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Options for Transitioning Your Business: Unlocking Private Company Wealth

In this presentation, Chris Mercer of Mercer Capital discusses the important concept of managing the wealth tied up in illiquid assets, mainly your ownership in a privately held business. Also discussed are pathways to liquidity without selling the business, including dividend policy, leveraged recapitalizations, and esops among others.

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Options for Transitioning Your Business: Unlocking Private Company Wealth

  1. 1. Options for Transitioning the Business Understanding Baby Boomer Business Owners Z. Christopher Mercer, ASA, CFA, ABAR Mercer Capital August 15, 2014 The Society of Financial Service Professionals
  2. 2. Our Journey Today #1 § Ownership Timeline § Key Valuation Concepts § Ownership and Management Transitions § The One Percent Solution § Buy-Sell Agreements § READY for Sale 2
  3. 3. Between the Bookends of “Status Quo” and “Third Party Sale” (or Other Planned Disposition) 3
  4. 4. The Ownership Timeline
  5. 5. The Ownership Transfer Matrix 5 ESOP / Management Outside Investor(s) Sales to Insiders / Relatives Combination Merger / Cash Out Going Public Gifting Programs Buy-Sell Agreements Death Divorce Forced Restructuring Shareholder Disputes Buy-Sell Agreements Sale of Business Stock Exchange w/ Public Co. Stock Cash Sale to Public Co. Installment Sale ESOP / Management Buyout Liquidation Buy-Sell Agreements Death Divorce Forced Restructuring Bankruptcy Shareholder Disputes Buy-Sell Agreements Things You Make Happen Things That Happen to You Partial Sale / Transfer Total Sale / Transfer
  6. 6. The General Ownership Timeline 25 to 35 35 to 55 55 to 65+ Buy-In Gift-In BSA Business and Strategic Cycles Divorce Shareholders Neighbors Suppliers Sell-Out Gift-Out BSA 6
  7. 7. The Ownership Timeline § Where are you in the ownership timeline? § Where is your business? § The challenges of cross-generational ownership § Valuation events can affect all parts of the ownership timeline 7
  8. 8. Overview of Key Valuation Concepts
  9. 9. Fair Market Value Valuation Methods Valuation Standards Sane, Rational Unique Compulsions What is Valuation? Strategic Value 9
  10. 10. Fair Market Value Valuation Methods Valuation Standards Sane, Rational Unique Compulsions What is Valuation? 10 Strategic Value 10 The Real World Appraisal World
  11. 11. The “GRAPES” of Fair Market Value #2 G It is a growth world § Price, Volume R It is a world of risk & reward § Capital, Three-Tiers, Investment, Returns A It is an alternative investment world § Markets, Economy, Uniqueness, Industry Integration P It is a present value world § A dollar today is greater than a dollar tomorrow E It is an expectational world § Most business value is prospective, not historical S It is a sane and rational financial world § Fair Market Value versus Strategic / Synergistic Value 11
  12. 12. Intro to Valuation Earnings x Multiplier = Value Company Data Financial Statements Management Discussion Other Company Information Market Data Market Pricing Industry Expectations Economic Outlook Information Investment Decisions Transaction Requirements Death & Taxes 12
  13. 13. Approaches to Value PRESENT VALUE INCOME APPROACH Future Focused MARKET APPROACH Hindsight, Anecdotal, Unreliable? ASSET APPROACH Company- Specific 13
  14. 14. Equity Value vs. Enterprise Value § Enterprise value (industry experts’ focus) - The value of your total “assets” - Conceptually familiar to many owners + Rules of thumb + Representative of virtually all transactions § Equity value (primary valuation focus) - Equity value + debt = enterprise value - Obscure to most business owners - Requires more disciplined modeling and considerations to develop 14 14
  15. 15. Basic Levels of Value 15 Control (Strategic) Value Strategic Control Premium Control (Financial) Value Marketa ble Minority Value Nonmarketable Minority Value Financial Control Premium Minority Interest Discount Marketability Discount
  16. 16. Basic Levels of Value Fair Market Value Levels (Equity Perspective) 16 Control (Strategic) Value Strategic Control Premium Control (Financial) Value Marketa ble Minority Value Nonmarketable Minority Value Financial Control Premium Minority Interest Discount Marketability Discount
