From family dynamics to avoiding common retirement pitfalls to the forgotten Generation X, the following posts, podcasts and video help business owners strengthen, grow and ultimately plan to transition their business.
Keeping the business in the family still requires an exit strategy as one generation hands over the reigns to the next. This post from Chief Executive offers business owners an idea of some of the factors that play into passing down the family business and a practical approach for planning the transition.
In this 30-minute video, certified financial planner Jeff Rose covers six common mistakes he has seen clients make when it comes to retirement. Jeff explains how these mistakes compromise the ability to retire on your own terms and how to avoid them.
Financial advisor Peter Huminski joins the Retirement Starts Today podcast to consider common mistakes business owners often make when it comes to selling their business. From insufficient preparation to failing to diversify to going it alone, Peter uses real world examples to illustrate common pitfalls and how to avoid them.
This podcast from Morgan & Westfield walks through the story of two business owners and how they started, ran and successfully transition their business while preserving their legacy.
While mountains of content focus on millennials and baby boomers, this post from Time reminds business owners that the future of their business may be better served by paying closer attention to the generation in the middle. The members of Generation X are few in the wake of their millennial counterparts, but positioned to be business’ next great leaders. They just might need a little help.
Small business owners tend to be locally minded. In a report published by the Business Journals on small to medium-sized business:
• 91 percent generate local sales
• 70 percent prioritize doing business with local companies
• 64 percent are actively involved in their local community to promote good will and generate business
• 63 percent consider the business they do directly with the local community key to their company’s success
• 58 percent rely heavily on local business
You can download the full report here.
Small business owners won’t be surprised by these numbers. Ties to the local community are well-established among entrepreneurs and a top concern when the time comes to sell. When we speak with business owners who are ready to retire, the overwhelming majority want to find a buyer who will continue the business’ legacy not only within the business (caring for employees) but within the community. Many of these owners have longstanding commitments throughout their cities and towns and it’s important the new owner continue to honor them.
This local focus is intrinsic to small business. The very existence of independent organizations pumps more into the local economy than larger chains are capable of. Economist and author Michael H. Shuman told American Express, “Every single dollar spent at a local business leads to two to four times the amount of jobs, income and wealth, tax collections and charitable contributions.” He goes on to say local companies have more local relationships, with a disproportionately positive effect. The 30/50 Project reported that “for every $100 spent in locally owned independent stores, $68 return to the community through taxes, payroll and other expenditures.” When patrons choose instead to spend that $100 at a national chain, only $48 stays local, and when they buy online that number drops to $0. Small to medium sized businesses understand the role they play in their communities and the importance of supporting other local businesses.
These strong ties to the community may be one reason many owners are sticking around longer. The Journals’ report showed a high number of business owners—57 percent—don’t plan to retire until after age 66. Of these, 19 percent plan to stick around past age 70 and 13 percent never intend to retire. The top reasons these business owners gave for their desire to continue working were to stay active and involved (69 percent) and simply because they enjoy the work (64 percent).
Continuing in the business isn’t necessarily the same as continuing to own the business, though. Plenty of owners are happy to hand off the reigns so they can be involved, but less so. This can be a strong advantage for the buyer, who has an opportunity to learn from the previous owner over time, smoothing out the transition and shortening their own learning period.
All this points to a market full of owners who are willing to wait for the right next owner. As Benjamin Gerut of Kuzari Group, LLC. put it to Axial, retiring boomer business owners want more than a check, they want succession. “Buyers must care about the employees. After working with many of these people for years or decades, it is hard for me to imagine an owner being comfortable simply selling to a [private equity group] without any comfort as to the long-term future of the company and its human resources.”
The desire to keep community commitments are enough to keep baby boomers working until they find a buyer who is as committed to the local community as they have been.
Good employees are the backbone of a business, but business owners know a productive, thriving workforce doesn’t just happen on its own. The posts, podcasts and videos listed below focus on issues such as attracting the right candidates so you can hire the best people, leading your employees through change and preparing them for a transition. With proper planning and strategy, you can empower your employees to thrive, even in the midst of change.
This post from Forbes takes the opposite perspective of the seller and looks at what employees often do when the new owner takes over. Whether you’re staying on to help for the transition period or not, this insight will help you be prepared for what comes next and inform decisions on how to prepare your employees for a new owner.
