| Exit Strategies Using ESOPs |
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| Written by Robert E. Massengill | |
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Alternative Transaction and Compensation Methods ESOPs are quite compatible with other transition strategies and do not have to be used independently. One growing opportunity in the market is private equity interest in the ESOP technique. Here investors provide funding, along with banks, in "low leveraged buyouts." The outcome is this: companies without as much debt but whose returns are shared with the investors. We have often heard business owners tell us that they want key managers to have the chance to earn or buy more than their ESOP account. For this reason, it is quite common to combine the ESOP with a management incentive plan or buy-in (do we need an example of what this might be?) so the next generation of leaders has an opportunity to benefit from their growth of the business. Some business owners believe that people care more about something they have purchased, and they are concerned that the ESOP provides only something given by the company. For these clients, we create a structure where managers buy in to the deal. Another approach is to create a performance-based award, where selected managers earn equity only if the appreciation in a given year exceeds certain targets. Often stock appreciation rights are used as the award since they are easy to understand and calculate. Stock appreciation rights become valuable only as the stock price rises, so value is still being accrued by everyone, though in differing proportions. Valuation Valuation is another topic that warrants discussion when considering transition strategies. The nature of construction businesses limits the valuations for most privately-held, middle market contractors. Even the roll-up craze in the late 1990s that disputed conventional rules of thumb for valuing contractors ultimately proved not to be the bellwether some anticipated. Perhaps the most important valuation principle to remember is that a given share of stock can have different values depending on the reason for the appraisal. A share of stock is worth more in a public offering, for example, than it is in an ESOP. A share of stock for a buy/sell agreement may have a lower value than the ESOP. A sale of all of the company will certainly have a greater value than a sale of less than a controlling interest. I've heard business owners say a dozen times, "I got an offer for my business at $5 million, so I want $5 million in the ESOP." Assuming the offer is bona fide, this makes all the sense in the world-until the owner tells me that he wants to sell only 30 percent of the company. Because one offer is for a controlling interest (usually >51 percent) and the other is for less, the price in the latter should be lower. Fundamentally, every valuation has to consider the percentage of stock being sold along with the characteristics of the situation that affect the marketability of the shares and the liquidity of the company offering the shares. For contractors, a rule of thumb for valuations is "book value." This rule of thumb has many weaknesses and is more applicable to some contractors than others, but it can provide a good starting point for determining a company's value. Another major factor for valuation is the sustainable level of profitability. Appraisers will end up relying mostly on several earnings valuation methods to arrive at a share's value, so profitability is the most important determinant of value. Typically, after the earnings methods have been calculated, the appraiser will compare those results to book value to see how they relate. If the earnings values are within a multiple range of book value, then the earnings estimate is probably a good one. For the right companies, using an ESOP as the whole or as a part of a transition strategy offers a degree of tax efficiency, control and flexibility not found elsewhere. While we advise most contractors to use ESOPs to buy a part of their stock, they retain the option to sell the remainder of the business later to the ESOP or to any other buyer. At the end of the day, the ESOP can be an excellent transition tool for a privately-held construction company in the right situation. For contractors seeking a gradual business transition in a tax efficient and controlled manner, an ESOP could very well be right for you. Robert E. Massengill is managing director of SES Advisors, a national provider of ESOP feasibility, financial advisory and recordkeeping services. He can be reached by phone at 888.SES.ESOP, or visit the company's website at www.sesadvisors.com. Comments (0)
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