your family business is someone or some group you already know. Such buyers don’t require the full ground-up familiarization process because they are already in tune with the risk and growth profiles of the business model. Accordingly, owners interested in a turnkey, walk-away sale of their business are often compelled toward a strategic buyer since strategic buyers can quickly integrate the family’s business into their own.
The moving parts of transaction consideration paid by strategic buyers can cover a broad spectrum. We see simple nearly 100% cash deals as well as deals that include various forms of contingent consideration and employment/non-compete agreements.
There is a good chance that a potential strategic buyer for your family business is someone or some group you already know
Many family owners in strategic deals are not inclined to work for their buyers other than in a purely consultative role that helps deliver the full tangible and intangible value the buyer is paying for. In many cases strategic buyers want a clean and relatively abrupt break from prior ownership in order to hasten the integration processes and cultural shift that come with a change in control. Further, strategic deals may include highly tailored earn-outs that are designed with hurdles based on industry-specific metrics. In general, earn-outs are often designed to close gaps in the bid/ask spread that occur in the negotiation process. These features allow sellers more consideration if post-transaction performance meets or beats the defined hurdles and vis-a-versa. Family business owners must be aware of the sophisticated means by which larger strategic buyers can creatively engineer the outcomes of contingent consideration.
In certain industries, strategic buyers may structure consideration as part cash and part or all stock. Sellers in the financials sector are often selling equity ownership as opposed to the asset sales that dominate most non-financial sectors. In such deals, sellers who take equity in the merged entity must be cognizant of their own valuation and that of the buyer. The science of the exchange rate and the post-closing true ups that may apply are areas in which family business owners should seek proper professional advisory guidance outside their family boards and advisors.
Financial buyers are primarily interested in the returns achieved from their investment activities. These returns are achieved by the conventions of 1) traditional opportunistic investment and 2) by means of sophisticated front end and back end financial engineering with respect to the original financing and the subsequent re-financings that often occur.
Most traditional buy-out financial investors are looking to satisfy the specific investment criterion on behalf of their underlying fund investors, who have signed on for a targeted duration of investment that by nature requires the financial investor to achieve a secondary exit of the business within three to seven years after acquisition (the house flipping analogy is a clear but oversimplified one). Financial investors may have significant expertise acquiring companies in certain industries or may act as generalists willing to acquire different types of businesses across different industries.
In general, there are three types of financial buyers:
- Private Equity Groups or other Alternative Financial Investors,
- Permanent Capital Providers, and
- Single/Multi-Family Offices
Despite their financial expertise, financial buyers usually do not typically have the capacity or knowledge to assume the management of the day-to-day operations of all of their investments. As such, the family’s management team at the time of a sale will likely remain involved with the Company for the foreseeable future. A sale to a financial investor can be a viable solution for ownership groups in which one owner wants to cash out and completely exit the business while other owners remain involved (rollover) with the business.
A sale to a financial investor can be a viable solution in situations where one owner wants to cash out and completely exit the business while other owners remain involved with the business
With respect to work force and employee stability, financial investors will ultimately seek maximum efficiency, but they often begin the process of making sure they secure the services of both frontline and managerial employees. In many cases, the desired growth of such investors can bolster the employment security of good employees while screening out those that resist change and impede progress.
The value of the assembled workforce is becoming a more meaningful asset to prospective buyers in the marketplace, whether they be strategic and financial in nature. Further, larger acquirers often can present employees with a more comprehensive benefit package and enhanced upward mobility in job responsibility and compensation. All this said, financial investors will ultimately seek to optimize their returns with relentless efficiency.
Lastly, as the financial buyer universe has matured over the past 20+ years, we have witnessed directly that many strategic consolidators are platform businesses with private equity sponsorship, which blurs or even eliminates the notion of a strictly strategic or financial buyer in many industries.
An outside buyer might approach your family business with an offer that you were not expecting, you and your family might decide to put the business on the market and seek offers, or your family might opt to sell to the next generation of the family in an internal sale. Whatever the case may be, most owners only get to sell their business once, so you need to be sure you have experienced, trustworthy advisors in your corner.
Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.
Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor to inform sellers about their options and to encourage market-based decision making that aligns with the personal priorities of each client.
Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help you and your family manage the transaction process.