When a company changes hands, it can create upheaval among the employees. By taking action prior to the transition, you can empower your employees to successfully ride out the changes. This post from Inc.com goes into five different ways you can prepare the people in your company for big changes.
This video from Pacific M&A and Business Brokers Ltd. points out the importance of choosing a wise buyer in light of assuaging your employees’ fears when they learn the business is transitioning. It also considers the effects of informing your employees early vs. after the sale and what you can do to minimize any damaging effects on your employees, the business and the new owner.
This three-minute video from iQuestions.com addresses the five stages employees go through during a transition, how their process differs based on personality and role in the organization, and how to respond to these different responses to make a transition smoother and more successful.
Selling a business can be a very up and down process, which makes deciding how, what and when to tell your employees complicated. There’s no reason to make them part of all the ups and downs, plus telling them about a potential sale too early can derail the sale and hurt your options. Telling them too late can foster a sense of betrayal. Inc.com delves into the question of whom to tell, what to tell them and when the best time is to do so.
Tax season is in full swing, as business owners are all too aware. While two of the posts listed below should prove helpful for considering the tax implications of transitioning a business, the other two offer a break from the subject of taxes by focusing on how a business transition fits into the bigger picture.
In the spirit of the season, this post from Inc.com discusses some of the strategies you will need to consider for tax purposes as you prepare to sell your business. Proper planning with the help of an expert can greatly reduce your tax burden and help you structure the sale to avoid huge bills from the IRS.
Selling your business is likely part of a bigger picture, namely retirement and what that will look like for you and your family. This post from Forbes addresses the subject in terms of creating a comprehensive plan for retirement income, considering the trade-offs with social security, how much it takes to fund retirement and the best time to leave the working world behind.
Business owners know the importance of having an exit strategy, but when you’re working on your business it can be hard to carve out time to think through a sale you’re not planning to make anytime soon. This podcast from Florida-based brokerage Morgan & Westfield discusses the importance of giving attention to an exit strategy long before selling is on your mind.
This post from law firm Miller Nash Graham & Dunn digs into the details of how tax laws play out in the sale or purchase of a business here in the northwest, shedding light on the laws surrounding business transactions and their real-world application.
As the number of businesses for sale increases, so does demand for information about valuation. This insightful post originally appeared in two parts on OneAccordPartners.com; we are re-posting it here with permission.
By Ed Kirk, Managing Director
We’ve all heard of multiples or rules of thumb that help benchmark a company’s value—four times earnings, six times free cash flow, etc. But what do these multiples mean and how do they relate to valuing businesses?
Formal business valuations are conducted for a variety of tax and legal reasons and the IRS and courts have provided guidance and rulings for reference. These types of valuations are required in many situations but are generally not necessary for estimating the price a company is likely to fetch on the open market. Different methodologies lead to different results because valuation is both art and science. These methods rely on judgment and experience and can yield a wide range of conclusions based on the perceived risks and potential opportunities in each case. In other words, value is subjective.
Extensive books, courses and careers have been dedicated to business valuation, but my intent in this post is to provide a high-level overview of the factors that go into valuing privately held businesses for the purpose of facilitating a smooth transition of ownership down the road, regardless of the company’s current stage or direction. Often, valuations of this kind rely on multiples of historical earnings.
We rely on multiples in valuations for many reasons, including:
Multiples are shortcuts. They take into account patterns you see across an industry and give you a way to arrive at what is likely an accurate range of values without having to go through extra steps. While shortcuts are not necessarily bad, it does help to understand their strengths and limitations. Back in the day when I was a college summer intern at an Army Corps of Engineers construction project in New Mexico, the project manager once told me to walk around the site with a tape measure and just measure things at random. The idea was the construction workers would see me and figure I knew what I was doing. I’m not sure I elevated the status of summer interns with this tactic, but it sure made me look relevant. In some ways, using multiples as rules of thumb in valuation is a little like the tape measure—a great tool, but far more effective when you understand what the measurements actually mean.
There are three methods frequently used in valuing private companies. The asset approach is, believe it or not, based on asset value, which is simply the market value of all assets minus the market value of all liabilities. Generally, this applies to companies with little to no profits or a low return on assets. The second method, the income approach, is based on how much income the company generates. This means the value is derived from the risk-weighted return on investment that the company provides, just like most other financial investments. The third method, the market approach, relies on comparing a business to the known value of other, similar companies which have recently changed ownership.
