ESOP vs. Private Equity vs. M&A Sale

There are many motives for owners of private business to transfer their stock, including:

  • Diversify their estate
  • Create a family legacy
  • Use transfer of business as a wealth-creating vehicle
  • Grow the business without using personal cash
  • Have no partners
  • Maximize the transfer process

Ultimately, a transfer motive leads an owner to action. Most owners think they have relatively few transfer choices. Some transfer professionals reinforce this limitation because they only work in a narrow specialized area and do not know the full range of available options. The owner may be advised that selling the entire business is the best solution, when in fact, it may be a less desirable alternative. Far from being limited, there is a wide spectrum of transfer alternatives. We believe it is of critical importance to engage professionals that can fairly evaluate all alternatives.

Transfer methods may be tax driven, market driven, finance driven, or a combination of all three. It is frequently possible to combine methods without violating the internal integrity of each, because transfer methods are not necessarily mutually exclusive. We have found it is often beneficial to pursue multiple methods simultaneously and only make a decision once all of the potential outcomes are know.

Inevitably, after-tax income is going to be a driving factor in determining the right exit strategy. When assessing whether to sell the company to a strategic industry buyer, recapitalize or sell your business to a private equity group, or explore the ESOP alternative, the diagram below best illustrates the comparative after-tax sale proceeds. It also speaks to both the amount of risk to personal capital a seller incurs after the transaction closes and what the estimated monthly income differences are when comparing the three common transaction alternatives. Our firm executes all three of these transactions for clients simultaneously.

While every situation is unique, this generally illustrates what often are the differences between the transaction forms. It is notable that one can almost always achieve at least as much or more in an ESOP transaction as one can with the other two, while availing yourself of the other features and benefits of the ESOP capital structure and culture.

Recognizing how well the ESOP alternative stacks up quantitatively usually leads one to request from our firm a custom (company specific) Valuation & ESOP Transaction Feasibility Analysis. This work product compares and contrasts the pros and cons of each of the three alternatives with each other and discusses the process, timelines and benchmarks of all three comparatively.

Strategic Stock “M&A” Sale

Because of synergies and duplicative costs within the respective P&Ls of an industry buyer and the target seller (“target”), the strategic, industry buyer can often value the target seller higher than the private equity firm who does not always have a portfolio company with such synergies and duplicative costs which can be cut. Note two things: First, the duplicative costs are quite often many of the people that helped you get the business to where it is today, and, despite the fact that this transaction’s valuation is often the highest it’s not significantly higher than what the ESOP’s tax benefits afford you on an after-tax basis. What follows describes the process and the respective perspectives of the parties to a Strategic Stock “M&A” Sale.

The Process:

A managed sale process generally relies on a Selling Memorandum to disseminate information to the buyers. This document basically tells the story of the target’s past, present and future. The Company’s financial statements would be recast for discretionary and one-time expenses.  The Memorandum includes whatever information is necessary to enable a buyer to make an informed offer, without giving too much sensitive data away too early in the process.  For example, customer and employee names should not be included in the Memorandum.  Product line profitability of the target might be included as long as no cost of sales detail is provided.  An asking price is typically not indicated in this process.

All interested buyers visit the seller within a fairly short period. This ensures buyers receive the same information at approximately the same time. For confidentiality reasons, visits are normally held outside of the seller’s facility.  Typically this meeting is the only direct contact with the Seller prior to offer and agreement.  Also, certain information considered too proprietary or sensitive to share with a broad list of potential buyers in the Selling Memorandum may be excluded and disclosed later in the process to a select few bidders.  Experienced investment bankers are instrumental in pacing sensitive informational disclosures to appropriate time windows in the managed sale process.

A “call for offers” occurs at some point after the last buyer visit. The goal is to receive at least three offers for the company. Unless one of the buyers makes a preemptive offer, the first round offers are just a starting point.  A preemptive offer is an attempt to lock out the other bidders with a high purchase offer.  While preemptive offers occur too often to be considered urban myths, most of the time the investment banker needs to improve one of several less-than-acceptable offers.  Every banker has developed methods for dealing with this issue.  Some will try to force or coerce a buyer into improving the offer.  Intimidating buyers into paying more works well in the movies, but not so well in the real world.   A better way of selling a business is to allow a buyer’s ego to dictate the price rather than the ego of the investment banker.

