Death, it sometimes seems, may be the easiest way out of a family business. With proper attention to insurance, succession, and estate planning, those who leave this vale of tears can also depart from their family firm with limited impact on the business. Other exits are often decidedly more traumatic for the businesses and the individuals involved.
Nonetheless, many family business owners have to realize there inevitably will come a time when some shareholders decide they want to do something else with their time and money. They may want to convert their investment into assets that are more liquid in order to meet other personal or business needs; they may want to diversify their assets to avoid relying too heavily on the company; or they may find themselves tired of the business — or (perish the thought) their relatives.
When a shareholder in a family business wants liquidity, “Rarely do these things end up with as much sweetness and light as when they start,” says Milton H. Stern, a partner in the New Jersey law firm of Hannoch Weisman and author of Inside the Family Held Business. Agreeing on a price is difficult when a company is privately held — and when the buyers and sellers are all related. And the company may have difficulty raising the cash to pay off the departing owners. Thus, when shareholders demand to be bought out, the fraying of nerves and the strain on liquidity can be substantial.
Once there seemed to be few alternatives. Remaining shareholders had to dig deep into their own pockets or into the corporate coffers for the cash to buy out those seeking liquidity, sometimes leaving themselves or the company burdened with debt. Or, if the pockets were not deep enough, the contented shareholders reluctantly had to join the footloose ones in selling the company.
One legacy of the financial engineering that Wall Street pursued in the eighties is a much wider array of alternatives for family businesses seeking to provide liquidity for some shareholders without undermining the company.
Dropping out of the picture but not off the company’s payroll
When a shareholder active in the business wants out, says Ronald H. Drucker, a partner in the accounting firm of Drucker and Scaccetti P.C., in Philadelphia, saying goodbye “doesn’t have to take the form of a sale of stock.” If the shareholder wants to ensure his or her financial stability but doesn’t need a pile of cash to reinvest right away, Drucker says, it may be possible to smooth the exit with continuing compensation.
Two devices are frequently employed: One is a consulting contract in which the departing shareholder is paid to remain available for consulting, whether or not the shareholder is actually called on to do anything. The other is a noncompete agreement in which the shareholder is obligated not to compete with the company in return for compensation. Both are valuable to the company if the shareholder-cum-employee is knowledgeable and experienced. But both also provide a handy way of transferring funds to shareholders with tax-deductible payments from the business.
Enabling an owner-employee to leave the firm and continue to receive medical benefits paid for by the employer is also an important option. Medical insurance coverage is not only less expensive, but usually more comprehensive under a company plan than it is when bought by an individual. “This can be important to many individuals,” Drucker notes.
Establishing a clearinghouse for buy-and-sell information
Another way to head off the problem of shareholders who want to sell a big block of stock all at once is to enable them to sell smaller blocks anytime they want. That can be facilitated through a clearinghouse, in which the company collects and distributes information regarding the interest of family members in buying or selling shares.
A clearinghouse isn’t needed for a company owned by a handful of family members all living in the same area. It only becomes necessary when shareholders have multiplied. For example, as ownership in a New Jersey manufacturing firm spread to several dozen cousins coast to coast, they agreed to notify the corporate secretary of any interest in buying or selling company stock.
“For regulatory reasons, the company must carefully avoid any appearance of dealing in the stock,” an investment banker notes. Thus, once the clearinghouse makes the would-be buyers and sellers aware of each other, it must step aside and let them negotiate their own transactions.
The problem with clearinghouses is that parties may not agree on a price, or there may be an imbalance of buyers or sellers. As a result, some companies become more involved in making a family market for their shares. They may become buyers of last resort: If someone wants to sell and no other family members step up, the company itself may buy the shares and retire them or turn them into treasury stock.
One way to institutionalize this process is to create an annual stock repurchase program in which money from operations is set aside to purchase a fixed number of shares once a year. If additional shares are offered, they can be purchased on a pro rata basis. Whatever the mechanism, the point is to enable family shareholders to raise cash whenever they need some. And helping them meet smaller liquidity needs may keep them from developing big needs.
Selling assets that aren’t critical to the company’s operations
Many companies can raise money by selling or spinning off small parts of their operations. They identify parts of the business that are peripheral to the main activity, split them of into separate entities, and sell them to generate cash for selling shareholders.
Retailing companies offer a clear way to do it. If a company has, say, eight stores, it could transfer ownership of one store to the shareholder seeking liquidity, and the shareholder could then sell the store and cash out.
Often this strategy works even for companies that may not appear to be divisible. Milton Stern notes that he helped restructure a company so that the business was placed in the hands of continuing shareholders, while real estate once owned by the business was given to those who wanted to get out. They could then sell the real estate, which housed some of the company’s operations, with provisos that enabled the company to keep using the sites.
