Financing Alternatives: Growth or Harvest
In addition to an outright sale or acquisition of a business for cash, there are many alternatives to finance a growth or harvest strategy.
Leveraged Recapitalization
The business owner or management team takes on debt to buy out other shareholders’ interests. An earn-out where other shareholders’ interests are bought out over a period of time has the added benefits of less debt up front and healthier cash flows.
- Ability to maintain controlling interest and equity position
- Job security for long-time employees and management
- Satisfy conflicting interests of successors to the business
- Cash pay-out may be unfavorably taxed as a dividend as opposed to capital gains
- Financing requires new equity committed, assets and/or healthy cash-flows
Leveraged Merger or Acquisition
The company undergoes a leveraged recapitalization above and then merges with or is acquired by another company. A third-party may take a large equity position in the privately held company providing capital to fund acquisitions, large expansions or R&D programs. When an acquisition is contemplated, the third-party invests equity and/or raises necessary supplementary financing.
- Same issues inherent to leveraged recapitalization
- Inherent restructuring that often includes selling or closing business units, factories, product lines
- Controlling interest is lost
- No job security for long-time employees and management
- Employment agreements used to protect business owners and management
Private IPO
The business owner sells to a levered buy-out firm and receives cash for equity. 49% of the equity is typically held by the buy-out firm who reinvests in common stock and 51% of the equity is retained by the business owner and management who reinvest in common stock on tax-deferred basis. The buy-out firm invests in preferred shares with an annual dividend and warrants exercisable for common stock if managements’ projections are unmet to bring firm to 65% ownership. Private IPO is financed with debt.
- Ability to maintain controlling interest and equity position
- Job security for long-time employees and management
- Satisfy conflicting interests of successors to the business
- Cash pay-out is reinvested and tax-deferred
- Debt financing compared to high cost equity financing is feasible
Employee Stock Option Plan
An ESOP is a stock bonus plan or contribution stock bonus plan with a money purchase pension plan that purchases employer’s securities with funds from the employer that would have been paid as some other form of compensation. A leveraged ESOP uses borrowed funds from the company and/or third party with company securities as collateral. The loan is repaid by the ESOP from employee/employer contributions with the requirement that the employer’s contribution as a percentage of payroll or profits provides for a minimum to pay principle and interest on the loan.
- Employee motivation and productivity improvement
- Potential negative impact on dilution, ownership and control
- Potential interference with other employee benefit plans
- Potentially high costs associated with navigating complex regulatory requirements and tax concessions
- Potential negative impact on closely held company due to required annual valuation
- Officers, major shareholders and highly compensated individuals may not be favored
- Long duration IRS vesting schedules (5 year cliff or 7 years scheduled)
Public Offering
- Ability to fund rapid growth
- Difficult option for smaller firms, especially if operating in more mature, lower growth market
- SEC restrictions on liquidation (years)
- Shift to short-term profit focus can have negative effect on business
- Potential negative impact on business and high associated costs of changes in business practices including reporting and disclosure