Ultimately the deal likely gets to the letter of intent stage and then to a closing.  It takes about 8-10 weeks to run the auction, and at least 6-8 weeks to close the deal depending on the time of the year.  Summer and the Holiday Season are notorious dead zones on the deal-making calendar.

Parties to the Soft Auction Transaction and their Agendas:

Sellers

Typically, owners and select members of senior management are privy to the fact that a transaction is being pursued. The CEO, CFO and Senior Sales and Marketing executives, if they aren’t owners, are apprized of the owner’s motivations prior to or during the process. The value of a business extends beyond its earnings capacity.  Management quality figures quite prominently.

It is impossible to achieve a company’s strategic value without involving senior management in the managed sale process, particularly during buyer visits. It is vital that senior management, particularly the CFO, have absolute clarity on what their financial situation will be post-transaction. Senior management’s alignment with the desires of owners is central to a successful transaction.  This takes the form of closing and retention bonuses allocated by the seller augmenting the buyer’s consideration.

Bottom Line Agenda: The seller’s agenda having chosen the Managed Strategic M&A path is to maximize the amount of money they receive in purchase price and to shift as much of the future business risk to the buyer as soon as possible.

Buyers

Depending on the size of the buyer it is not uncommon for the CEO or CFO of the company to attend the buyer visit. Other senior management could include titles such as V.P. of Corporate Development, Strategic Planning or Business Development. These individuals often are former investment bankers now on staff operating solely for the buyer as an employee.  They can often have much more transactional experience than the CEO or CFO who are necessarily more focused on the operations of the business.  You underestimate the importance and influence of these V.Ps or S.V.P.s at your peril.

Highly experienced buyers will work hard to develop rapport and the seeds of a relationship with you and your team. They will want you to think that they can relate to you in some way and or for you to think that they can best understand your company, your situation and your future desires. A wise buyer, for example, will ask the owner how much vacation time he or she takes in order to gauge the depth of management below the owner(s).  Experienced buyers will never publicly point out faults with your business as they ask you pointed questions to assess the financial risk they are about to take.  They know they are in a “beauty contest” of buyers and want to be selected as your future owner.  While they care very much about the economics of the transaction (buying you at the right price), they also are assessing the culture of your company for how it might or might not fit within theirs.  Be yourself and beware of experienced buyers.

Bottom Line Agenda: Buyers want to buy your company and earnings as accretively (less expensively) as they can and for you to assume as much risk on the future results of the business as possible for as long as possible via seller’s representations, warranties and indemnities in the Definitive Agreement.

Attorneys

It is vital that the attorney representing the seller be very experienced with corporate finance and M&A transactions. Knowing what to insist on and what to give away during contract negotiations is very often the difference between closing the deal successfully or not closing the deal and still being stuck with a legal bill that is 80% to 90% the size it would be had you closed and realized your liquidity. We advise you have a very frank conversation with your attorney (only) as to your motivations and the importance of consummating the transaction, so he or she doesn’t lose sight of this over-arching importance in your life plan.  The attorney may not be as motivated to close the transaction as quickly as you may be.  The more issues to negotiate and the longer the process takes, the higher the attorney’s fees will be.  Finding an attorney who knows how important momentum is to closing a transaction and managing this carefully is of great import.  There are great, experienced transaction attorneys and your experienced investment banker is the best source of these contacts.

Bottom Line Agenda: Attorneys, like all businessmen, care about how much money they make and that their total bill reflects the amount of value they believe they added to the transaction. This can be in the form of billable hours, which can delay deals, or in pre-negotiated pricing and time-based closing bonuses.

CPAs

The more transaction-experienced your CPA firm the better, but it’s not as important as your deal attorney. Clearly, the tax planning he or she can provide you pre-transaction is worth more than every dollar you pay for it as you embark down the liquidity event path as this planning drives the ultimate structure your transaction will take. Many non-tax issues your accountant helps you with are of great importance, as well.  The quality of your assets, liabilities and earnings, as booked, is central to the buyer’s analysis as is objectively calculating the necessary working capital required to operate the business going forward as this calculation can figure prominently into your after-tax proceeds calculation.  Buyers care very much about the quality of your earnings and assets.  Your CPA is the independent arbiter and presenter of the quality of those items.  The deal-experienced CPA, like the quality deal lawyer is worth every dollar you invested in them on the day of close.