  17. 17. Basic Levels of Value Direct Value Methods Deal-specific; Enterprise Multiples 17 Indirect Value Control (Strategic) Value Control (Financial) Value Marketa ble Minority Value Nonmarketable Minority Value
  18. 18. Income Approach Methodologies § Direct Capitalization - Converts a singular performance measure to a value § DCF Analysis - Converts projected future benefits to present value 18 18
  19. 19. The Income Approach Value = Profit x Multiple § Equity value vs. Enterprise value § Which profit measure is used? § What is the relevant multiple? 19
  20. 20. Key Factors § Mark expenses to normalized or pro forma levels - Non-recurring or unusual events - Differentiating return on labor from return on capital + a.k.a. compensation adjustments and other benefits - Strategic vs. financial adjustments/ considerations 20
  21. 21. Intro to Valuation Value = Multiple x Performance Measure Equity Value Total Capital Value Equity Value Total Capital Value P/E (1/(R – G) Weighted Average Cost of Capital Equity Return Market Multiple Net Earnings Debt-Free Net Income Net Cash Flow to Equity EBITDA Gross CF to Invested Capital 21
  22. 22. What’s the Big Deal About EBITDA? § Gross cash flow of an enterprise providing for six critical things § Reinvest in capital expenditures or other investments § Working capital needs from growth § Interest payments on debt § Principal payments on debt § Taxes § Returns to shareholders 22
  23. 23. Levels of Value Meets Basic Valuation Equation Strategic Control Value Financial Control Value Marketable Minority Value Nonmarketable Minority Value Conceptual Math Relationship Value Implications CFe(c,s) Rs – [Gmm + Gs] CFe(c,f) Rf – [Gmm + Gf] CFe(mm) Rmm – Gmm CFsh Rhp – GV CFe(c,s) ≥ CFe(c,f) Gs ≥ 0 Rs ≤ Rf Ve(c,s) ≥ Ve(c,f) CFe(c,f) ≥ CFe(mm) Gf ≥ 0 Rf = Rmm (+/- a little) GV = Rmm CFsh ≤ CFe(mm) Gv ≤ Gmm Rhp ≥ Rmm Ve(c,f) ≥ Vmm Vmm Vsh ≤ Vmm 23
  24. 24. What Is a Multiple? § Required rate of return - Equity - Total Capital (WACC) § Growth rate § 1 ÷ (Rate of Return – Growth Rate) § No magic § R -15% § G = 5% § 1/(15% - 5%) = 10x 24
  25. 25. Reconciling the Value Conclusion § Averaging of methodologies § Adjustments - Discounts and premiums - Non-operating assets - Contingent assets & liabilities 25
  26. 26. Tests of Reason § Relative value analysis § Reconciliation of current value with past value § Reconciliation with broad market financial measures § Reconciliation with transaction activity (internal and external) § Reconciliation to rules of thumb? 26
  27. 27. Last Look at Basic Levels of Value $30 MM $20-$22 MM $14 MM Control (Strategic) Value Strategic Control Premium Control (Financial) Value Marketa ble Minority Value Nonmarketable Minority Value Financial Control Premium Minority Interest Discount Marketability Discount 27
  28. 28. Approaches to Value Methodologies #3 INCOME APPROACH Capitalization DCF MARKET APPROACH Public Cos Internal Transactions Market Transactions ASSET APPROACH Net Asset Value Excess Earnings 28
  29. 29. Ownership and Management Transitions www.ChrisMercer.net
  30. 30. Truth in Advertising? – Not! Understanding Baby Boomer Business Owners???? Z. Christopher Mercer, ASA, CFA, ABAR August 15, 2014 The Society of Financial Service Professionals
  31. 31. 25 to 35 35 to 55 55 to 65+ Buy-In Gift-In BSA Business and Strategic Cycles Divorce Shareholders Neighbors Suppliers Sell-Out Gift-Out BSA Die in Saddle? The Ownership Timeline 31
  32. 32. 10 Reasons That Businesses Change Ownership 1. A primary owner dies unexpectedly 2. A key employee leaves 3. The owner gets “tired” and decides to sell 4. Unexpected offers come along 5. Business reversals happen 6. The primary owner divorces 7. Life-changing experiences occur 8. Gift and estate tax planning 9. The second (or third) generation is not up to the task 10. Normal lifetime planning dictates timing 32
  33. 33. 10 Thoughts on CEO Management Succession for Private Companies 1. Transition before it is necessary 2. Transition before you are ready 3. Link leadership development into succession planning 4. Share knowledge with your senior team 5. Consider potential successors 6. Set an emergency plan into place 7. Succession planning is a risk management function 8. Avoid the “just like me” trap 9. Develop a succession plan and don’t wait on events 10. Figure out the ongoing role for the old CEO 33
