Milk, not Steak
Entrepreneurs who want to get cash out of their business without giving it up have a number of options that can be adapted to suit a wide array of preferences and circumstances. At the blunt end of the stick is the straightforward bank loan. But depending on the owner’s preferences, he or she can employ other, more complex tactics such as selling part of the business to employees through an employee stock ownership plan (ESOP), or selling shares to a trust for family members. For those who plan to cede control at some undetermined point in the future, taking on equity partners in a deal structured to accommodate an eventual, rather than immediate, exit can offer the biggest payout.

The liquidity strategy must conform to the owner’s vision of a personal and professional future. Many find that, ultimately, they will sell the company either in whole or part, so giving careful thought to one’s preferences and goals is the first step. “You need to use a decision tree,” says Holly Isdale, managing director in the wealth advisory team at Lehman Brothers in New York. “Do you want to grow the business, or just take out equity for personal use? Do you think you will eventually sell the business, or give it to your children?”

For those who want to keep their business closely held, the most straightforward option is to swap equity for debt—that is, have the company borrow money and pay the proceeds to the owner as a special dividend. Bankers typically refer to this as a leveraged recapitalization because the owner is changing the capital structure of the company by boosting the amount of debt. These transactions are attractive when interest rates are relatively low, as they are now. Also, since banks typically have no desire to run a business, the owner is generally free to operate the company as he or she sees fit. However, bank loan covenants do typically restrict an owner’s purview. For example, they may bar the company from borrowing more, or prohibit it from undertaking large acquisitions or asset sales within a given period.

“If your long-term goal is to give the business to the children, then the loan option is attractive since the family can simply tap into cash flow and repay the loan over time,” Isdale says. The downside is that some banks may be reluctant to lend if the primary purpose of the loan is to put cash in the founder’s pocket, not to invest in the business. In most cases, they will demand a higher interest rate than on loans that finance a business opportunity.

If the goal is to eventually pass the mantle to children, Susan Mucciarone, regional managing director of Calibre, the family office arm of Wachovia Bank in Philadelphia, says owners can integrate a recapitalization into their overall estate plan. For example, the owner might find it advantageous to lend a trust the money to buy a minority or nonvoting stake in the company, which the trust would hold for the benefit of his or her children. The trust uses cash from the company’s earnings to service the loan.

This strategy gives the current owner some financial flexibility and the ability to diversify assets, while keeping the company firmly in the family’s control. Again, the current low interest rate environment benefits these transactions. (The federal government sets the minimum interest rates for such arrangements.) However, with this strategy, the payout is spread over the life of the loan, and may not suit entrepreneurs who want an immediate lump sum.

ESOP Fables
For those who want that lump sum, Troy Smith, a financial planner at Navigon Financial Group in Durham, N.C., recommends setting up an ESOP, an increasingly popular liquidity option that makes employees of a company stockholders in the business. According to the ESOP Association in Washington, there are approximately 10,000 ESOPs in the United States, and 90 percent of those are in privately held companies. “It’s a fantastic way for a closely held company to create liquidity for shareholders,” he says.

In these transactions, an owner sells shares in the company to an ESOP, which finances the purchase with proceeds from a bank loan. The owner receives a lump sum payment and can actually defer capital gains taxes on that payout by buying qualified assets that diversify his portfolio. The corporation can deduct the loan payments the ESOP makes to the bank. Meanwhile, the owner retains control of the company.

The trick with an ESOP, Smith explains, is ensuring the appraisal of the value of the stock prior to the sale is incontestable. If the ESOP trustee later claims to have paid too much for the stock, the entrepreneur could find himself and his company financially liable. Also, because the shares sold to the ESOP are themselves illiquid (they are not traded on an exchange) and often nonvoting, they are worth less than traded, voting shares would be, so the payout that the owner receives is often smaller than that which he would have received if he took the company public.