In the M&A Sale the company will be sold and the buyer will bring in their own CPA firm for the future. It is not lost on the incumbent CPA that he or she will be losing a valuable client when the transaction closes. For this reason it is equally important to express to your CPA the importance of your transaction closing for your own personal reasons.

Bottom Line Agenda: The CPA firm cares about keeping their clients for as long as they can.

Investment Bankers

Contrary to popular belief within the investment banking industry, not every transaction requires an investment banker. If an investment banker cannot add more value (after-tax sale proceeds) to the transaction by virtue of being involved, then he or she should not be involved, generally. If, however, an experienced investment banker’s compensation is structured properly – so as to be almost entirely aligned with the seller’s interests (which is not often done), then an investment banker can almost always add more value than they cost in the Soft Auction Process.  While it is invaluable to have a highly transaction-experienced expert quarterbacking your professional team and matching the experience that is sitting across the table with the buyers, in reality most of the value an investment banker brings to a transaction is in managing the competitive auction that, when executed properly, yields multiple bids for the company.  Fostering this competition, globally, without angering the bidders results in price maximization and terms optimization.  The reason every bankruptcy sale, for example, must legally be an auction is that an auction is the only way for all constituents to the transaction to know beyond the shadow of a doubt that “the market” truly valued the asset at its highest point.  The investment banker with specialized knowledge and experience (ESOPs for example) may be the exception to the aforementioned “rule of thumb”.

Bottom Line Agenda: The investment banker whose compensation is not aligned with the seller’s agenda cares only about actually closing the transaction. The investment banker whose compensation is aligned with the seller’s agenda cares only about closing the transaction at the highest purchase price possible.  The only thing they care about after that is being able to brag about what they did in the form of their “tombstone” announcements.

Employees

Your employees should not be told the company has new owners until you can look them in the eye and answer the following questions your employees will, justifiably, have for you: (i) What does this mean to my job security and compensation, (ii) Who do I report to, if changed, and, (iii) how is my retirement plan affected by this transaction? If your employees come to you during the Soft Auction Process asking if the company is for sale your answer should laughingly be, “Not a month goes by that I don’t get an offer from somebody to buy this company – why are you interested in buying it”? This always deflects and diffuses any anxiety.  The fear that employees will leave if they discover the company is for sale is just that – a fear.  The only employees that we’ve seen leave, and it’s very rare, are the ones that should leave and it’s a blessing.  Your employee just wants to know what to tell their spouse when they get home that day.

Pros and Cons of the Soft Auction Sale

Pros:

Price Maximization. The Soft Auction is designed to expose what you have built to every known potential buyer on every continent of the globe. It pits strategic buyers against one another such that each buyer will be placing a value on your company based not just on what they can do with your company’s assets and earnings, but they’ll be valuing it on the basis of what their fierce competitors cannot do in the marketplace without your company.  This is the essence of price maximization and terms optimization.

Risk Shifting. The seller may suspect that something negative about the future of the company, the industry or the economy will come to pass and no longer wish to be exposed to the market risk they are currently exposed to. This financial risk aversion may simply be a function of the seller’s age.  As he or she approaches retirement age, they are being told that they should reduce and diversify these types of risks so as not to lose their nest egg corpus.  While not providing an absolute clean break from the future risks of owning the business, the M&A transaction best shifts these risks, contractually, to the new owner.

Cons:

‘Being Done’. For many business owners, particularly founders, their business is more than a financial asset. It’s a source of enormous pride.  It’s what they’ve built.  It’s their identity in many instances.  Selling the business can be akin to losing a child.  Leaving a legacy is something that seems to be hard-wired into all of us.  When you sell the business it’s done.  You’ve given up control in the M&A transaction.  Don’t let an employment agreement fool you.  The buyer will keep you around as long as they feel insecure about the business and they’ll be looking to dispatch you as soon as they can.

Future Growth. Unlike in a Private Equity Re-capitalization or an ESOP transaction, with the M&A transaction you very rarely are able to participate in the future growth prospects of the business. Some seller’s have remorse when they see what another buyer does with the company in terms of growth.