  34. 34. 5 Ownership Transition Mistakes to Avoid 1. No Buy-Sell Agreement 2. Delay or Avoidance in Making Desired Gifts/Transfers 3. Patriarch Won’t Let Go of Control 4. No Strategic Thinking in Transfer of Ownership 5. Failure to Transition Ownership to Next Management Generation 34
  35. 35. 7 Questions for Highly Effective Business Transitions 1. Is your business _________ for sale? 2. Are you _________ for your business to be ready for sale? 3. What is _________ all about? 4. Do you treat your ______ as the ______ that it is? 5. Will your buy-sell agreement _________? 6. Are you _________ to make a successful transition happen? 7. What will you _________ after you sell/ transition/graduate? 35
  36. 36. 7 Questions for Highly Effective Business Transitions 1. Is your business _________ for sale? 2. Are you _________ ready for your business to be ready for sale? 3. What is _________ all about? 4. Do you treat your _________ as the _________ that it is? investment 5. Will your buy-sell agreement _________? 6. Are you _________ to make a successful transition happen? 7. What will you ___ after you sell / transition / graduate? 36 ready perform readiness prepared business do
  37. 37. 10 Questions to Ask Yourself 1. How much is my company _________? 2. What has been the shareholders’ _______ for: § The last year? _____% § The last five years? _____% 3. What portion of your _________ is tied up in your closely held business? 4. Is your wealth adequately _________ (including your business)? 5. Does your business make _________ in excess of taxes each year? § What is your _________ of _________ on reinvestments in the business? § Are you accumulating excess ______? 37
  38. 38. 10 Questions to Ask Yourself 1. How much is my company _________? 2. What has been the shareholders’ _______ for: § The last year? _____% § The last five years? _____% 3. What portion of your _________ is tied up in your closely held business? 4. Is your wealth adequately ___________ (including your business)? 5. Does your business make _____________ in excess of taxes each year? rate return § What is your _________ of _________ on reinvestments in the business? § Are you accumulating excess ________? 38 worth return wealth diversified distributions capital
  39. 39. 10 Questions to Ask Yourself 6. Are you personally reinvesting distributions in a plan to _________ your wealth? 7. What is the _________ to obtain liquidity from your ownership of the business? 8. Is your business _________ for sale? 9. Are there things you know _________ for your business to be ready for sale? 10. What is the _________to transfer ownership and/or management of your business? § Is the plan _________? § If it is not _________, it does not _________. 39
  40. 40. 10 Questions to Ask Yourself 6. Are you personally reinvesting distributions in a plan to _________ your wealth? 7. What is the _________ to obtain liquidity from your ownership of the business? 8. Is your business _________ for sale? 9. Are there things you know _________ for your business to be ready for sale? 10. What is the _________to transfer ownership and/or management of your business? § Is the plan _________? § If it is not _________, it does not _________. 40 maximize plan ready plan
  41. 41. Would you be interested if I could tell you how to… § Accelerate cash returns § Enhance returns on equity § Enhance value growth § Develop shareholder liquidity § Optimize capital structure § Enhance company performance § Shareholder diversification § Reduce overall portfolio risk § Focus management attention 41
  42. 42. Would you be interested if I could tell you how to obtain liquidity and diversification without selling ALL of the business? § Dividends § Special dividends § Dividend recapitalizations § Stock repurchases § Leveraged stock repurchases § Combined special dividends and redemption (with leverage) 42
  43. 43. Would you be interested if I could tell you how to obtain liquidity and diversification without selling ALL of the business? #4 § Partial management buy-in (installment sale) § Management buy-in with outside equity § Private equity investment § Private equity recapitalization § ESOP (Service Companies) § Private merger with partial redemption 43
  44. 44. The One Percent Solution
