One of the advantages of using an ESOP is that it provides a tax-advantageous method for generating liquidity and transitioning stock to employees since company contributions to the trust are generally tax-deductible. This method also rewards long-term employees by giving them the opportunity to become owners of the company. A primary disadvantage is that it increases the administrative burden on the company and creates legal complications, such as creating a fiduciary duty to the ESOP. In addition, the valuation of the company is usually not as high as with some of the other liquidity options because the liquidity is being created from continuing company cash flow and available current leverage.
Another method through which employees can obtain ownership of the company is a management buyout. In this scenario, management purchases the company from the owner, which they can accomplish with a combination of funding sources: using their own funds, teaming up with a third party that will provide the capital and borrowing from third-party lenders (capital markets currently are robust with liquidity). The advantage to sellers is that the business remains with familiar faces, cutting down on due diligence costs, major disruption to the business and uncertainty. In addition, management is often in the best position to understand the upside potential of an investment in the company.
Initial Public Offering
Depending on the size of the business and the health of the public markets, a business owner can also consider an initial public offering. Under this scenario, the business owner obtains liquidity by selling shares to the public. This option can provide liquidity to all the shareholders of the business and can raise the prestige of the company. After going public, the business will have a valuable tool for attracting and retaining key employees—public company stock. In addition, the company will have a better ability to issue its own stock as part of any future acquisitions.
However, there are many drawbacks to going public. The process can be costly and take tremendous time and resources. For example, once the company becomes public, it will be subject to reporting requirements that take time and money to fulfill. In addition, the company’s financial information will no longer be confidential and the company will face pressure to meet the public’s expectations on performance.
Going public was a very popular exit option many years ago. In today’s environment—with stricter oversight and reporting requirements—fewer business owners are considering this option.
Dividend Recap
Some business owners seek to realize some liquidity and take some “risk off the table,” but are not ready to consider a sale of their equity. A dividend recapitalization is a technique to accomplish this goal. This entails borrowing funds from a lender, secured by the company assets. The loan is then distributed to the company as a dividend to the owner. The company now has more leverage on its balance sheet, but the owner is able to realize liquidity as a result (which is often tax advantageous). The capital markets are competitive, and often good companies can borrow attractive multiples of earnings at very low rates without any personal recourse to the owner. However, this may not work if the company already has incurred significant debt or if its free cash flow will not allow it to meet its debt obligations. In addition, business owners may not like the idea of taking on debt to pay themselves, as leverage often scares business owners who are not used to operating with debt. This technique is a quick and inexpensive way to retain ownership and capitalize on the value of the business.
A recent example of a dividend recap involved a private equity client that wanted to take some profits out of one of its portfolio companies. Since the private equity client had only owned the company for two years, it was not ready to sell the company. However, a rapid growth in earnings caused a lot of profit to be held in the company. Rather than sell, the private equity firm had the company take on additional debt, the proceeds of which were distributed to the private equity firm so it could realize some of its investment profits.
Decisions, Decisions