Tax considerations are important in structuring these transactions. Francois de Visscher, the head of de Visscher & Co., a financial advising firm in Stamford, Connecticut, cites the case of a manufacturing company in which a subsidiary was spun off into a trust for the shareholders who wanted to sell their stock. Those shareholders, in essence, exchanged their stock for the stock of the subsidiary. “Then,” he says, “we went ahead and sold that subsidiary and had the proceeds go directly into the trust for the benefit of the selling shareholders.” He says the trust made it possible to avoid double taxation at the corporate level; since the proceeds from the sale went to the trust rather than directly to the shareholders, taxes weren’t incurred by both the company and the shareholders.
Selling a stake through convertible preferred stock
While many families frown on the idea of selling shares to outsiders, a public sale of stock need not mean the beginning of the end of family control. Thus, notes Thomas S. Shattan, managing director in charge of private equity financing at Kidder, Peabody & Co. Inc., a company should explore private equity financing — generally in the form of convertible preferred stock or common stock — with institutions or individual investors to provide the equity to buy out some of the family members.
Convertible preferred is nonvoting stock that pays a higher dividend than common stock and is convertible to common at a predetermined price. Many companies find it advantageous to use convertible preferred as a financing vehicle because it adds to the company’s equity base rather than piling on more debt, yet it doesn’t initially add any voting shareholders.
Shattan warns that outside investors don’t want to feel they’re being asked to acquire the interests of family members who are bailing out of troubled companies.”The key factor” in attracting new investors, he says, is “if it’s an exciting, interesting company with some strong prospects for some growth.”
In fact, Shattan adds, “Often investors like to do these kinds of financing in conjunction with new money being raised to grow the company. Investors like to see that their money is going not only to provide liquidity to shareholders but also to grow the business.”
Public equity financing is another option, but companies should generally have at least $20 million in sales and strong growth potential before entering that playing field.
Teaming up with a strong partner on the outside
Like selling equity to outsiders, any talk of joint ventures may seem to violate the objective of keeping the company in the family. But there are situations in which this may not be the case.
One is an industrial joint venture with a foreign company. With a change in corporate structure, a family business becomes a holding company that owns the operating company. The family then sells a minority interest in the operating company to a foreign firm, with the cash generated by the sale used to buy out shareholders without saddling the operating company with debt.
Ideally, the new foreign partner in the operating company won’t want to be an active manager. That’s all very nice as long as the silent partner remains silent. But foreigners are increasingly involved as active players in the U.S. market and few remain content to invest in a company solely for a bird’s-eye view of America.
A safer bet is a financial joint venture, which de Visscher describes as “a fairly recent technique that combines leveraged recapitalization with a joint venture. In this process, a bank or other financial institution would purchase a minority position in the operating company, generating cash to buy out shareholders. But then, over a period of four to six years, the financial partner would be bought out, and the family would be back to 100 percent ownership.”
For tax reasons, de Visscher says, a financial institution buys all of a family’s stock with a combination of equity and senior debt. The family reinvests part of the money back into the new operating company in return for a majority stock position, and uses the rest to buy out family shareholders who want to leave the company. Over a period of years, the family uses a portion of the company’s cash to buy out the financial institution’s stake, re-establishing complete family ownership. De Visscher emphasizes that “the motivations of the financial partner are purely financial.” Unlike a foreign industrial corporation, a financial institution will not suddenly decide to run the business in a new way.
As a means of raising money, he notes, “this gives a high valuation. It approaches the valuation of selling 100 percent of the stock.” It also facilitates the tax-free reinvestment of the proceeds. But it increases leverage, and, therefore, may introduce a new degree of risk in running the company.
Utilizing tools developed for the big guys
Leveraged recapitalizations, a major Wall Street phenomenon of the eighties, are now an intriguing tool for family businesses seeking to provide shareholders with liquidity. Although the tool comes in various shapes and sizes, it essentially is a change in the capital structure of a company whereby some of the existing family shares are exchanged either for cash or a different form of security.
A leveraged recapitalization involves a tender offer for the company’s stock in which the original group of shareholders in a company essentially sells the company to a new set of shareholders consisting of those original shareholders who still want a stake in the company. The transaction is typically completed through the sale of senior or subordinated debt or through the issuance of preferred stock.
The company could offer to pay for the stock with cash or a combination of cash and securities. The advantage of a noncash offer is two-fold: it limits the amount that has to be borrowed to finance the purchase, and “you can actually do an estate freeze with the issuance of that paper, as long as it’s non-voting stock,” says de Visscher.