The income and market approaches are widely used methods for valuing profitable companies. Their strength is that they both incorporate fairly robust quantitative analysis and time tested methodologies to calculate value. The drawback is they both rely on assumptions, judgment and less than perfect information. Accuracy is more important than precision when it comes to business value, so the right multiple correctly applied can give as good or better an indication of value than a detailed discounted cashflow model with unrealistic projections.
Regardless of the method used, business fundamentals are always going to be central. Some of the most common value drivers include outlook for growth, margin strength, revenue diversification, management strength and depth, quality of financial statements and customer retention to name just a few. Focus on what you can influence and realize that it takes time to build value. There are some things that are out of your control, such as the health of the overall economy, but you can increase value either by increasing revenue and profits or by decreasing perceived risk.
In a prior life, I was involved with M&A work in the oil industry for ConocoPhillips, and I saw many substantial deals at least get narrowed down to the final few buyers simply based on eight times net cashflow. This seemed to be an industry standard unless there were unusual circumstances involved. Don’t get me wrong, management required a thorough discounted cashflow analysis before final approval (no need to sell your oil stocks!), but there was some validity to using rules of thumb. I mentioned above that there are three widely used methods for valuing privately held companies—the asset, income and market approaches. Let’s look at the income approach in more detail.
Income Approach Theory and Future Income
The theory behind the income approach is that an investment is worth the value of the expected future income discounted back to the present at a rate appropriate to the riskiness of the investment. Discounting is the process of determining the present value of a future stream of income. For privately held businesses these discount rates are frequently in the 20-30% range to account for the inherent uncertainty associated with future income streams of private companies.
The challenge with using future income to measure value is coming up with a reliable forecast. Nobody knows what income a business will bring in the future. Since we don’t have a crystal ball to tell us, we rely on either historical financial performance or realistic, supported projections (or a bit of both) to estimate the future income of a business. The reason for using past performance to predict future performance is that it’s based in fact. I can look at a business’ past performance and see without a doubt, in black and white, the income it brought in over time. If I see a positive trend of more income over time, I have reason to believe the business may continue in that direction. Valuations of this kind commonly look at the business’ performance over the last 12 months or so, but it’s also a good idea to look at trends over a longer term, ideally a full business cycle, to see how the company performs in both favorable and unfavorable conditions.
For most established companies, past performance is the best indicator of future performance unless there are specific, tangible reasons to believe otherwise (new markets, products, patents, contracts, etc.). Business owners often tell me that the value of their business should be based on potential and, even though it might be a 20-year-old company with flat growth, they believe all the new owner needs to do is increase marketing or hire a couple of sales reps and profits will skyrocket. Without a proven track record, I have no way to measure the company’s real potential and cannot base value on a hunch with no data to support it. There’s also the case where a company has grown profits 20 percent per year for the past few years and the owner believes the value should be based on the assumption that the business will continue growing at the same rate. To put that in perspective, 20 percent annual growth implies the company will be six times its current size in 10 years. Though technically not impossible, this is unrealistic. Sustainable, supported, realistic forecasts are essential for deriving a sensible value.
In the case of early-stage companies and those going through a turnaround, projections will be more important than past performance, but you can also expect a higher discount rate because of the greater risk involved with forecasts that are not in line with historical performance. So the more you can prove the market potential, even if it’s just a few years of growth, the more valuable the company is going to be. For you Shark Tank fans, this should sound familiar.
The other part of the equation is determining what income stream to measure. EBITDA (earnings before interest, taxes, depreciation and amortization) is commonly used because it allows for comparison between similar companies regardless of capital structure or tax strategies employed. However, multiples can be applied to a variety of benefit streams including revenue, gross margin, operating income or net cashflow, depending on the industry and situation.
So how do discount rates and projected income relate to the multiples?
The simple answer is that the inverse of the discount rate minus the growth rate is the multiple. For example, a 25 percent discount rate applied to a company with 5 percent long-term, sustainable EBITDA growth equates to a value of five times EBITDA. For the mathematically oriented, that’s 1/(25%-5%). Yes, discount rate minus growth rate is a capitalization rate commonly used for real estate valuation. The only complexity in applying this to business valuation is that income from most companies rarely grows in a linear, predictable fashion, but the concept is the same (that’s also why Excel has a net present value, or NPV, function).
