The Red Zone
How entrepreneurs contemplating their exits can
reduce the risks of bad timing and just plain bad luck.
Baby Boomers built businesses in record numbers, and likewise are now preparing to enjoy record numbers of exits. In fact, many studies indicate that 50% or more of all closely held U.S. businesses will undergo some form of ownership transition in the next five-to-seven years.
Ironically, just as the end zone comes into sight for these entrepreneurs, so, too, do new threats to the value of their businesses. While these threats can do more financial damage than the most troublesome competitor, they are as easy to see coming as a middle linebacker. Here, we will give you a playbook.
If you are contemplating selling your business and sailing off into the sunset, you are no longer an entrepreneur - you are a market timer. This is not necessarily a bad thing, but when your time horizon is short, it’s a risky one.
THREAT: Imperfect Timing
As the chart below illustrates, business valuations fluctuate through cycles. Within any given industry those valuations may fluctuate much more dramatically. If your timing isn’t right, you may wind up working longer than you wished, with your net worth overly concentrated in one industry, as you wait for valuations to recover. Or you may decide to sell anyway, taking a disappointing multiple from a market that temporarily values your business less than you do.
If your full exit is still a few years (or more) away, you can mitigate the risk of selling into or waiting out a weak valuation cycle by selling a portion of your company when valuations are favorable. This is particularly appealing to owners who wouldn’t mind realizing some liquidity sooner rather than later, and who occasionally lose sleep over the excessive concentration of their wealth. Such a sale need not – indeed should not – affect your control over your business, and can even add significantly to the business’ value when you are finally ready to exit for good.
DEFENSE: Partial Sale
Partial Recap Short for partial recapitalization, a partial recap is a transaction in which a financial partner (typically a private equity firm) buys a stake in your business, and you retain the remaining portion of the equity. If you wish to continue to control the business, you would sell only a minority stake. This then sets the stage for a subsequent liquidity event (a “second bite at the apple”), typically four-to-seven years later, when you sell the remainder to the equity sponsor, or together with the equity sponsor sell to a new buyer. This structure not only lets you create liquidity and diversification when you believe the market is strong, you can continue to take a salary from the business and defer capital gains taxes. Moreover, your new financial partner will typically want you to retain your management team. You represent, literally, skin in the game - often an important part of the investment strategy for these buyers.
Recaps can also be used to generate capital to invest back into the business and fund the next wave of growth, to eliminate the need for the owner’s personal guarantee on debt, or to avoid the financial stress of buying out a retiring shareholder.
THREAT: Key Leaders Leave Sometimes the writing is on the wall, and sometimes the people reading it get nervous. The departure of key players in your business during the handful of years before you intend to exit can mean not only a brain drain, but a value drain.
Your best employees could leave for what they perceive to be a more stable future, or worse, form a competitor to your company - particularly if you find yourself in a business segment with low barriers to entry. Losing them will make your business less attractive to potential financial buyers (the kind you will court if you contemplate a full or partial recapitalization). An employee stock ownership plan (ESOP) will tie those you choose to your business with ownership, where they can continue to help you grow and will represent a stable transition to a future buyer.
DEFENSE: Make Your Leaders Owners
An ESOP can be unleveraged (the company contributes shares of its own stock, or cash to buy shares) or leveraged. In a leveraged ESOP, the company borrows money to buy shares, which are placed in trust to be granted to key employees, subject to a vesting schedule.
As the owner, the sale of those shares represents a liquidity event for you, ideally during a period of favorable valuations, potentially with capital gains taxes deferred indefinitely. The proceeds can be used to diversify your wealth or reinvest in the business. In these ways it not only helps keep key employees in place, it represents an alternative to the partial recap as a way mitigate the risk of hitting a trough in the valuation cycle when you are finally ready to retire.
Grants – Shares, Options, and Phantom Equity
If your goal is to retain key people in order protect the value of the business in the years leading up to a sale, but you are not looking to partially cash out yourself, you can consider equity grants, which come in a variety of flavors.
