The purpose of this “White Paper” is to provide you with a general overview of the options on how you can diversify some of your personal net worth away from your Company. We have outlined the following six options, each of which will allow you to take some chips off the table in various ways.
Option 1: Taking a Dividend
In this scenario the Company will borrow funds from a senior lender. The amount the Company can borrow will depend on the underwriting standards of the bank, but in general will be a multiple of the Company’s free cash flow. The cash flow computation is subject to a secondary review of the Company financials and “add backs” to identify the adjusted EBITDA or free cash flow of the Company. Typically a bank will lend between 2x and 4x of the free cash flow of the
business. In other words, how much the bank feels comfortable the Company can pay back or debt service. Once the loan is closed the new cash comes in to the Company and then is paid out to you as a dividend.
The dividend will be taxed as capital gains to you; however the Company will not receive a deduction for the dividend it pays out.
Pros:
- You diversify some of your net worth away from the Company immediately.
- You retain 100% ownership and control of the Company.
- You have the ability to invest the funds received and create additional yield.
Cons:
- There is no transition of ownership to your management group or anyone else.
- The Company is leveraged and you will personally guarantee the debt.
- The Company and you personally will pay tax on the amount of the dividend.
Option 2: Selling your stock to an ESOP
In this scenario your Company creates an Employee Stock Ownership Plan (“ESOP”). One of the uses of an ESOP is to allow one or more owners of a business to sell all or part of their stock to an ESOP for employees of the business and then “roll over” the sale proceeds into other investments, including U.S. public companies and mutual funds, without having to recognize gain on the sale for federal income tax purposes. There are certain tests that must be met, but they are not too demanding as long as the employer is a C-corporation. The ESOP is permitted to borrow money in order to purchase the stock, and the company is allowed to guarantee that loan.
Also with any ESOP there are “qualified plan” benefits under the Employee Retirement Income Security Act (“ERISA”). The company can make tax-deductible contributions to the ESOP that can be used by the plan to retire its indebtedness or to purchase additional company stock. The company profits or dividends attributable to the stock which is owned by the ESOP are not subject to tax. The employees’ ESOP accounts may vest in accordance with a vesting schedule prescribed in the plan. The non-vested portion will be forfeited upon termination of employment, so there is an incentive for employees to stay with the company. As employees, the participants will also play a part in the success of the company. There are also favorable tax benefits to the employees for certain plan distributions of company stock.
The tax implications of the ESOP are on several levels. The Company receives a deduction for making a contribution to the ESOP plan. The shareholder can either recognize the gain or defer it by selling greater than 30% of his stock and reinvesting in publicly traded stock.
Pros:
- You diversify some of your net worth away from the Company immediately.
- Some studies show that ESOPs increase production and profitability due to the employee’s sense of ownership
- You begin to transition ownership away from you to your employees. Over time you can sell off 100% of your stock.
- You can maintain control of ownership of the Company by voting the unallocated stock held in the ESOP.
Cons:
- There are regulations and annual compliance including annual appraisals and notifications to shareholders that can be burdensome.
- ESOPs are retirement plans and employees become over weighted in their retirement funds to the Company and lose some diversification.
- ESOP participants must be allowed to vote their allocated shares on major issues, including selling the Company.
- The Company is leveraged and you may have to personally guarantee the debt.
Option 3 – A Private Equity Partner
In this scenario, WRA will find you an operational and financial partner. The Private Equity Group (“PEG”) will take an equity position in your company, which can be a control position or a minority position. Most likely the PEG will leverage their buy in by structuring part of their buy in as secured senior debt or possibly subordinate debt. The PEG will be looking for a strong management team, opportunities for growth and will work with you on your exit strategy.
Also, the PEG will bring operational insight and controls that will be designed to grow the company for a later exit at a higher valuation than what they bought in for. You will be expected to roll in or keep a portion of your equity to participate in any future sale. Stock that you sell will be taxed at the capital gains rate.
Pros:
- You diversify some of your net worth away from the Company immediately.
- You have a strong financial and operational partner to grow the Company.
- You transition ownership away to the PEG or to your management group depending on the structure.
- You can participate in a secondary offering of the Company at hopefully a higher valuation to sell off your
remaining stock.
Cons:
- The PEG will want controls on the company. That can be either through majority ownership of the Company, Board rights, or covenants. You will have a partner who will have a say in how the Company is managed and run.
Option 4 – A Management Buyout
This scenario is similar to Option 1 and Option 3 above. Similar to Option 1, the management team secures a bank loan, based on the financials of the Company to purchase all or substantially all of your shares. In this case the management team can own up to 100% of the Company. The proceeds of the loan are paid to you as a one-time cash payment for your stock in the Company. The difference between the loan amount and the total amount you want for the Company is the value retained by you. That retained ownership can come in different forms including common stock, preferred stock, a seller note or include both stock and a note.
Alternatively, similar to Option 3 above, the management team gets a PEG as a financial backer and the PEG and the management team buys all or substantially all of your shares in the Company. In this case the management team would most likely own between 5% to 10% of the Company in total at closing, with the opportunity to increase their ownership through the award of options tied to performance hurdles of up to 20% of the Company over time. In either case, the management team will be expected to put in equity which is substantial to them even if it is not substantial to the size of the transaction. As above, stock sold will be taxed at a capital gain rate.
Pros:
- You diversify some of your net worth away from the Company immediately.
- You transition ownership over to your management group.
- If using bank debt, you and your management team retain control of the Company and provisions can made for control to pass as the debt is paid down or paid off.
- The pros and cons to a PEG were outlined above in Option 3.
Cons:
- The Company is leveraged and you may have to personally guarantee the debt.
- Depending on structure you could lose majority control and decision making of the Company.
Option 5 – Shareholder Loan
This scenario is similar to Option 1, but instead of paying out a cash dividend to you, the proceeds to you are structured as a loan to you. In essence the Company borrows the money and then turns around and lends it to you. There is no tax due by you as long as there is a valid note and the interest is paid.
Pros:
- This has the least tax expense to you.
- You retain 100% of the ownership of the Company.
- You diversify some of your net worth away from the Company immediately.
- You can invest the proceeds of the note and create a yield on the invested dollars.
Cons:
- Again there is no succession plan.
- The principal will have to be repaid, typically as part of the sales process whenever you do sell the Company.
The Company is leveraged and you may have to personally guarantee the debt.
Option 6 – A Sale
In this scenario you put the Company up for sale. WRA would conduct a private auction for the Company including our 25,000 PEGs and strategic buyers. We would look to get the highest value for the Company. Different than Options 1-5,the new buyer may ask you to stay on during a transition phase as a consultant, but ultimately in this strategy you are looking to walk away now and sell 100% of your stock in the Company.
Pros:
- You diversify all of your net worth away from the Company.
- You are free to start new ventures or retire.
- Structured correctly you walk away with no on-going liabilities or guarantees
- You can invest the proceeds.
Cons:
- There is no guarantee what will happen to your employees or management team with new ownership. We can work to obtain employment agreements for the Senior Management and yourself as part of the sale transaction.
- You have no control or leadership in the Company as it relates to future customer relationships or vendor relationships.
Note: Options 1, 2 and 5 can be supplemented with a stock option plan. Assuming you retain majority ownership of the Company but still want to lock your management team in, you can create a stock option plan. We understand this is a significant decision and so we are happy to discuss your options and how we might be able to help you in your specific situation.
In addition, the WRA parent company Chapman Hext & Co. can under separate engagement provide operational and data room support, tax, and consulting on other financial or GAAP issues.
Should you have any questions, please don’t hesitate to contact us.