Options for Transitioning Your Business: Unlocking Private Company Wealth

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

Our Journey Today #1

§  Ownership Timeline

§  Key Valuation Concepts

§  Ownership and Management Transitions

§  The One Percent Solution

§  Buy-Sell Agreements

§  READY for Sale

2

Between the Bookends of “Status Quo” and “Third Party Sale” (or Other Planned Disposition)

3

The Ownership Timeline

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 That

Happen to You

Things You Make Happen

Partial Sale / Transfer Total Sale / Transfer

Buy-In

Gift-In

BSA

Business and Strategic Cycles

Divorce

Shareholders

Neighbors

Suppliers

Sell-Out

Gift-Out

BSA

25 to 35 35 to 55 55 to 65+

The General Ownership Timeline

6


§  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

Overview of Key Valuation Concepts

Valuation Methods

Valuation Standards

Sane, Rational

Fair Market Value

Unique Compulsions

What is Valuation?

9

Strategic Value

9

Valuation Methods

Valuation Standards

Sane, Rational

Fair Market Value

Unique Compulsions

What is Valuation?

10

Strategic Value

10

The Real World

Appraisal World

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

Intro to Valuation

Earnings x Multiplier = Value

Financial Statements

Management Discussion

Other Company Information

Company Data

Market Pricing

Industry Expectations

Economic Outlook

Market Data

Investment Decisions

Transaction Requirements

Death & Taxes

Information

12

Approaches to Value

INCOME APPROACH

Future Focused

MARKET APPROACH

Hindsight, Anecdotal, Unreliable?

ASSET APPROACH

Company- Specific

PRESENT VALUE

13

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

Basic Levels of Value

15

Control (Strategic) Value

Control (Financial) Value

Marketable Minority Value

Nonmarketable Minority Value

Strategic Control Premium

Financial Control

Premium

Minority Interest Discount

Marketability Discount


Fair Market Value

Levels

(Equity Perspective)

16






Financial Control

Premium




Direct Value Methods

Deal-specific; Enterprise Multiples

17

Indirect Value





Income Approach Methodologies

§  Direct Capitalization

-  Converts a singular performance measure to a value

§  DCF Analysis

-  Converts projected future benefits to present value

18

18

The Income Approach

Value = Profit x Multiple

§  Equity value vs. Enterprise value

§  Which profit measure is used?

§  What is the relevant multiple?

19

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

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

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

Levels of Value Meets Basic Valuation Equation

Strategic Control Value

Financial Control Value



Conceptual Math Relationship Value

Implications

CFe(c,s)

Rs – [Gmm + Gs]

CFe(c,f)

Rf – [Gmm + Gf]

CFsh

Rhp – GV

CFe(mm)

Rmm – Gmm

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

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

Reconciling the Value Conclusion

§  Averaging of methodologies

§  Adjustments

-  Discounts and premiums

-  Non-operating assets

-  Contingent assets & liabilities

25

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

Last Look at Basic Levels of Value

$20-$22 MM

$30 MM

$14 MM






Financial Control

Premium



27

Approaches to Value #3 INCOME

APPROACH Capitalization

DCF

MARKET APPROACH

Public Cos

Internal Transactions

Market Transactions

ASSET APPROACH Net Asset Value

Excess Earnings

Methodologies

28

Ownership and Management Transitions

www.ChrisMercer.net

Truth in Advertising? – Not!

Understanding Baby Boomer Business Owners????

Z. Christopher Mercer, ASA, CFA, ABAR August 15, 2014

The Society of Financial Service Professionals

Buy-In

Gift-In

BSA

Business and Strategic Cycles

Divorce

Shareholders

Neighbors

Suppliers

Sell-Out

Gift-Out

BSA

Die in Saddle?

25 to 35 35 to 55 55 to 65+


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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

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

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

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

7 Questions for Highly Effective Business Transitions


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?

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ready

perform

readiness

prepared

investment

ready

business

do

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 ______?

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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 ________?

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worth

return

wealth

diversified

distributions

capital

rate return


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?


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 _________.

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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?


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 _________.