Shares can be issued outright or under a schedule, subject to time or performance requirements. Alternatively, stock options can be issued; these are particularly popular in high-growth industries in which an IPO is the intended exit strategy. Options will dilute-down existing shareholders but, unlike share grants, don’t come with an out-of-pocket cost to the business.
While shareholders have an incentive to stay and perform, they also have rights, and those rights can present risk to the entrepreneur and the value of the business. An alternative to these strategies – one that behaves like equity but carries none of its risks and less of its costs - is phantom equity.
Phantom equity confers the right to receive cash in the future, usually a share of the proceeds of the eventual sale of the business. It can be structured so that it matches what the employee would have received were they granted actual stock and, like other stock agreements, the agreement can stipulate forfeiture should the employee leave.
In addition to the above strategies, simple cash agreements, such as retention bonuses (which can be structured as a forgivable note), or “golden parachutes,” (which can guarantee generous compensation in the event a key employee is laid off by a future acquirer) are tools business owners commonly use to keep valuable people in their positions when a sale lies in the future.
Sometimes the departure of a key player is not a matter of choice. Even if everyone’s healthy, things can change overnight, and ill fortune tends to have a terrible sense of timing. Make sure you have a formal succession plan that has been communicated clearly with all of the affected parties. In addition, if you are in business with a partner or significant shareholder whose death or disability could put your ownership structure and control at risk, then you probably already have a buy-sell agreement. If you don’t, you should consider it an essential part of your exit planning process.
THREAT: Untimely Death of a Partner
A buy-sell agreement is like a will for your business. It stipulates who will buy out the interest of a partner or significant shareholder, and under what terms. The agreements are usually financed by an insurance policy, and because they pay out to the surviving partner, the funds can then be given to the beneficiaries of the deceased in a transaction that would not be subject to estate tax.
DEFENSE: Buy-Sell Agreement
It is arguable that more wealth is forfeited due to premature sale discussions than from all of the competitive threats, regulatory pressures, lawsuits, credit challenges and other risks facing American businesses. This is because at some point, an innocent exploratory discussion about a possible sale can become a negotiation. If tax-sensitive wealth transfer strategies are not in place at this stage or earlier, the proceeds from the eventual sale may be 100% unprotected and subject to the full impact of the U.S. tax code.
THREAT: Sale Negotiation Before Wealth Structuring
This, the greatest threat to the wealth you have earned in your business, is also the most predictable and manageable.
DEFENSE: Pre-Liquidity Planning
The process is often called pre-liquidity planning. It is a comprehensive financial planning exercise and should begin five years before an anticipated sale. It includes lifestyle planning and cash flow forecasting, philanthropic planning, estate planning, and the establishment of trusts that will protect your wealth from unnecessary taxation while providing the desired income and wealth transfer functionality.
Business owners who find themselves walking the halls of M&A firms and wealth advisors will inevitably overhear the horror stories of entrepreneurs who forfeited 10%, 20%, even 30% of the proceeds of their liquidity events, simply because their trusts were not implemented prior to negotiating terms of an eventual sale. The wealth preservation techniques available could fill a textbook and are beyond the scope of this article, but if you have not yet begun the process the most important strategy of all is to start the conversation with your advisor now.
While the challenges described above are nearly universal among business owners, others will only affect a minority of entrepreneurs, but nevertheless represent substantial financial risks that must be mitigated.
• Intellectual property not properly secured. A weak record defending I.P. can erode value for a buyer at exactly the wrong time. Audit your protections and firm up your track record of defending your rights.
• Natural and man-made disasters. Audit your insurance coverage to expose any gaps in coverage for employee suits, commercial and intellectual property disputes, and product liability.
If you are a business owner reading this, chances are you are actively planning an exit or expect to begin the process in the next few years. This puts you in the red zone.
While Fieldpoint Private believes that downside protection is an essential element of proper risk management for any investor, it is even more critical for business owners, whose assets are far more concentrated, and whose life’s work is literally at stake. The strategies described above are all potential tools for downside protection, but the essential first step is pre-liquidity planning. If you have not yet begun the process, we encourage you to reach out to your Fieldpoint Private advisor to discuss.