The 92% Opportunity: Exit Strategy You’ve Never Fully Considered
With the economic recovery in its sixth year and the stock market making repeated record highs, many middle market business owners who put off examining exit strategies in recent years are beginning to consider the topic again.
Our smart friends at MB Financial Bank in Chicago recently asked an even 100 owners and operators of businesses about their preferred exit strategy. And, after the 24% who said they plan to keep the operation within the family, the breakdown was roughly in line with feedback we get regularly in the marketplace:
–15% expect they’ll sell to private equity buyers.
–15% plan to sell to managers and/or partners already involved in the business.
–13% figure a strategic buyer, meaning a competitor, will buy their company.
–13% are mulling an IPO.
–12% are undecided.
–And 8% are thinking of selling to their employees, as in an Employee Stock Ownership Plan, or ESOP.
I have spent my professional life, more than 25 years, helping companies structure and execute ESOPs and you might think seeing my preferred ownership format come in dead last in this survey would be depressing. But it’s just the opposite: what the survey numbers suggest to me is, in encountering a business owner of a certain age and level of success, I have a 92% chance of speaking to someone who doesn’t yet fully know the remarkable value proposition represented by an ESOP.
Because rarely have I met a founder/entrepreneur/CEO who was not surprised – and suddenly interested – when the actual benefits of an ESOP were spelled out. That doesn’t mean every owner I talk to ends up doing an ESOP; employee ownership isn’t for every business, especially those with already high levels of debt and those with high levels of employee turnover. But I have found business owners universally appreciate the tax and operating benefits of an ESOP, and that such a discussion causes employee ownership as an option to move up among owners’ choices.
Skeptical? Let me summarize the benefits: Quite often a better after-tax price to the seller than private equity buyers can offer; Preservation of your business legacy and the jobs of employees who helped you build it, something a strategic buyer mightn’t offer; You can sell part of the company and remain in control, selling the remainder later; and dreaded earn-outs are not an issue.
Oh, and perhaps the biggest benefit of all: companies adopting an ESOP often find employees become more productive, offer up fabulous ideas formerly unshared, and that the workplace becomes freer of friction. In other words, everyone’s acting like an owner.
Let’s go through the four major claims I made about benefits to a seller in an ESOP transaction:
1. If your business is a C Corporation and you reinvest the proceeds from selling it in qualifying equities (yes, stocks), you can avoid capital gains taxes. Those can add up to about 23% of sale proceeds, more if you add state taxes, particularly in high tax states like California, so that’s a huge advantage. If your business is now, or becomes after the sale to an ESOP, an S Corporation, it pays no federal or state income taxes (ESOP participants pay taxes when they retire or otherwise withdraw funds). These significant tax benefits mean more cash flow to service debt and thus a potentially larger acquisition price.
2. A strategic buyer has every incentive to cut costs drastically in your operation. Maureen Beal, CEO of National Van Lines, had seen that happen plenty of times in the moving business. “What happens is the employees get hurt,” she says. Often, too, the company name disappears into a larger acquirer and the business legacy is gone. She and her brother sold to an ESOP and National remains a vibrant and independent business, with loyal long-tenured employees.
3. You don’t have to sell all at once. Many ESOPs start out as minority partners to founders. That lets the founder take some money off the table yet remain in charge and share in the upside of the business.
4. Earn-outs aren’t an issue with ESOPs, and that’s a big difference. SRS/Acquiom found that in 2013, earn-outs represented a stunning 40% of potential deal proceeds, up from 23% three years earlier, in typical middle market M&A transactions. Two-thirds of deals end up with a battle over escrowed funds, with buyers trying to withhold cash.
Many business owners sell a partial stake to an ESOP, stick around to run the business and remain controlling owners. With all that skin in the game, no need to use an earn-out. And when selling the entire company, it’s typical that the management team below the owner sticks around. They’re intimately familiar with the business and its prospects, likely have a higher level of trust in their soon-to-be former boss, and thus there’s far less call for an earn-out or other post-closing purchase price adjustments.
So, the next time you mull an exit strategy, include as an option an ESOP – if you want to maximize your return; keep intact the business you built and keep employed the workers who helped you build it; and avoid earn-out hassles in getting paid out.