In football, the “Red Zone” is the territory inside the 20-yard line. There, a long drive is challenged by the opponent whose back is to the wall. The closer you get, the greater the risk. Business owners know that feeling well after many years of building their companies. The closer they get to the goal line, the more concentrated the risk becomes, in the form of competitive pressures, management defections and referees whose uniforms say “IRS.” Below are concrete financial strategies that can help take the risk out of these plays.
Threat: Imperfect Timing
If you are contemplating selling your business and sailing off into the sunset, you are no longer a business owner—you are a market timer. This is not necessarily a bad decision, but when your time horizon is short, it’s a risky one.
Business valuations fluctuate through cycles. 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 undervalues your business.
Defense: Partial Sale
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 value when you are finally ready to exit for good.
• 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 equity. If you wish to continue to control the business, you would only sell a minority stake. This 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, but you can also 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, eliminating the need for the owner’s personal guarantee on debt or avoiding 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 also a value drain.
Defense: Make Your Leaders Owners
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.
• Leveraged ESOP. An employee stock ownership plan (ESOP) will tie employees of your choosing to your business with ownership, where they can continue to help you grow and will represent a stable transition to a future buyer.
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, but also represents an alternative to the partial recap as a way to 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 to 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 company owner 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 he/she 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.
Threat: Sale Without Proper Wealth Structuring
It is arguable that more wealth is forfeited due to the failure to do pre-sale wealth structuring, aka estate planning, than from any other source. In our environment of high income and estate taxes, this oversight is tantamount to leaving money on the table.
Defense: Pre-Liquidity Planning
While this is the greatest threat to the wealth you have accumulated in your business, it is also the most predictable and manageable. There is an old adage: “The estate tax is a voluntary tax; you can either pay it, or plan around it.”
This process called pre-liquidity planning is a comprehensive financial planning exercise that should begin five years before an anticipated sale. It includes lifestyle planning, cash flow forecasting, philanthropic planning, and income and estate tax planning. The latter focuses on the establishment of trusts that will protect your wealth from unnecessary taxation while providing for the desired income and wealth accumulation needs of your family.
Business owners who find themselves walking the halls of M&A firms will inevitably overhear the horror stories of those who forfeited 10%, 20%, even 30% of the value of their liquidity events, simply because of a failure to take these steps soon enough. 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 advisors now.
The football season is upon us. The good professional teams score two thirds of the time when in the Red Zone. Make sure you are one of them.