FIVE WAYS TO SIMPLIFY THE DECISION ON PERPETUATING YOUR FIRM: 'Freedom of choice is what we have. Freedom from choice is what we want.' -- Devo
Leader's Edge Magazine - November 2005
Author: Robert J. Lieblein
Fast Focus
- Different strokes for different folks. Before you hand over the keys to the firm, consider various perpetuation strategies.
- Alternatives to the traditional sale include employee owners, a management buyout, re-caps and sale of a minority interest.
Whether or not you remember DEVO, the so-called “spud boys” of mid-1980s rock and roll, their ironic pop-song lyrics about being bombarded by advertising have a jangling of truth beyond the intended meaning. Sometimes, the owner of a privately held business (let’s just pull one randomly out of a hat for illustrative purposes—how about the owner of a mid-sized insurance brokerage?) just wants to hit the road (or the golf ball) and leave the rest of life’s decisions to someone who is less tired of making decisions. In other words, gain the freedom to not have to make choices. Sounds pretty good at the end of a busy Monday, doesn’t it? You don’t have to be wearing a flowerpot upside down on your head (sorry—see DEVO again) to figure that out.
So, you want out. You could hop the next plane to Belize. Or you could spend a few thoughtful moments considering your options—a choice that might leave you with more liquidity to be used for world touring and greens fees.
Once they’ve decided to perpetuate their brokerage, many owners believe that their only viable choice is to simply troll for a third-party buyer. However, there are a number of good alternatives to selling your brokerage outright, and many of them take into account the various reasons for brokerage perpetuation.
While there are many deviations to the most likely options, let’s start by considering these five major options:
- Employee Stock Ownership Program (ESOP)
- Management buyout (MBO)
- Recapitalization (Re-cap)
- Third-party sale
- Minority interest sale
Only by looking at the finer points of each option can you determine which fits your situation and goals.
Employee Ownership
In the summer of 2005, General Motors started an ad campaign to revive sales of its flagging brand by trumpeting “Employee Prices for All!” It sounded so good, and boosted sales so immediately, that the other major automakers jumped on the bandwagon. In a short time, the sizzle was replaced by a look at the actual steak, however, and consumer advisors noted that these campaigns were nothing more than the annual summer sale, dressed up in red, white and blue bunting. You weren’t really being invited to the company picnic, but you could crash the edges of it and get a free hot dog.
The concept of an ESOP is somewhat similar. It postulates that everyone can be the boss and participate in ownership. In this case, it’s really the truth, although it takes faith and patience to achieve. In an ESOP, the current owner transfers ownership to employees in stages over a period of time, possibly up to 10 years.
There are numerous tax advantages to forming an ESOP. Perhaps the biggest is a “1042 Transaction.” For a C corporation seller of shares to an ESOP the entire gain on the sale is not recognized if an amount equal to the proceeds is invested in “qualified replacement property (QRP).” There are certain IRS rules related to what is deemed a QRP but for the most part, these requirements are fairly easy to meet.
More sophisticated tax planning allows you to “leverage or monetize the QRP” using borrowed funds through a floating rate note. You can offset the cost of borrowing by the profits in the “second” tier portfolio to further enhance your gains and cash flow while at the same time effectively eliminating all federal and state capital gain taxes.
While a 1042 transaction is not available to an S corporation, a major tax advantage for an ESOP formed by an S corp is that income attributable to the S corp stock owned by an ESOP is not subject to federal income taxes.
Other general advantages of forming an ESOP include:
- Deducting principal payments on an ESOP if using a leveraged ESOP;
- Gain tax deduction for C corporation dividends to ESOP;
- Raising working capital by selling new shares to the ESOP;
- Using ESOP stock tax advantages to facilitate acquisitions.
Aside from the idea of gaining liquidity, an ESOP is an employee benefit program, not much different than a profit sharing plan. Therefore, such a perpetuation strategy also helps the company retain key employees, and studies have shown that ESOP firms historically perform at higher levels than traditional firms.
But while the advantages are strong, there are serious disadvantages, too. Consider the length of time it takes to complete an ESOP. Do you really want to (or can you afford to) wait up to 10 years to get your money out of the company you’re selling? Generally, the company needs to borrow from a bank to finance the ESOP, which creates a highly leveraged firm. Also, ongoing costs, such as administrative expenses and valuations, take a toll on company resources, and an additional cost lurks in the buy-back provisions that need to be in place for employees who may retire. Finally, management must be willing to have an “open books” policy so the company will get that energy from employees truly believing they are owners.
As with all strategies, an ESOP may not be for everyone. I like to say that a brokerage considering an ESOP should, at a minimum, have these characteristics:
- Profitable with steady cash flow;
- Minimal debt so leverage can be used in implementing the ESOP;
- Annual payroll should be at least $1 million to take advantage of tax benefits;
- Owner willing to believe in the “open book” policy with his new shareholders;
- A strong second tier management team to help with the ultimate transition of the brokerage owner.
Management Buyout
An MBO is similar to an ESOP in that it allows someone from within the firm to buy the brokerage. In this case, it is a key manager or group of them. As with an ESOP, the purchase generally takes a number of years. But such a long-term transaction also allows for a smooth transition, especially if the owner wants to stay involved over an extended period of time. The MBO is often done when someone within the owner’s family wants to transition into ownership.
