January 13, 2023 •David Blauzvern
The difference between a positive liquidity event and seller’s remorse often comes down to strategic alignment. Deal terms and pricing are important, but the right structure often matters more. The "right" transaction generally reflects a business owner's distinct goals and needs.
Common Merger and Acquisition Options
To illustrate, let's explore three typical private company transactions: strategic sales, private equity (PE) deals, and leveraged ESOPs. Each carries its own unique pros, cons, financial benefits, and tax implications. While "perfect fit" is an elusive M&A concept, certain options may offer greater situational utility. With that in mind, we'll also look at each strategy through the lens of common priorities among a company's shareholder priorities.
When business owners envision a mergers and acquisitions exit, this option is usually top of mind. Generally speaking, a larger player or deep-pocketed upstart is the acquiring company. They will purchase a target company to gain assets, product lines, intellectual property, customers, and/or sales territory.
- An acquisition deal is a widely understood process
- Transaction valuations may exceed fair market value (FMV)
- Strategic buyers often have a greater appreciation of market dynamics and nuances
- That familiarity may facilitate a smoother integration process for the newly combined company
- Confidential company information is shared with potential competitors throughout process
- Selling shareholders pay taxes on their proceeds (capital gains)
- Employees, including tenured staff and top talent, may not be retained by acquiring companies
- Staff at target companies are often left with hard feelings and little to show for their efforts
Generally, these deals are leveraged buyouts. To complete an acquisition, a financial buyer will lever-up a company’s balance sheet with private debt. Once in charge, the acquirer may seek to professionalize operations and drive future efficiencies.
- Selling shareholders will often receive a substantial portion of the purchase price upfront
- Private equity firms generally have the means and expertise to grow and/or scale a business
- Sellers may also financially benefit from future add-on acquisitions and M&A activities
- Sale proceeds are fully taxable
- Sellers usually reinvest a portion of their proceeds in the post-transaction structure
- PE firms often have final say in future operational, strategic, and M&A decisions
- Risk of putting excessive leverage on the target company
Similar to a management buyout, a company finances the purchase of an owner’s stock. But in this instance, the buyer is an employee trust, rather than a management team.
- Sellers can eliminate capital gains taxes on sale proceeds and maintain potential upside
- Company receives tax deductions equivalent to the sale value and can become an income tax-exempt entity
- Board of directors continues to oversee operations
- Employee stock allocations are generally periodic and subject to a vesting schedule
- Employee trust cannot pay more than FMV
- Highly structured deal process
- Regulatory oversight by Department of Labor and IRS
- Outside lenders often provide non-recourse financing, but this may only cover a portion of the transaction (seller notes fund the remainder)
Evaluating M&A Options Vis-a-Vis Owners' Goals
So, let’s consider these transaction types in light of common shareholder priorities.
Seeking Complete Exit
Owners who are ready to leave their businesses and want an up-front cash payout, should give serious consideration to a strategic sale. This option likely represents the cleanest of breaks – free of continuing management duties and most other ongoing entanglements. Post-sale, the acquiring company is clearly in charge.
Of course, a third-party sale is subject to capital gains taxes, so a premium valuation can take on outsized importance.
Looking to Gradually Step Back
When a company's shareholders seek to pare back their day-to-day involvement and diversifying their personal portfolios, a PE or ESOP sale may be right option. Both can provide a partial liquidity event with potential upside. Ongoing “skin in the game” takes the form of rolled equity in a PE sale and retained stock and/or stock warrants in an employee stock ownership plan transaction.
Businesses seeking an infusion of outside talent could be well-served by a PE buyer. These firms often specialize in industry-specific transactions and provide operational know-how and human capital to scale their portfolio companies. The common trade-off is a loss of independence for the acquired company. While selling shareholders may play a role in the restructured entity, day-to-day control is generally assumed by the PE firm.
If a company already has the bench strength to facilitate a gradual leadership transition, an ESOP may be an attractive alternative. Sellers and their companies can reap the associated tax benefits with only a 30% sale to an employee trust. Even in the event of a majority or 100% ESOP sale, the company’s board of directors will continue to operate the business, and sellers can continue to earn a salary and a maintain meaningful role, without being obligated to stay.
Solely Focused on Financial Diversification
While certain owners may be fully invested in their business, it could be the right time to take chips off the table. The case for an ESOP is compelling under these circumstances. The selling company can complete a partial, fair market value sale to an employee trust and still maintain a majority stake.
Under a minority ESOP, operations and leadership remain largely unchanged, while the company benefits from increased cash flow, thanks to the ESOP’s tax incentives. Employee-owned companies, on average, are also more stable and productive than their non-ESOP equivalents. The company's stock incentive can help foster increased employee engagement and provide a unique incentive for attracting and retaining top talent.
An employee-owned company also has significant flexibility to accommodate evolving stakeholder goals and future growth. Partial ESOP sales can be followed by a range of transactions including secondary sales, M&A or PE deals, and ESOP plan terminations. As a result, owners have the latitude to actively shape their business legacies even after a minority employee stock ownership plan sale.
The sale of a company is one of the most significant transactions a company's shareholder will face, and it can have a huge impact on their future and the legacy they leave behind. An educated seller (often working alongside a knowledgeable financial advisor) will almost always end up with the best possible outcome among available options.
Taking the time to explore the full impact of transaction alternatives, on all stakeholders, puts business owners in a position to avoid surprises while choosing the best path forward.