Multiples are great shortcuts to value, as long as you understand what they represent. Be realistic about your assumptions and don’t be afraid to validate them with feedback from others.
The definition of healthy food has changed. In the 1980s it was low-fat at any cost—high sugar and chemical content was entirely permissible if it created a tasty, fatless version of our favorite foods. Today there’s an increasing emphasis on reading labels and selecting products based on the purity of their ingredients. Diets like Paleo or Whole30 are becoming lifestyles instead of temporary approaches for losing weight, and focus on the importance of simple, high-quality ingredients. Can’t pronounce it? Back on the shelf. Don’t recognize it? Back on the shelf. Too many ingredients? Back on the shelf.
This means many formerly off-limits foods are enjoying a renaissance as retailers extol the newfound virtue of premium ingredients. Chocolate is a prime example of this shift. According to the Wall Street Journal article, “When Is It OK to Eat Chocolate?” sales of what was once a guilty pleasure have increased 18 percent since 2011. The article contends that high cocoa content, premium ingredients and elegant designs that encourage small portions are attracting shoppers looking for a treat that won’t derail their health and nutritional goals.
The chocolate world is responding. Smaller companies are giving the Big Four brands a run for their money, dominating the premium market with the simple, organic and all-natural ingredients that resonate with consumers. According to Confectionary News, Mars is the only Big Four brand in the top tier of premium chocolates, sharing the highest spots with Ghirardelli (owned by Lindt), Lindt Chocolates and Godiva (owned by Yildiz Holding). Lindt’s 90 percent cocoa bars are one of their fastest-selling products while 7-Eleven is producing its own high-end chocolates to stock the shelves and Godiva has introduced G by Godiva, a bar made with cocoa beans from Mexico featuring thumb-sized indentations.
Young moms and millennials are driving this change by favoring products that are natural, non-GMO, organic and gluten free. These young consumers are not brand loyal, so switching from what Mom used isn’t a big deal as they wander the grocery store or check out online. They are more likely to buy based on word of mouth recommendations or online reviews and have the ability to learn about products and ingredients on the fly while they shop. With a quick search on their smartphone they can read up on the difference between whole grain and whole wheat, what guar gum is and what research says about xylitol. And umbrella ingredients like “natural flavors” can send them running when they see what their trusted bloggers and researchers have to say about such terms.
Companies in the food and beverage industry can increase their marketing effectiveness by speaking directly to the concerns of these demographics in the places where they look. Social and mobile technology is an ever-increasing priority. This demands a strong presence on social platforms like Twitter, Facebook and Yelp that emphasizes reviews, endorsements, testimonials and education around the ingredients of a product. Websites must be mobile friendly. There’s also an opportunity here to emphasize the quality of ingredients when consumers are searching for your product online.
In the store, presentation and packaging reflect the quality of what’s inside. Consumers are paying attention to how your food is packaged as well as how it’s made. This means quantity is not as important as quality. A king-sized chocolate bar that will tempt your buyer to overeat questionable ingredients is becoming less attractive than the smaller, finely-wrapped chocolate indulgences touting carefully selected cocoa beans and premium, natural ingredients.
Responding to the demands of this market can spell long-term success for a business in the industry. As we’ve seen with chocolate, this may be the moment for smaller companies to make a dent in big-brand territory. As Hormel Food’s Vice President Jim Splinter pointed out to the Journal, when a brand meets the demand of the discerning indulger, it opens the door to a loyal and frequent buyer.
The process of selling your business encompasses everything from financial matters to family considerations to the (often unexpected) psychological and emotional effects of suddenly not being an owner. As you shape your plan for transitioning your own business, the following list of articles can help you consider a few of these aspects and how to handle them.
As a business owner looking toward your own retirement, you’re likely aware of the need to prepare your company to run without you. As you hand off the reigns, consider carefully what the generational makeup of your company will communicate to a buyer. This article from Generational Equity sums up the growing issue of brain drain in the marketplace and what you can do to prepare your business to thrive beyond this generation and the next.
Generational differences can be tough to overlook, but stanching the brain drain will likely require bringing on some millennials to ensure your business outlasts your ownership. Tire Business published a series of posts examining the overarching traits of the multiple generations currently active in the workplace. Knowing what you can expect from much of the Y generation can help you define which traits will help your business, which traits to avoid and how to screen for these in your hiring process.