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maximize

plan

ready

plan

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

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

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

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The One Percent Solution

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

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§  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


+ 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

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Asset Allocation of a Business Owner with $5 Million of Liquid Assets

49

The Reality if that Business Owner Has a $20 Million Closely Held Business

50

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

Wealth Management Principles Phase Investment Principles

1 Set Objectives 2 Establish Strategies 3 Regular Monitoring 4 Constantly Enhancing 5 Review re: Reallocating

52

What is the Yield/Return … …on an investment?

(Dividends + Change in Price)

Beginning Price

53

…from your business?

(Dividends

+ Above Normal Compensation

+ Change in Price)

Beginning Price

54

What is the Yield/Return … #5

Valuation is an Essential Element of Monitoring Performance

Critical Valuation Issues

Growth Margin Activity

Financing

Yield

Return on Capital

Value = Earnings x Multiple

55

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

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Buy-Sell Agreements

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

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

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Potential “Trigger Events”

Q Quits

F is Fired

R Retires

D Disabled

D Death

D Divorce

B Bankruptcy

Others?

60

The 20 Ds

§  Departure

§  Discharge

§  Death

§  Divorce

§  Disability

§  Default

§  Disqualification

§  Disaffection

§  Disagreement

§  Disclosure

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§  Dispute resolution

§  Dilution

§  Dividends

§  Distributions

§  Drag-along rights

§  Double entities

§  Differential pricing

§  "Don’t compete" agreements

§  Donate

§  Distributions after a trigger event

Three Kinds of Buy-Sell Agreements #6

§  Fixed price

§  Formula

§  Appraisal process

§  Multiple-appraiser processes

§  Single appraiser processes

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Three Questions to Ask Yourself

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

1 2 3

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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

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How Is Your Client’s Buy-Sell Agreement Funded? #8

+ The company will issue a promissory note…

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Potential Funding Sources

»  Life insurance

»  Cash

§  Corporate assets

§  External borrowings

§  “Sinking fund”

»  Selling shareholder notes

»  Combination of cash and shareholder notes

66

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

Corporate Asset or

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True Story: Life Insurance

Dead

WHAT HAPPENS NOW? 68

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 50.02 Stock Ownership (%) 100.0% 50.0% 50.0%3 Pre and Post Life Insurance Value ($m) $10,000.0 $5,000.0 $5,000.04 Life Insurance Proceeds $6,000.05 Repurchase Liability ($5,000.0)6 Post-Life-Insurance Value $11,000.0

7 Repurchase Stock ($5,000.0) $5,000.08 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 $11,000.012 Post Life Insurance Proceeds $5,000.013 Net Change in Value from Repurchase $1,000.0

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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 50.02 Stock Ownership (%) 100.0% 50.0% 50.0%3 Pre-Life Insurance Value ($m) $10,000.0 $5,000.0 $5,000.04 Life Insurance Proceeds ($m) $6,000.0 $3,000.0 $3,000.05 Post-Life Insurance Value ($m) $16,000.0 $8,000.0 $8,000.06 Repurchase Liability ($8,000.0)7 Post-Life-Insurance Value $8,000.0

8 Repurchase Stock ($8,000.0) $8,000.09 Retire / Give Up Stock (50.0) (50.0)

10 Remaining Stock 50.0 0.0 50.011 New Stock Ownership (%) 100.0% 0.0% 100.0%12 Post-Life Insurance Value of Co. $8,000.0 $0.0 $8,000.013 Post Life Insurance Proceeds $8,000.014 Net Change in Value from Repurchase ($2,000.0)

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Be Prepared #9

§  Life is unpredictable

§  Protect yourself

§  Protect your business

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Is Your Business READY for Sale?

Is Your Business READY for Sale?

+ R

+ E

+ A

+ D

+ Y

isk

arnings

ttitudes, Aptitudes, Actions

riving Growth

ear-to-Year Comparisons

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“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!

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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

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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

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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

Between the Bookends of “Status Quo” and “Third Party Sale” (or Other Planned Disposition)

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#10

Resources

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Z. Christopher Mercer, ASA, CFA, ABAR [email protected] 901.685.2120 www.mercercapital.com www.ChrisMercer.net www.linkedin/in/zchristophermercer

MERCER CAPITAL 5100 Poplar Avenue, Suite 2600 Memphis, Tennessee 38137

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Options for Transitioning Your Business: Unlocking Private Company Wealth

Economy & Finance

Transcript of Options for Transitioning Your Business: Unlocking Private Company Wealth