With a staged turnover to new management, stability is maintained. The owner’s “legacy” is preserved, and often minimal changes occur. It eliminates the fear that managers and employees (and, for that matter, the selling owner) might have about the company being swallowed up within a larger brokerage, losing its corporate culture, being the victim of substantial changes, etc. Also, an MBO is a transaction that can be completed relatively quickly and usually does not extend as far into the future as an ESOP.
That’s not to say that everything about an MBO is peachy. For such a purchase to work, a strong management team must be in place. Also, just like an ESOP, the brokerage should have steady cash flow and a positive outlook for continued success to be able to service the debt that will be taken on. Unlike most traditional financings, MBOs tend to result in higher debt amounts for the brokerage after completion. Finally, the current owner generally does not get the highest possible price for the business, since it is usually not a competitive sale as there are no strategic synergies that can be gained that can drive the “premium” that most agencies receive when sold to a public broker or bank with a distribution platform.
Re-capitalization
With the emergence of private equity groups taking a high interest in insurance distribution, re-caps have become a popular trend in insurance distribution. In a re-cap, the owner sells a majority interest (e.g., 80%) to a third party, usually a private equity firm, while retaining an ownership interest in the brokerage. The brokerage owner also usually maintains a senior management position in the firm. A re-cap is often done so the owner can gain some liquidity and use infused capital from the private equity group to enact growth plans that would otherwise be unavailable. Conversely, the brokerage becomes leveraged in a new way, as the equity firm uses a combination of equity and debt to accomplish the transaction financing. Therefore, most agencies that want to consider a re-cap should have minimal existing debt.
Other factors to consider with a re-cap are the loss of independence and the likelihood of another sale in the near future. A brokerage owner who becomes the manager of the newly capitalized firm will ultimately be at the mercy of the new majority owner, who retains the ultimate control over the future direction of the brokerage. Also, the private equity firm will want to realize gains on its investment and so will likely plan to sell the brokerage within five to seven years.
The next advantage is what I call the “double dip.” Basically, the brokerage owner can get a bonus from this approach since he or she will stand to receive a significant upside from his remaining interest in the firm when it is sold. Re-caps are not for every brokerage. Typically, a brokerage needs to be of size and scalability that would allow for significant growth. The minimum size of a property-casualty brokerage considering a re-cap is generally north of $10 million in revenue.
Third-Party Sale
The most familiar method of selling a firm is probably so because it’s also the easiest method: put the firm on the market and sell it to an interested third party. This generally results in the highest purchase price, which is determined in the competitive marketplace. (Timing, of course, is a key issue.)
The seller generally is paid the total purchase price over the shortest period, usually no more than three to four years. Often, arrangements can be made for the owner to stay involved for an extended period of time, if that is what the seller wants. The buyer provides additional capital to grow the business after the sale, which delivers additional opportunities to employees.
The disadvantages to this type of transaction are that it generally takes longer than other methods—sometimes six to 12 months—and the possibility exists that confidentiality of the deal will be broken and competitors will find out the brokerage is up for sale. This can be detrimental to renewals and new business if not handled carefully.
The seller, if staying on after the sale, becomes an employee of the new organization and will generally have no control over changes to the firm. There can be a negative impact on employees, too, as a new corporate culture is contemplated. Perhaps there will be layoffs, elimination of positions, or other steps taken by the new owners that will cause a disruption for employees. This, too, can have an effect on sales and profits.
Selling a Minority Interest
The last major mechanism is selling a minority interest in the firm to a third party. In this scenario, the current owner remains in control but now has a bit more capital to apply to growth. There can be some liquidity available to the brokerage owner, too, if the seller cashes in part of the value of the brokerage to use for private purposes rather than reinvestment. Unlike ESOPs, MBOs and re-caps, selling a minority interest typically does not result in leveraging the balance sheet through debt. Also, selling a minority interest to another company can be the starting point of a strategic alliance and can set the stage for the ultimate sale of the remaining ownership interests at some future date.
This type of sale, though, rarely results in the brokerage getting the highest possible price, as would be expected from selling the entire firm to a third party. After a minority sale, the owner has a new partner, and that partner will need to be included in the decision-making process. Generally, such deals require the owner to either buy back the minority interest or sell the remaining interest in the firm to the minority buyer within a set period of time, often three to five years.
Whether you consider working with a group of employees or managers to buy the firm, or you’re structuring a grab for capital to fuel growth by taking on partners, you’ll need to consider many details and apply the pros and cons against your unique situation. An outright sale to a third party may seem like the only option available to you, and in many cases it ends up being the best course. But still, an owner is wise to sit down with a knowledgeable adviser and identify, evaluate and understand the advantages and shortcomings of all these strategies.
Arriving at your freedom from choice means diving into the thick of options before eventually narrowing them down to one. (Even a big funnel has a small opening, but you hope it will be large enough to allow you and your golf clubs to squeeze through.)
Anybody can complete a perpetuation plan, but there is a big difference between completing a plan and implementing a successful plan. And what you do not know may result in you not even knowing that you weren’t successful.
So narrowing the choices to the right one means in the end you have a relatively easy and obvious decision to make—in fact, you’re not really forced to make a choice at all. Who knew DEVO was a closet business consultant?
Lieblein is a contributing writer and managing principal of WFG Capital Advisors. rlieblein@wfgca.com |
