Client Background
In late 2017, the owners of a management consulting company approached a Beacon Hill referral partner who is a financial advisor to explore a possible exit from their business. The business owner had been a client of the referring advisor for a number of years, during which the referring advisor provided a number of advisory services, including helping with the design of a plan to increase the value of the business.
The owner and his wife owned 91% of the business and there were approximately 200 employees working at the company in 2017. The company’s primary service was developing training and safety classes for the nation’s largest utility and oil and gas companies. The business had been an S-corporation for many years but had recently withdrawn the S-election for certain tax reasons. Also, the business had appointed an experienced manager to take over as CEO in 2016. The company had experienced steady revenue growth since 2014, and the 2017 revenue was just under $40 million, generating an impressive, above-market level of EBITDA (Earnings Before Interest Taxes Depreciation and Amortization).
Client Issues
The clients had several main goals to achieve through their exit. They wanted to diversify their wealth and maintain a personal lifestyle, maintain day-to-day involvement in the company until the owner was satisfied and ready to step away, share the benefits of the business value with key employees, and include some sort of charitable gifting in their exit.
Although there was a CEO in place, she had plans to retire within the next ten years, so this would eventually leave the owners with no successor and no other formal business continuity arrangements. Like most privately-held businesses, this growing company consumed and required a substantial amount of the cash available in the EBITDA, leaving the client with a majority of their total wealth illiquid and tied to their business. Hence, a value gap analysis revealed that the owners had a substantial gap between what was needed to maintain their lifestyle and what they had available in savings outside of the Company. The planning process illustrated that some form of liquidity could substantially reduce the value gap and have the owners take a large step towards personal financial independence.
Planning Solutions/ Outcomes
The referring financial advisor worked with the owners to craft an exit plan by following the six-step processes. After conducting an initial review of the owner’s financial and mental readiness using the Business Exit Readiness Index (BERI) survey, the owners self-defined as “stay and grow” owners. The owners had low mental and financial readiness for an exit. The financial advisor was tasked with creating exit options that would adhere to the owners’ personal goals and promote a successful outcome for the future of the company. With the owner being classified as a “stay and grow” owner, the Private Equity Group recap exit option was initially very attractive. However, after hearing the details of the Employee Stock Ownership Plan (ESOP), our owners began gaining some more clarity.
Exit Option Analysis
With low financial readiness and low mental readiness, a PEG recapitalization could satisfy the owners’ goals by bringing in a strategic financial partner. Through this transaction, the owners would achieve personal diversification and be able to maintain their jobs at the company, likely continuing to control the daily operations of the business. However, the owners would most likely sell a majority stake of the business, ceding strategic and financial control to the new partner, through a recapitalization transaction. A number of other options, including different scenarios of certain options, were illustrated in the full exit plan.
The next option presented to the client was an ESOP. The financial advisor illustrated two different ESOP scenarios for the client, one would sell all of the owners’ shares to an ESOP and the other option would only sell approximately 40% of the owner’s shares. Both ESOP scenarios would achieve the owners’ post-exit goals and allow continued control of the company post-transaction, namely by not bringing in the capital and expectations of a 3rd party.
The third option was the most obvious; to stay and grow the company. With no successor in place, it would not be a bad option for the owner to stay and increase their personal savings for a few years which would open more lucrative exit options in the future, but there would be no liquidity today.
The fourth exit option presented was an outright sale of all the owner’s shares. An outright sale could be the most financially lucrative option for the owner, but it would not allow the owner to maintain control of the company and would likely impact the unique culture of the business that the owners had cultivated over the years. There was something about selling control of the business and dealing with the uncertainties that a new majority owner would bring and just didn’t sit easy with the owners – particularly if their personal and business goals could be met with another exit option.
After considering their options, the owner decided an ESOP would best suit their exit needs.
Outcome
In August of 2018, an ESOP was executed that satisfied all the owners’ personal and business goals. The newly formed ESOP acquired approximately 40% of the owner’s shares was the desired plan. To finance the transaction, a loan agreement was entered into with a new bank that specialized in ESOP company loans. This loan amount was not only enough to pay for the shares being sold, but the company’s balance sheet was strong enough to avoid personal guarantees from the owner to achieve this liquidity. Moreover, these owners were able to execute on a Code Section 1042 roll-over to defer the taxation on the sale of the shares, achieving deferral of millions of dollars in capital gains taxation, and allowing 100% of the sale proceeds to be put to work in an investment portfolio.
This transaction also substantially eliminated the owners’ personal value gap that was measured in the exit plan, making them financially ready for a full exit with their remaining shares, whenever they desired and using any of the other exit options that they learned about in the exit planning process. The ESOP option also allowed the owner to maintain control of their company and maintain ownership of around half of the company’s shares.