Another problem with ESOPs is their expense; they typically cost a minimum of $100,000 to set up and then $20,000 a year to maintain. Other liquidity transactions typically have a one-time cost of $10,000 to $40,000.

The sharing of ownership with employees is another factor with which the entrepreneur must be comfortable. The advantages of an ESOP notwithstanding, bringing in minority shareholders can be risky. Smith argues these can be more trouble than they are worth, especially if the business suffers a downturn. Depending on state law, he says, minority shareholders can force the dissolution of the company, or the buyout of their shares at a premium. “I’ve seen it a lot,” he says. “So sometimes, someone trying to create liquidity might end up shooting himself in the foot.”

From Your Side of the Table

Five essential questions to ask your financial advisor about liquidity strategies for your company:

1. Do current interest rates and my company’s credit quality make a leveraged recapitalization a viable option for obtaining liquidity? 2. Would the costs of establishing an ESOP outweigh the benefits for my company? 3. How do I ensure I obtain an accurate valuation that an ESOP trustee cannot challenge later? 4. Can I take my company public and still maintain control? 5. Can I sell a stake to a private equity firm and still bequeath control of my company to my children?

The Adoring Public
Taking a company public is, for an entrepreneur who is interested simply in gaining some liquidity, a drastic step. While it certainly delivers liquidity, and (depending on the stake offered to investors) allows the owner to maintain a degree of control, this strategy comes freighted with caveats and considerations. “This is the last thing we’d recommend,” maintains Tony Greene, a cofounder of StillPoint, a family office based in Atlanta. The costs of going public and of complying with securities and accounting regulations can total several million dollars. Indeed, most underwriters take 5 percent of the proceeds, at least, as a fee. “Frequently you don’t create as much wealth as you might think,” Greene notes.

Even those owners who maintain a controlling stake must realize that managing a public company differs significantly from running a private one. The intense scrutiny under which public companies operate is unlike anything that most family run businesses endure. With thousands of stockholders questioning every move management makes, business decisions can no longer be made with an eye strictly to long-term goals. Investors and analysts demand quarter-by-quarter performance. They nose around the operations and look askance at the quirks that over time can spring up in family businesses. “The fact that you pay Aunt Susie $200,000 a year to come in twice a week to empty trash cans, well, guess what, in the public markets you can’t do that,” Greene says.

This leaves the private equity route, which allows the owner to retain control in the short run, but usually requires him to cede it in the longer term. Joe Greco ultimately chose to sell a stake in his company to Summit Partners, a well-known, Boston-based private equity firm. He says he now benefits from additional credibility with client prospects, who before worried about PSC’s long-term viability. Summit has two of five board seats at PSC and has already helped grow the business by introducing PSC to its own portfolio companies, two of which are now customers. “These guys are savvy and smart, with all kinds of contacts. They have experience dealing with banks, and they have experience on the M&A side, all of which will help grow the business.”

Selling a large voting stake in a company will often deliver a higher valuation, a larger payout and attractive tax benefits. Many entrepreneurs—like Greco—eventually come to terms with taking on business partners and accept the trade-off of cash for control. However, this is only a first step: Private equity firms and venture capitalists want an exit strategy three to seven years down the road. “You’re committing to a liquidity event or impairing the balance sheet through a loan,” Isdale points out. “You don’t want to go the private equity route unless you’re comfortable with that.”

For Greco, coming to grips with the fact that he would no longer be in sole control of his company was difficult, and took time. “It was a psychological hurdle,” he says. “You’re thinking, ‘Oh my God, I’m not going to be the only one in the room.’”

However, he determined that the benefits of partnering with Summit outweighed this cost. “I was able to take some money off the table, and never have to worry about money again,” he says. “Depending on what the final exit strategy is, I’d be OK if we sell to a larger firm and they say, ‘We want you to stay,’ or if they say, ‘We don’t need you.’ In that case, I’ll just start another business.” 

Michael Sisk, based in Pelham, N.Y., is a regular contributor to Worth. michaelasisk@yahoo.com