(As a side note, if the very thought of the “everybody gets a trophy” generation makes you roll your eyes, remember not every millennial was happy to receive a trophy inscribed “Participant.”)
Building a business is a long, involved and difficult journey. Signing on the dotted line may signal the official end of your role, but it doesn’t erase the connection you’ve built with your work. Just as you planned for the succession of your business, planning for your life after the sale will help make your own transition smoother. This post from Harvard Business Review confronts the little-discussed issue of transitioning from business owner to retiree, with suggestions for avoiding the emotional fallout.
Transitioning a business demands just as much attention as building one. This Seattle Magazine article covers many of the steps you can expect to take in your transition plan as well as advice for avoiding common pitfalls.
Recent events have turned the conversation among business owners to what last week’s inauguration means for them and their organizations.
Venable LLP recently hosted a summit to examine this issue, highlighting the following. These are thoughts for consideration, not predictions, and do not represent an exhaustive list by any means.
Despite the attention on the Republican-led House and Senate, congressional leadership didn’t experience any dramatic change post-election.
The composition of the Senate remains narrowly divided with 52 Republicans and 48 Democrats. A total of 60 votes is necessary to defeat a filibuster, but Democrats with an eye on midterm elections may side with Republicans on signature legislation.
Trump has emphasized a desire to reduce government regulation and the cost of doing business. The Financial Services Committee will face the question of deregulation which, generally speaking, Republicans support and Democrats oppose. We can be certain the parties will clash over this issue.
The House Ways and Means Committee has a new ranking member: Democrat Richard Neal of Massachusetts. Considered more moderate than his predecessor, his presence increases the odds of tax reform making its way to the Congress floor.
Trump’s selections for his cabinet—a mixture of insiders, former adversaries and successful business people—are expected to be confirmed by the Senate. A full, interactive list of his nominees is available at the New York Times. Among the appointments not subject to Senate approval is the position of Regulatory Czar. Carl Icahn, Trump’s choice for the role, has unapologetically stated he wants to repeal two regulations every time a new regulation is set.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
While Trump has been difficult to read in terms of his plans, he has been vocal about immediately repealing Dodd-Frank. Such a repeal is not a one-man job. It will require a long process, the House Financial Services Committee, the Senate Banking Committee and a 60-vote majority in the Senate.
Financial Choice Act
Many of the desired revisions to Dodd-Frank would be accomplished through the Financial Choice Act. These revisions, which would impact middle-market businesses and their owners, provide relief from various registration requirements and make it easier to raise capital and run funds. As these revisions are apt to change throughout the legislative process, middle-market participants are in a unique position to voice their opinions to help shape the policy.
While corporate and individual tax reforms are likely to pass in 2017, they will most likely be done in the budget reconciliation process. This will require budget resolution, a time-consuming process that sets the most optimistic timetable just before August. With Congress focused on repealing Obamacare, however, tax reform is likely to slide into the latter half of the year. The proposed reforms include:
If these reforms pass, whether they will be retroactively applied to 2017 or look forward to 2018 remains to be seen.
Repealing major parts of the Affordable Care Act does not require the 60-vote majority if it’s done as part of the same budget reconciliation process that was used to enact it. This process can remove aspects such as:
Non-revenue aspects of the act would be untouched by the process. These include the requirement that health insurance providers issue coverage regardless of pre-existing conditions and the mandate allowing children to remain on their parents’ health insurance up to age 26.
The repeal will likely be delayed by two to three years while the Senate focuses on creating Obamacare’s replacement.
In summary, the first 100 days of Trump’s presidency will not be lacking in activity, but the results of that activity remain to be seen. While this high-level roadmap is based on current expectations, Venable emphasized that the only thing we can be certain of is the uncertainty ahead.
When it comes to marketing practices for modern companies, it’s no surprise that inbound is king. Not only is this form of marketing less expensive, it’s also more effective than traditional tactics.
Hubspot released its eighth annual report on the state of inbound marketing this month. You can download the full report here. In this post we’ll cover some of the highlights and implications business owners and marketers will want to consider as they shape their strategy.