An estate freeze essentially locks in shareholder values for the purpose of computing taxes and removes future appreciation in the value of the business from tax calculations. By using preferred stock redeemable at a specified price, or some other kind of fixed-value security, “the seller, in effect, freezes the estate because the value is set and future appreciation won’t go into the estate any more.”
While a leveraged recap enables a group of shareholders to cash out, its estate-freeze feature makes it particularly useful in passing control to a new generation. It could be used, for example, to buy all the stock of the older generation in return for nonvoting preferred stock or subordinated debt.
“The convertible preferred allows you to bring a layer of equity into the company that may not necessarily be voting equity, which allows you to take on more debt on top of it,” says de Visscher. If the company only needs to buy out small shareholdings, it may just borrow the money to pay for the stock. “But, ifyou’re dealing with 30 or 40 percent of the shareholders,” he says, “the company may not be in a position to borrow that much money, so it needs to have other ways to finance it.”
That’s when the convertible-preferred option becomes useful. Convertible debt initially costs the company less than straight debt, and it provides an upside kicker for the investor in the form of the right to turn it into stock.
Leveraged recaps may be too expensive to implement for companies with sales of less than $5 million. Jonathan D. Scott, vice-president in charge of the closely held business and real estate group at Provident National Bank in Philadelphia, warns,”There are fewer banks out there doing LBOs.” As a result, “an LBO for a small company tends to involve very expensive money.” However, if it can be done, it fetches good prices for the selling shareholders.
Welcoming workers as shareholders of the firm
A good alternative to selling out or going public is to bring in employees as shareholders through an employee stock ownership plan.
ESOPs are trusts that hold company stock for the benefit of employees. Each year, the company can make tax-deductible contributions of stock or cash up to 25 percent of its payroll. The cash is used to purchase shares from family members. An ESOP can also be leveraged. The company provides a loan, or guarantees a loan, to enable the ESOP to purchase shares; in some instances, the company can deduct both interest and principal payments from its taxable income. Because many banks derive tax benefits from ESOP loans, the financing may be relatively low-priced.
For family members ESOPs offer a great tax break. If the ESOP acquires at least 30 percent of the company’s stock, family members can defer the capital gains on the sale of their stock if they invest the proceeds in qualified securities — typically, publicly traded stocks and bonds — within 12 months after the sale. Taxes are deferred until these securities are sold.
Scott notes that the ESOP helps provide a valuation of the company’s stock. ”This makes a nice way for family members to get out because there’s not a fight over the price.”
ESOPs can also help improve employee relations. Families who not only share ownership but also provide information to employees and involve them in decision making often see big improvements in productivity. “One manufacturing company I know of,” says Scott, “has a very active ESOP, and it currently holds nearly 25 percent of the company. Since it was established, we’ve seen an incredible jump in productivity because the shareholders are now the people out there on the plant floor.”
ESOPs can cost $20,000 or more to set up. Companies considering a plan should have a minimum fair market value of $1.5 million, a payroll of about $500,000, or at least 40 employees.
Harvey D. Shapiro is a contributing editor to Institutional Investor. Finding a fair price
The question of how much to pay exiting shareholders is often as thorny as how to pay them. Obviously, those shareholders who are selling want to maximize the price and put it in their pocket, while the remaining shareholders want to minimize it, not only to keep the money in the business but also to avoid establishing a high valuation on the stock for their own estate-planning purposes.
Moreover, the price per share for a portion of the company is far lower than the price per share for the whole company. This is because a minority stake in a company is worth less than a stake that is large enough to give its owner control. A risk faced by exiting shareholders is that the entire company could be sold the next year, which means that everyone but them would share in the control premium. That’s why sellers sometimes want a “look-back” or other provision ensuring that if the company is sold within a specified period of time, and if the price paid per share is more than they received, they will share in the increment. ln assessing prices, there are also very different perspectives, depending on whether shareholders are active in the business. Ronald Drucker, a partner in Drucker & Scaccetti P.C., notes that active shareholders often tend to attribute the success of the business to their labors, while distant non-employee shareholders tend to ascribe the success to the founders and feel that family members currently in the business have been granted sinecures. These views lead to rather different perspectives when non-active shareholders want active ones to buy them out.
François de Visscher, the head of de Visscher & Co., says it’s clear that “in any kind of private company, the best way to get the maximum value is to sell the company.” Short of that, he adds, joint ventures and leveraged recapitalizations “often get you very close” to these kinds of values.
The leveraged recap may put the company deeply in debt, however. And valuations can be zero-sum games in which the sellers’ gains are viewed as losses by everyone else.”The main thing is that both parties have got to be willing to compromise,” says Drucker.
— H.S.