By Nathan Perkins

Choosing the Right M&A Option

As we enter the later stages of the Coronavirus pandemic, companies are seeing the light at the end of the tunnel. Typically, after economic adversity, there is significant pent-up demand for liquidity events. Our current moment is no exception. M&A activity is again on the rise, and established business owners are asking themselves tough questions.

“Do I have another market cycle in me?”

“Is now the time to sell?”

“What would life be like without my business?”

This uncertainly doesn’t end once an owner opts to pursue a liquidity event. Instead, a whole new set of questions may arise. That’s because a sale process isn’t binary. Sellers have transaction options. Partial sales are possible, and even complete sales have differing sets of pros and cons, depending on the buyer.

For the purposes of this article, we’ll explore three sale options: to a competitor, to a financial buyer such as private equity, and to an employee stock ownership plan (ESOP).

Option 1:  Strategic Sale

When most owners think about a sale, this is the option that first comes to mind. A larger player or deep-pocketed upstart who wants to take over your assets, intellectual property, customers, and/or sales territory buys your company.

Pros

 

Cons

  • Widely understood process
  • Potential buyers will likely appreciate the market dynamics and nuances of your business
  • That familiarity may facilitate a smooth transition for your customers and operations
 
  • Sale proceeds are fully taxable
  • Employees, including tenured staff and top talent, probably won’t be retained (a buyer won’t need 2 CFOs)
  • Many employees will likely be left with hard feelings and little to show for their efforts
  • Share confidential corporate information with potential competitors throughout process
 

Option 2:  Private Equity Transaction

Most PE deals are a type of leveraged buyout. To complete an acquisition, a financial buyer will lever-up a company’s balance sheet with private debt. Once in charge, the PE firm may seek to professionalize operations and drive future efficiencies.

Pros

 

Cons

  • Selling shareholders may receive a substantial portion of the purchase price upfront, potentially at a valuation premium
  • Buyers are often focused on growing and scaling a business, rather than completely absorbing it
  • PE firms often have financial resources and expertise to support add-on acquisitions
 
  • Sale proceeds are fully taxable
  • PE firms often have final say in operational and M&A decisions
  • Seller may be required to reinvest some of their sale proceeds in the new business structure
  • Risk of using excessive leverage, amortized with after-tax dollars​
 

Option 3:  Leveraged ESOP Sale

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.

Pros

 

Cons

  • Sellers can eliminate capital gains taxes on sale proceeds and maintain potential upside
  • Company receives tax deductions equivalent to the sale value
  • Company can become a tax-free entity as a 100% S Corp ESOP
  • Board of directors continues to oversee operations
 
  • Employee trust cannot pay more than fair market value
  • 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)
 

There isn’t necessarily a right or wrong option for business owners who decide to move ahead with a sale. But there are “best fits” relative to a seller’s needs and goals. A well-reasoned decision can mean the difference between a positive transaction and seller’s remorse.

So, let’s review these options based on a selling shareholder’s priorities.

Seeking a Complete Exit

Owners that want to cash out and not look back 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.

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

For shareholders seeking to pare back their day-to-day involvement while diversifying their personal portfolio, a private equity 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 private equity 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. 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 PE 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.

Primarily Seeking Personal 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. Selling shareholders 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 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.

Conclusion

The sale of a company is one of the most significant transactions a business owner will face, and it can have a huge impact on their future and the legacy they leave behind. An educated seller will always end up with the best possible outcome given the available options. Taking the time to explore the full impact of transaction alternatives, on all stakeholders, puts business owners a position to avoid surprises while choosing the best path forward.