First off, if you’re not entirely clear on the difference between outbound/traditional and inbound/new marketing, this infographic from Blue Frog Marketing sums up the basic differences and provides some rationale for the shift toward inbound.
Hubspot reported that 73% of its respondents utilize inbound for marketing their products and services. Of marketers who prioritize inbound, 81% reported their strategies are effective while only 18% of marketers who focus on outbound methods called their strategy effective.
Of the marketers who consider their marketing a success, 67% said their best source of quality leads come from inbound practices, followed by self-sourced leads from the sales team (17%) and outbound marketing (16%). Even marketers who don’t consider their strategy effective cited inbound as their best source for leads.
The ultimate goal of growing a company through marketing depends not only on bringing in the leads (marketing) but converting those leads into customers (sales). The more tightly aligned your marketing and sales teams are, the more likely you are to see growth. Of the companies who consider their marketing effective, 84% have closely aligned marketing and sales departments.
Inbound marketing practices with tightly aligned sales and marketing teams make up the winning combination for growth.
Part of aligning your teams includes creating a feedback loop between the two. When it comes to quality, salespeople graded marketing leads as low. This means even if the marketing team is bringing in hundreds of leads, salespeople won’t be able to close them because the majority of these prospects aren’t part of the company’s target market. In order for your marketing team to fix the problem, they need to know there is a problem in the first place—and that won’t happen without building feedback into your process.
Marketers’ top priorities as we head into 2017 are to:
Their biggest challenges are:
The challenges feed directly into the priorities. Generating leads is the prerequisite to conversion, but those numbers are only going to go up if you’re marketing to the right people in the right places. Know your audience. If you need to do a survey of your current customers, it will be well worth your time and can help improve the return on your investment.
If you haven’t taken the time to assess who your ideal customer is and where they get their information, you’re not alone. According to Hubspot’s report, lead-to-customer conversion was less than 20% in 2016. Marketers across the board are having a hard time attracting the right people, which means some extra effort on your part can go a long way in setting you apart from the competition.
Do your research. Peppering your message out to the masses because “it’s a numbers game and somebody will buy” is the mindset of traditional marketing. The ability to target the right audience is part of the power of new marketing.
Measuring the success of your marketing is essential to determining your strategy, budget and next steps. If you have a marketing team, they need to show they’re getting results. If you are the marketing team, you don’t want to waste your time on activities that don’t grow the business. So gather your metrics, analyze your data and move forward accordingly.
If you’re struggling to prove the effectiveness (or ineffectiveness, which is also valuable information) of your current marketing strategy, start paying attention to:
By collecting this data on a regular basis, you’ll be able to see where the issues lie and what is and isn’t working. If your sales team works 1,000 MQLs but only closes five, there’s an issue with your marketing team’s qualification process. Now you know what to fix.
Collecting data adds a step to your marketing processes, but just like getting to know your audience it’s worth it to take the time and develop the process. When you see these metrics improve, you’ll know exactly what value your marketing efforts are providing. Of those marketers who track ROI, 72% believe their strategy is effective. For those who don’t track these results, only 49% said the same. Don’t guess. Know.
The point of marketing today includes education so a prospect is well-versed in your brand and product or service by the time they speak to a sales rep. However, 63% of those surveyed said prospective customers are only “somewhat” or “not at all” informed about their company before a sales rep makes contact. This makes selling more difficult. If you want to help your sales team, educate your audience. There is a direct correlation between how much a prospect knows and how likely they are to buy.
For 2017, marketers are paying attention to the rise in the power of video with 48% planning to add YouTube to their marketing mix and 39% planning to integrate Facebook video. This trend of prioritizing video is consistent for marketers globally. Other additions to companies’ marketing tactics in 2017 will include:
What you add to your marketing mix depends on your unique business and audience. Keep your ears open for new channels of communication and find out if your audience uses it. You just might be surprised.
Business owners looking to exit their business are often curious about setting up an Employee Stock Ownership Plan. An ESOP basically allows an owner to sell the business to his or her employees, who then become shareholders of the company. This can be an attractive option when you read about the potential tax benefits and implications for your employees–not to mention your legacy–but proceed with caution. ESOPs are not a good move for every business. They are complex, expensive and, for some businesses, not viable. ESOPs can also open a business up to legal action, so be sure you understand the risks of an ESOP and know your options before moving forward.