  45. 45. Pre-Liquid vs. Liquid Wealth: Things to Remember 1. The definition and importance of the concept of pre-illiquid (i.e., liquid) wealth 2. Pre-liquid wealth is always in a process of becoming liquid wealth. Business owners should focus on and accelerate this process where reasonable to manage all their wealth 3. Buy-sell agreements are a critical tool for managing and protecting pre-liquid wealth 45
  46. 46. The One Percent Solution § Consider an annual budget for managing your illiquid private company wealth (defined as your ownership interest in your private company) similar to the fees paid to manage your liquid wealth (stocks, bonds, or other liquid assets). It costs money to manage wealth whether liquid or illiquid, so create a budget for managing your illiquid private company wealth. Source: Unlocking Private Company Wealth 46
  47. 47. The One Percent Solution + Allocate a percentage of value for the illiquid assets under management to provide the budget necessary to manage wealth + Liquid Assets - 1% of assets under management, +/-, depending on asset category + Pre-Liquid Assets - 0.5% to 2% of value (AUM) for businesses depending on value 47
  48. 48. 48
  49. 49. Asset Allocation of a Business Owner with $5 Million of Liquid Assets 49
  50. 50. The Reality if that Business Owner Has a $20 Million Closely Held Business 50
  51. 51. Why Should You Care? Are you working to manage ALL your wealth, both liquid and pre-liquid? Baby boomers are transitioning their wealth and seeking to begin the next phase of their lives 51
  52. 52. Wealth Management Principles Phase Investment Principles 1 Set Objectives 2 Establish Strategies 3 Regular Monitoring 4 Constantly Enhancing 5 Review re: Reallocating 52
  53. 53. What is the Yield/Return … …on an investment? (Dividends + Change in Price) Beginning Price 53
  54. 54. …from your business? (Dividends + Above Normal Compensation + Change in Price) Beginning Price 54 What is the Yield/Return … #5
  55. 55. Valuation is an Essential Element of Monitoring Performance Critical Valuation Issues Growth Margin Activity Financing Yield Return on Capital Value = Earnings x Multiple 55
  56. 56. One Percent Solution Activities § Life insurance funding § Wealth manager compensation § Annual valuations and monitoring value growth § Buy-sell agreement pricing (per annual valuations) § Annual legal reviews § Estate planning § Financial planning § “Make ready” consulting projects 56
  57. 57. Buy-Sell Agreements
  58. 58. What Is a Buy-Sell Agreement? § Buy-sell agreements are agreements by and between the shareholders (or equity partners of whatever legal description) of a privately owned business and, perhaps, the business itself that establish the mechanism for the purchase of stock following the death (or other adverse changes) of one of the owners. In the case of corporate joint ventures, they also establish the value for break-ups or for circumstances calling for one corporate venture partner to buy out the other partner 58
  59. 59. Buy-Sell Agreements Require agreement at a point in time Relate to transactions that will or may occur at future points in time Define the conditions that “trigger” the buy-sell provisions Determine the price(s) at which the specified future transactions will occur 59
  60. 60. Potential “Trigger Events” Q Quits F is Fired R Retires D Disabled D Death D Divorce B Bankruptcy Others? 60
  61. 61. The 20 Ds § Departure § Discharge § Death § Divorce § Disability § Default § Disqualification § Disaffection § Disagreement § Disclosure 61 § Dispute resolution § Dilution § Dividends § Distributions § Drag-along rights § Double entities § Differential pricing § "Don’t compete" agreements § Donate § Distributions after a trigger event
  62. 62. Three Kinds of Buy-Sell Agreements #6 § Fixed price § Formula § Appraisal process § Multiple-appraiser processes § Single appraiser processes 62
  63. 63. Three Questions to Ask Yourself 1 2 3 Do you have a buy-sell agreement? If so, what type of agreement is it? Do you know what your buy-sell agreement says? There are six defining elements that must be in every process agreement if you want the valuation process and, therefore, the agreement, to work How is your buy-sell agreement funded? How life insurance proceeds are treated can make a big difference in the valuation of the company 63
  64. 64. The 6 Defining Elements of Process Buy-Sell Agreements #7 Standard of Value Qualifications of Appraisers Level of Value Appraisal Standards The “As Of” Date Funding Mechanism 64
