7 Ways to Monetize Your Equity
Most owner/CEOs look forward to the day when they can cash
in some or all of their business “chips.” Many have not, however, thought much
beyond the dollar signs to the process or mechanics by which the pay out can be
achieved. When asked, their answer is often “I guess I will just sell the
business.” And while selling the business may be the right choice (more on that
later), some other options are worthy of consideration as well.
But first, let’s consider a few preliminary questions. Your responses
to these and similar questions may help to clarify the liquidity options most appropriate
for your particular situation.[1]
For example:
- Is your business mature or still growing rapidly?
- Is your industry stable, consolidating or declining?
- Does the business generate excess cash or require continual
investments?
- Do you wish to continue working?
- Is successor management in place or available?
- Are there logical buyers or investors?
- Do you want cash now or over 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?
- Will you accept only Cash[2]
or will you consider an Earnout,[3] Seller
Notes,[4]
If you are considering a transaction which involves a
currency other than cash, the transaction really becomes an investment decision
requiring that you think carefully about the pros and cons of accepting that
particular currency before you proceed.
Depending on your answers to the preliminary questions and
your appetite for the available currencies, here are 7 ways to monetize your
founder’s equity.
1. Pay 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 state taxes which should be carefully analyzed before proceeding.
On the other hand, the current 15% 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.
2. Recapitalize
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 off the table now but continue
to work for a larger payout down the road, or
- Today’s outright sale value is insufficient to meet your
needs or desires, and the infusion of external cash and other resources will
help you generate the larger value later.
But now you have a partner in the business to whom you will
owe performance accountability. Most private equity investors will expect a
final sale transaction within 5 to 7 years, although some private equity
investors are long term holders. Either way, you should be sure you are
comfortable with the notion of having a partner, as well as the particular
partner, before committing to a formal recap.
3. Go Public
For some companies, an initial public offering or “IPO” may
be the preferred route to founder equity monetization. An IPO can generate some
founder liquidity immediately and create a market for future stock sales, while
leaving the founder in control of the business. Being the CEO of a newly public
company can produce significant psychic income while also putting money in your
pocket. But there are many downsides.
The public markets are not available to everyone. 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 optimism 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 onerous for young or
smaller public companies.
4. Sponsor a
Management Buyout
A management buyout or “MBO”
is a common method for monetizing founder equity in small and mid-sized
closely-held companies. Essential ingredients include capable and established
non-owner senior managers who can take over management of the business;
business capacity to take on and service significant new debt; and senior
managers willing to borrow money against personal assets to contribute 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 need to take back some
seller paper to make the MBO numbers work.
MBOs can provide an excellent vehicle to put ownership in
the hands of loyal and trusted managers and employees while protecting their
jobs and livelihoods. Depending on the number of employees to be included in
the new ownership group, an employee stock ownership plan or “ESOP” may be an
efficient vehicle for transferring ownership to employees. ESOPs, however, are
very complex and require significant legal, tax and financial advice to ensure
that they are created and operated properly.
5. Hire & Retire
or just Retire
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.
6. Liquidate
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.
7. Sell Out
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 expand their business
by moving into your space. 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 solid 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 without successor management
internally, 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 industry
is preferable to selling to a new operator without such experience, especially
if you must accept seller notes.
*****
While there are numerous variations on these 7 ways for
monetizing your equity, some thoughtful consideration of these techniques
undertaken today could well improve the probability of successfully monetizing your
founder’s equity at some time in the future.
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Wayne Wilson is the Principal of Wayne Wilson & Company, a business advisory services firm providing executive coaching and advisory services on growth-related issues to owner/CEOs of middle market companies. For more information, visit www.waynewilson.com.
Notes
[1] Disclaimer – The material presented in
this article 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 in this article.
[2] Cash is always my first choice recommendation: certainty
of value with little or no future performance risk. If your goal is to leave
the business behind completely, and the valuation is acceptable, cash is
usually the best currency.
[3] An earnout
may provide the opportunity for greater total cash over the near term
(typically, 6 months to 5 years) based on the future performance of the
business, but it usually requires the owner to stay and make it happen. If you
wish to continue working, the all-cash valuation does not meet your target, or
you are selling for other reasons (such as the need for additional capital in
the business), an earnout can be a very profitable way to monetize your equity.
[4] “Seller notes,”
or “seller paper,” refers to purchase
money debt issued by the new owner or the acquired business as part of the
purchase price. Seller notes may take the form of term notes payable in annual,
quarterly or monthly installments of principal and interest or balloon notes
payable in a lump sum several years out (typically, 5 years). The notes may be
secured or unsecured and are typically subordinated to any new or existing bank
loans. While seller notes often carry above market interest rates, repayment will
be heavily dependent on the continued health of the business as well as the
management competence of the new owner(s).
[5] A selling owner may also receive stock for the sale of the business. If the buyer is a public
company, taking stock may allow diversification of your investment, deferral of
some or all of the capital gains taxes which might otherwise result from a
sale, and a public market for the gradual or eventual sale of the shares.
Holding the buyer’s stock provides a continuing upside opportunity but also
subjects your proceeds to the risk of a performance decline by the buyer. If
the buyer is a financial buyer, the stock you receive or retain may be stock in
your own company or a “newco” formed to acquire the business. While the value
of such stock may be more under your control if you are the continuing manager,
there will generally be no market liquidity until a future sale or public
offering of the business.
Copyright © 2007 Wayne Wilson & Company. All Rights Reserved.