We’ll lay out some basic information in this post, along with some of the pros and cons. If you’re considering an ESOP, be sure to research your options thoroughly with the help of your trusted advisors before deciding the best option for your business.
The ESOP was invented in the 1950s, though it was largely unheard of until the 1970s. The basic idea was to sell shares of the company directly to employees. This served as both a reward for years of hard work and motivation for employees to act in the best interests of a company in which they were literally and figuratively invested. The first ESOP was a protective measure meant to preserve the legacy of a newspaper business when its owners retired. Today the ESOP is the most common form of employee ownership in the U.S.
ESOPs are an attractive option for several reasons.
For the large number of baby boomers looking to sell their businesses, an ESOP can solve the contentious issue of finding a buyer in a market on its way to saturation with businesses for sale.
ESOPs can offer a number of tax advantages—provided the business meets a long list of regulations. And while setting up an employee stock ownership plan is very expensive, it can be less costly than selling the business, depending on the business, its structure and a long list of other factors.
For employees, an ESOP represents an opportunity to take ownership of the company, potentially with little upfront personal expense.
Middle-market companies can usually accomplish their ESOP goals with a carefully planned exit strategy. The ESOP then has the potential to reward key managers and employees for their performance and loyalty while maintaining the legacy and stability of the business. The company remains in the hands of people the owner knows and trusts. This can reflect very well on the owner who chooses to put his or her employees at the helm and sale to an ESOP can be gradual or all at once, giving the owner flexibility in how to exit the business.
As attractive as all this may sound, ESOPs are not for everybody. They come with exacting conditions and many limitations and liabilities. Your company’s ability to utilize an ESOP depends on its structure and not every company meets the legal requirements necessary to institute such a plan. The tax benefits, while attractive, are also carefully regulated and depend on their own variables, including the structure of the business.
ESOPs are extremely complex and comparatively expensive to administer. For the simplest plan, an owner can expect to pay a minimum of $40,000 just to get the ball rolling. For the life of the plan the business will encounter legal, administrative, compliance, valuation and trustee fees due annually to third parties. There are also transaction fees surrounding the addition of new employees and the retirement of established ones.
In addition to these fees there’s the matter of repaying the loan that bought the shares in the first place, because in an ESOP a trust borrows money to buy the company and then uses cash to repay that loan.
When an ESOP purchases the shares of a business, it does so based on a theoretical valuation report from a qualified firm. This valuation can be significantly lower than what a competitive selling process could achieve with multiple interested buyers and investors. It depends on the business, but in the majority of cases a company can receive a valuation for the purpose of selling 20-30 percent higher than an ESOP valuation.
These fees and payments, plus the repurchase obligations of an ESOP, mean less cash is available to invest in growing the business, hiring talent, exploring new markets, etc. The constant strain on cash flow and liquidity can stifle the business’ ability to invest in growth and innovation, which now take a back seat to funding the ESOP.
ESOPs are extremely complex and getting an unbiased opinion about them from the industry is challenging because many of the parties involved benefit in the form of third party fees. To avoid conflicts of interest, many plans hire an independent trustee to serve participant interests as well as outside firms to manage plan administration and record keeping. On top of this, Fiduciary Liability Insurance is recommended to protect the business against any claims of mismanagement of employee benefits.
Despite these precautions, the number of lawsuits associated with ESOPs are on the rise. And if an ESOP fails, it can create significant legal risks for the trustees.
ESOPs are very difficult to unwind because participants have broad voting and shareholder rights. A single participant has the ability to derail a fair transaction. Even raising capital is problematic, as new investors often prefer to avoid diluting employees’ shares or opening themselves up to lawsuits claiming they undervalued the equity of the company.
Ultimately the decision of whether an ESOP is right for you depends on your unique situation. It could be ideal or it could be a legal disaster. There is no formula. Only a careful look at your personal situation can determine what’s right for your business.
Like any business transition, setting up an ESOP takes time and planning. With so many regulations and complex requirements, talking with a professional first to determine the best path for your business will save you time, money and legal trouble. If you’re wondering whether an ESOP is right for your business, give us a call. OneAccord Capital specializes in the sale and acquisition of small to medium sized businesses in the Pacific Northwest and can help you decide whether an ESOP is a good option. Contact us today via email or call 425-250-0883 to speak with an expert about your transition plan.