Privately held businesses may be more concentrated, the standalone and nonsystematic risk tends to be very high, and the asset is generally illiquid. Noninvestment psychological issues are often significant. The owner may derive a large part of his sense of self-worth as well as his income from the business. Business and personal life are often intermixed. If the concentrated position was received from a family member, there can be a strong sense of attachment to the holding.
Exit strategies for the business must be considered. Exit strategies include monetization, sale, a phased sale over time, or an adjustment to the business structure that will provide the owner with cash. Exit strategy analysis should consider:
- The value of the business.
- Tax rates that would apply to the potential exit strategies.
- Availability and terms of credit, as borrowing may be involved in financing any transaction.
- The buying power of potential purchasers.
- Currency values if the transaction involves foreign currencies.
The strategies to consider in managing a private business position include:
Strategic buyers take a buy and hold perspective and generally offer the highest price to the seller. Strategic buyers seek to combine the business with an existing business of the buyer.
A financial buyer or a financial sponsor is often a private equity fund planning to restructure the business, add value, and resell the business (typically in a 3 to 5 year period). They generally purchase more mature, established businesses and offer a lower price than a strategic buyer.
Recapitalization is generally used for established but less mature (middle market) companies. In a leveraged recapitalization the owner may retain 20% to 40% of the equity capital and sell 60% to 80% of his shares back to the company. The owner continues to manage the business with a significant financial stake. A private equity firm could arrange the financing for the company to purchase the owner’s stock. In exchange, the private equity firm receives equity in the company. This could be part of a phased exit strategy for the owner; sell and receive cash for a portion of his equity in the initial transaction, then participate in and sell his remaining shares when the private equity firm resells their position in a few years. Taxes are owed on the cash received in the initial recapitalization, but additional taxes are deferred until the owner’s remaining stock is sold. If tax rates are expected to increase in the future, the transaction can be structured with more cash in the initial transaction.
In a sale to (other) management or key employees, the owner sells his position to existing employees of the company. There are drawbacks:
- Generally the buyers will only purchase at a discounted price.
- The buyers may lack financial resources and expect the existing owner to finance a significant portion of the purchase with a loan or a promissory note, which is a promise that the buyers will pay in the future.
- The promissory note is often contingent on future performance of the business with no assurance current employees or managers are capable of running the business and making the payments. This structure may be called a management buyout obligation (MBO) because existing managers buy the business in exchange for an obligation to pay for the business in the future.
- Negotiation with employees to sell the business to them may fail and damage the continuing employer/employee relationship needed to continue operating the business.
In a divestiture, sale, or disposition of non-core business assets, the owner sells nonessential business assets and then directs the company to use the proceeds to pay a large dividend to, or repurchase stock from, the owner. In either case, the owner receives cash while retaining the rest of the stock and control of the business.
A sale or gift to family members could be structured with tax advantages such as the estate tax freeze or limited partnership valuation discounts discussed earlier. If the family members lack the financial resources to pay cash, the existing owner could do an MBO and accept a promissory note for the purchase price. Unfortunately, neither a gift nor MBO sale provides the existing owner much immediate cash flow.
A personal line of credit secured by company shares. The owner can borrow from the company and pledge her company stock as collateral. If the company does not have the financial resources to make the loan, the company could borrow to obtain the cash for the loan to the owner. Interest paid by the company can be a tax-deductible business expense.
Alternatively, the line of credit (loan to the owner) could be from a third-party lender. The company may offer the lender a put, allowing the lender to transfer the loan to the company for cash. This increases the lender’s assurance of repayment in exchange for more favorable loan terms to the owner.
With an initial public offering (IPO) the owner sells a portion of his shares to the public and transforms the remaining shares into liquid public shares. Generally, IPO purchasers will expect the owner to retain a significant ownership stake and continue to manage the business. The existing owner now faces the increased scrutiny of running a public company.
With an employee stock ownership plan (ESOP), the owner sells stock to the ESOP, which in turn sells the shares to company employees. In a leveraged ESOP, the company borrows the money to finance the stock purchase. In the United States (subject to additional restrictions), the owner’s sale of shares may not trigger a capital gains tax.