Equity Monetization Planning
Several Ways to Monetize Your Equity
Most owners look forward to the day when they can monetize some or all of their business. Many have not, however, thought much beyond the dollar signs to the actual process or mechanics by which the pay out can be achieved. When asked, their answer is often “I will just sell the business.” And while selling the business may be the right choice in some instances, possible other options are worth considering as well.
The best way to begin is to consider a few clarifying questions. Your answers to these questions may help to identify the liquidity options most appropriate for your particular situation. For example:
- Is your business mature or still growing rapidly?
- Is your industry consolidating, stable or declining?
- Does the business generate excess cash or require continual investments?
- How long do you wish to continue working?
- Is successor management in place or a consideration?
- Are there logical buyers or investors?
- Do you want cash now or over a period of time?
- Do you wish to retain an equity upside?
- Do you have other business opportunities with greater potential?
- Are there other personal, family or health issues?
If you are considering a transaction which uses a currency other than cash, the transaction really becomes an investment decision. This will require you to think carefully about the pros and cons of accepting that particular currency before you proceed.
Depending on your answers to these preliminary questions and your interest in the available currencies, here are several ways you can monetize your founder’s equity.
Sometimes a business has excess capital but not much cash. In these circumstances, a recapitalization or “recap” may be the best way to free up capital in the form of cash. A recap can be as simple as borrowing money to finance a dividend or stock buyback or involve a formal recap through the sale of a majority or large minority equity interest to private equity or other external investors.
An informal recap requires a strong balance sheet because commercial banks, the typical lenders to small and medium-sized companies, are seldom keen on lending you money to put in your pocket. On the other hand, if the business holds a valuable asset such as appreciated real estate which is not essential to the business, taking out a real estate mortgage to finance the distribution may make sense.
A formal recap involving outside investors may allow for a larger cash distribution because the new investor will bring new equity capital to the business as well as its own lenders who are typically more accustomed to lending into high-leverage situations.
This can be an excellent path in two particular situations:
- You want to take some money out of consideration now, but continue to work for a larger payout in the future.
- Today’s outright sale value is not enough to meet your needs or desires, and the infusion of external cash and other resources will help you reach the larger value later.
If you consider this option, you will now have a partner in the business to whom you will owe performance accountability. Most private equity investors will expect a final sale in the ranges of 5 to 7 years, although some private equity investors are long term holders. Either way, be sure you are comfortable with the notion of having a partner, as well as the particular partner, before committing to this option.
Paying a Dividend
If your business generates excess cash on a regular basis or has accumulated excess capital over time, consider distributing it in the form of bonuses or dividends. There are numerous tax issues here relating to the legal form of your business, reasonable compensation guidelines and the effects of federal and state taxes which should be carefully analyzed before proceeding.
On the other hand, the current 20% federal income tax rate on qualifying dividends is probably the lowest rate you will ever see. If a dividend distribution makes economic sense, don’t let the tax tail wag the business dog.
Sponsoring a Management Buyout
A management buyout or “MBO” is a common technique for monetizing founder equity in small and mid-sized closely-held companies. Necessary elements include capable and established non-owner senior managers who can take over management of the business; business capacity to take on and service major new debt; and senior managers prepared to borrow money against personal assets to supply equity to the business and/or personally guarantee the new business debt required to buy out the current owner(s). The selling owner may also be required to take back some seller paper to make the MBO numbers feasible.
MBOs can provide an excellent vehicle to put ownership rights in the hands of loyal and trusted managers and employees while protecting their jobs and livelihoods. Depending how many employees are to be included in the new ownership group, an employee stock ownership plan or “ESOP” may be an efficient vehicle for shifting ownership to employees. However, ESOPs are very complex and require significant legal, tax and financial advice to ensure that they are created and operated properly.
Hiring & Retiring or just Retiring
Some businesses are sufficiently established and well managed that a founder/owner can simply retire from active management while continuing to draw a salary, receive dividends or establish some other form of compensatory consulting arrangement. If the business has strong middle managers but lacks a clear CEO candidate, the solution may be to hire a new CEO and then provide for an orderly management transition.
Under these scenarios, the founder/owner may retain final decision-making authority for certain strategic decisions, while effectively delegating all operating decisions to one or more trusted senior managers. Although the retirement option does not solve the long-term ownership or estate planning issues, it may provide an appropriate next step for some founder/owners who wish to pursue other activities and do not need to liquidate all of their equity at once.
Taking the Company Public
For some companies, an initial public offering or “IPO” may be the preferred way to founder equity monetization. An IPO can generate some founder liquidity quickly and create a market for future stock sales, while leaving the founder in control of the business. But there are many downsides.
Not everyone has access to the public market. There are many limitations to access based on the type and size of business, expected future revenue and earnings growth rates, and “market conditions.” Market conditions include investor appetite for IPOs as well as the general stability and positive outlook of the public equity markets. In addition, the Sarbanes-Oxley era has placed many new corporate governance, reporting, and regulatory burdens on public companies. These requirements can be especially taxing for young or smaller public companies.
For many small or medium-sized businesses, their most valuable asset may be the real estate on which the business operates. And if the business itself is marginally profitable, profits may barely cover the owner’s salary. In such a case, closing the business and selling the real estate may be the best option for monetizing the owner’s equity value.
For other historically profitable businesses which have now fallen on hard times, liquidation may also be preferable to having the owner’s remaining equity value consumed by the operating losses of a declining business. Despite the negative effects of liquidating a business on the employees and other stakeholders, an orderly liquidation now will likely preserve more value than a fire sale under duress later.
And finally, there is the out right sale. For many owner/CEOs, selling the business will be the most direct path to equity monetization. Common types of acquirers include strategic buyers, financial buyers, or new operators.
Strategic buyers include competitors in consolidating or contracting industries or owners of businesses in adjacent spaces who see an opportunity to grow their business by moving into your space. Sometimes, strategic buyers are often willing to pay more for the business, if they believe that cost savings or other synergies can be obtained through the combination.
Financial buyers include private equity firms and other external investors. Financial buyers are typically more interested in established businesses with strong cash flows and little or no debt currently. They will expect to acquire control, if not 100% ownership, and use large amounts of debt to fund their purchase. Financial buyer timeframes are often short and they may subject the business to intensive restructuring, including employee layoffs, in order to achieve their target financial returns.
For many smaller businesses with no internal management successor, selling to a new operator/owner may be an effective vehicle. These types of transactions frequently require the owner to accept a large amount of the sales price in seller paper even if the new operator has significant cash available to contribute to the deal. And selling to someone who has management experience in your particular industry is preferable to selling to a new operator without such experience, especially if you must accept seller notes.
These suggestions for monetizing your equity, with some thoughtful consideration of the techniques detailed above could improve the probability of successfully monetizing your founder’s equity at some time in the future.
Disclaimer – The material presented is intended solely for informational purposes and does not constitute accounting, tax, investment banking or other professional advice. Please seek appropriate professional advice before acting upon any information presented.
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