  65. 65. How Is Your Client’s Buy-Sell Agreement Funded? #8 + The company will issue a promissory note… 65
  66. 66. Potential Funding Sources » Life insurance » Cash § Corporate assets § External borrowings § “Sinking fund” » Selling shareholder notes » Combination of cash and shareholder notes 66
  67. 67. Funding the Buy-Sell Agreement » Life insurance typically purchased by company for corporate buy-sell agreements » Key question: Is life insurance intended as a Funding Vehicle or Corporate Asset 67
  68. 68. True Story: Life Insurance Dead WHAT HAPPENS NOW? 68
  69. 69. Funding Mechanism What about Life Insurance Treatment for Valuation Purposes? Harry Proceeds are a Funding Vehicle Company (Estate) Sam 1 Stock Ownership (Shares) 100.0 50.0 50.0 2 Stock Ownership (%) 100.0% 50.0% 50.0% 3 Pre and Post Life Insurance Value ($m) $10,000.0 $5,000.0 $5,000.0 4 Life Insurance Proceeds $6,000.0 5 Repurchase Liability ($5,000.0) 6 Post-Life-Insurance Value $11,000.0 7 Repurchase Stock ($5,000.0) $5,000.0 8 Retire / Give Up Stock (50.0) (50.0) 9 Remaining Stock 50.0 0.0 50.0 10 New Stock Ownership (%) 100.0% 0.0% 100.0% 11 Post-Life Insurance Value of Co. $11,000.0 $0.0 $11,000.0 12 Post Life Insurance Proceeds $5,000.0 13 Net Change in Value from Repurchase $1,000.0 69
  70. 70. Corporate Asset What about Life Insurance Treatment for Valuation Purposes? Harry Proceeds are a Corporate Asset Company (Estate) Sam 1 Stock Ownership (Shares) 100.0 50.0 50.0 2 Stock Ownership (%) 100.0% 50.0% 50.0% 3 Pre-Life Insurance Value ($m) $10,000.0 $5,000.0 $5,000.0 4 Life Insurance Proceeds ($m) $6,000.0 $3,000.0 $3,000.0 5 Post-Life Insurance Value ($m) $16,000.0 $8,000.0 $8,000.0 6 Repurchase Liability ($8,000.0) 7 Post-Life-Insurance Value $8,000.0 8 Repurchase Stock ($8,000.0) $8,000.0 9 Retire / Give Up Stock (50.0) (50.0) 10 Remaining Stock 50.0 0.0 50.0 11 New Stock Ownership (%) 100.0% 0.0% 100.0% 12 Post-Life Insurance Value of Co. $8,000.0 $0.0 $8,000.0 13 Post Life Insurance Proceeds $8,000.0 14 Net Change in Value from Repurchase ($2,000.0) 70
  71. 71. Be Prepared #9 § Life is unpredictable § Protect yourself § Protect your business 71
  72. 72. Is Your Business READY for Sale?
  73. 73. Is Your Business READY for Sale? + R + E + A + D + Y isk arnings ttitudes, Aptitudes, Actions riving Growth ear-to-Year Comparisons 73
  74. 74. “Ready” vs. “Up for Sale” + Not a discussion of why or when you might sell your business + No encouragement whatsoever to sell your business + No judgment that you should sell your business + Simply encouragement to get the business “ready” so that when you are ready, the business will be ready, too! + Or when something unexpected happens and you need to sell, you will also be ready! 74
  75. 75. Compelling Logic for Readiness + Most businesses do not make it to the second generation + They go out of business + They are sold or merged + Non-family/original shareholders run (and likely own) the business + A generation is roughly 20 years + Logic suggests that on average, business will “change hands” every 10 years or so + “Half-life” less than 10 years 75
  76. 76. Observations on Readiness + Business life seems to present one non-recurring event following another following another (“Yes, buts” in waiting…) + Why is it that most of the surprises that occur in business are adverse to earnings and value? + If you understand the nature of business value and the value of your business, you will enhance your focus on planning and readiness for life’s unexpected as well as expected events 76
  77. 77. The End of Our Journey Today § Ownership Timeline § Key Valuation Concepts § Ownership and Management Transitions § The One Percent Solution § Buy-Sell Agreements § READY for Sale 77
  78. 78. Between the Bookends of “Status Quo” and “Third Party Sale” (or Other Planned Disposition) #10 78
  79. 79. Resources Give me your business ChrisMercer.net Amazon.com card for publication notification Visit Mercer Capital’s website to subscribe to complimentary newsletters and helpful industry publications, as well as review our library of articles. MercerCapital.com
  80. 80. Z. Christopher Mercer, ASA, CFA, ABAR mercerc@mercercapital.com 901.685.2120 www.mercercapital.com www.ChrisMercer.net www.linkedin/in/zchristophermercer MERCER CAPITAL 5100 Poplar Avenue, Suite 2600 Memphis, Tennessee 38137 80

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