Two Bites of the Apple
Sometimes in business, like in poker, it’s wise to take some chips off the table, even when you’re not ready to get out of the game. There is a very effective, and often prudent way to do this that I call “double dipping.” In effect, you have the opportunity to sell your company more than once.
The strategy is to sell a significant interest in the company to a private equity fund, roll over a meaningful ownership interest on a tax-free basis — which allows you to continue to own a sizeable piece of the business and to run the company — and invest the proceeds to diversify your net worth and establish liquidity.
The executive/owner’s daily management role does not change dramatically. Plus, you still have tremendous upside if you continue to grow the business, and you can sleep much better at night knowing most of your net worth is no longer tied up in the value of your company. Does this sound too good to be true? Actually, it happens every day.
Over the past few decades, an increasing percentage of corporate America has become owned by private equity funds. These funds aggregate money from large institutions such as pension funds and insurance companies with the express purpose of investing in the ownership of private companies, as opposed to the stocks of public companies. Some of these funds are household names such as KKR and Carlyle Group, while others are much smaller and typically do deals below the radar screen of the Wall Street Journal.
In Atlanta there are a few such firms including CGW Partners, Crescent Capital and Peachtree Equity Partners that primarily invest in mature, privately-owned businesses. The reason that the private equity funds have grown so much is that the returns they provide investors are thought to be higher than they are for the money managers who invest in public markets.
The way the transaction works is that the “Equity Sponsor,” i.e. the private equity fund, and the owner agree on the value of the business (much easier said than done.) The private equity firm then purchases a controlling stake in the company; for illustration purposes, assume 80 percent. The owner now has cash (at least what is left over after capital gains taxes, which is a lot more today than it might be after November) to invest in whatever beach homes, hedge funds or Treasury Bills he or she wishes. Because the equity sponsor pays for its shares partly with borrowed money (assume 50 percent for simplicity) the business owner’s piece of the pie going forward is actually 40 percent, although they just “sold” 80 percent of their company for cash.
Private equity funds are always looking for “platform companies,” which are businesses that they can use as a platform to do additional acquisitions of related businesses. If a private equity fund can purchase businesses that are synergistic with existing portfolio companies, they can achieve superior returns (at least in theory). Because the MBAs who operate private equity funds are not in the business of running businesses, they need the management team of the companies they acquire to stay on to run the business afterward to help them cash in.
As a business owner/CEO this presents a tremendous opportunity to build an empire using someone else’s money with significant upside — you still own a chunk of the company — and minimal downside; most of the value of your company is now in the bank.
For an owner/CEO who is at least five to seven years away from hanging up their spurs, selling to a private equity fund can be a compelling option. In addition to the estate planning benefits previously mentioned, there are several other advantages. For instance, if you have key managers who have helped you build your company who are not involved in the ownership of the company, the equity sponsor will typically allow, if not encourage, them to become shareholders through the transaction. Most private equity funds respect the value that your key managers bring to the table and will also establish incentive stock option plans or some other form of equity incentive to keep everyone rowing in the direction of shareholder value.
And if the senior managers are already shareholders, as they were in the case of Jaymar Furniture, then they can have two bites of the apple as well. In 2000 River Associates, a Chattanooga, TN-based private equity group, cashed out the principal owner of Jaymar and allowed a key executive (Guy Patenaude) to sell some of his shares. Patenaude stayed on to run the company, built it nicely, and in March 2003 sold his remaining shares along with River Associates to a public company at a much higher price than the 2000 deal.
If you manage the deal properly, selling to a private equity fund typically leads to a greater value than attempting to parcel out shares to employees or selling outright to management without the participation of an equity sponsor. If you simply went to the bank to borrow money for the company to re-purchase your shares, you would likely receive a much chillier reception. Banks that would not lend you the money to retire shares in your company in a typical leveraged re-capitalization are often willing to support an equity sponsor with a proven track record of successfully managing leveraged enterprises, particularly because they are coming to the table with a substantial pile of cash.
However, there are downsides to this strategy. Once you sell a controlling stake in your company, you are no longer in control. While this is patently obvious, many business owners seem to overlook this fact. It is problematic for some to sit in the same office running the daily operations of a business that may bear their name, and no longer be the potentate.
Using company resources to pay for that family vacation, or the leased jet service, are no longer standard operating procedure once a private equity group is involved. If the son-in-law is on the payroll because he was essentially unemployable elsewhere, he will need to find a new job. And if performance fails to meet or exceed projections, the board meetings will be a lot more intense.
In other words, some business owners are very uncomfortable with the accountability that goes along with ownership by a private equity fund. If you are not wired to deal effectively with accountability, do not do it. You will be very frustrated, particularly if the equity sponsor assigns a staffer two years out of B-school to be your new director and primary contact.
But the greatest shortcoming of this strategy is simply that it is not available to most companies. You have to have a real plum business to be a candidate for a private equity fund. This typically includes owning a business in a growing market sector, with consistent cash flows, limited debt, and a strong management team willing to stick around for a few years. If your company does meet this profile, it would be well worth it to at least consider taking two bites of the apple.
Reprinted with Permission from Catalyst Magazine March 2004
Michael Jacobs, Author
Michael Jacobs is the CEO of Jacobs Capital and Professor of the Practice of Finance at The University of North Carolina at Chapel Hill. He's the author of several books and a certified speaker.
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