Employees. Unlike the ESOP transaction wherein you may retain complete control, if you wish, in the M&A transaction you have no control over how your future employees are treated. This can be an enormous issue for sellers.  Some sellers chose to allocate a percentage of their purchase price to the employees as a bonus.  In some cases the buyer and seller will agree that the buyer retaining the employees is central to the transaction, so they mutually allocate purchase consideration to a ‘retention pool’ where employees who stay on for the required time period receive the cash bonus.

Private Equity Asset Sale

With the explosion of private equity groups (PEGs) in the last two decades owing to massive flows of institutional capital into alternative investment classes such as venture capital and private equity investing this class of buyers has created its own unique transaction form, the leveraged buy-out (LBO) and leveraged re-capitalization transaction. If the business owner truly seeks growth capital and new management expertise to help the business achieve new heights and shareholder liquidity is a distant second priority, then a PEG transaction may be the best transaction. If liquidity is the primary driver, however, and you’re willing to remain active in the business for at least 2-3 more years, then the PEG alternative won’t be more attractive than the ESOP transaction when you do the deep dive and truly evaluate the pros and cons of the two transactions.  You should know, incidentally, the PEG transaction is almost exactly the same transaction form as the ESOP transaction but with loss of control and without the tax and employee benefits; they are virtually the same from a leverage point of view.  Any company being pursued by PEGs should obtain an ESOP Transaction Feasibility Analysis before going too far down the road with the PEGs.  An ESOP sale is, effectively, doing your own PEG transaction.

Where a few PEGs really do shine, though, is on the management expertise front. For the right situation there can be nothing better than bringing in a leader who has previously faced the industry and business challenges the company is about to face in its next leg up. In order to differentiate themselves from each other and from strategic industry buyers PEGS tout the “help” they can be operationally and in the board room in growing the business.  The truth is, and statistics bear this out, most PEG investment returns are dismal.  They are dismal because the PEGs general partners don’t bring the level of management and operational help they advertise. Only a select few PEG fund investment returns are exceptional and it’s almost always because the fund focuses on an industry where the general partners have significant industry experience themselves.  A sophisticated seller will flesh these nuanced issues out, often with the help of his investment banker, prior to giving up control of the business in exchange for the same leverage and liquidity he or she can deploy and obtain in an ESOP transaction.  This is why you are increasingly seeing reports in the press about large companies snubbing PEGs and even IPOs in favor of the more flexible ESOP transaction.

With this said, relative to a managed sale process it is usually possible to secure at least three LOIs from PEGs, as is the case with strategic buyers. Practically speaking, PEGs are approached together with strategic buyers of the business when we execute the managed sale process. Alternatively, if the seller is solely focused on a leveraged recapitalization (rather than selling 100% of the company in an M&A transaction) a managed process can be conducted solely with Private Equity Groups with the same benefits noted in the strategic M&A sale section.

What follows describes the process and the respective perspectives of the parties to a Private Equity Asset Sale.

Parties to the PEG Transaction and their Agendas:

Sellers

Sellers interested in a private equity sponsor partner are typically not ready to hang it up. They are willing to commit to two to five more years of growing and managing the company, but would like to “take some chips off the table” extracting a certain amount of cash, while receiving an infusion of growth capital into the business to effect rapid growth or acquisitions. Typically, owners and select members of senior management are privy to the fact that a private equity transaction is being pursued. The CEO, CFO and Senior Sales and Marketing executives, if they aren’t owners, are apprized of the owner’s motivations prior to or during the process.  Management quality and depth is crucial to the financial buyer as they rarely have the industry experienced management team that a strategic buyer from within the industry will have.  Where the PEG has an existing portfolio company with these people this isn’t always the case.

Like in the strategic M&A sale process it is impossible to achieve a company’s optimal “financial value” (as opposed to its strategic value) without involving senior management in the process, particularly during financial buyer visits. Senior management’s alignment with the desires of owners is central to a successful transaction and can often be the driving force for the transaction.

It is vital that senior management, particularly the CFO, have absolute clarity on what their financial situation will be post-transaction. More than one CFO has fouled a deal because he or she would not be financially settled for at least three years post–close going into the selling process. This is your responsibility to solve and your investment banker can help you do so.

Bottom Line Agenda: The seller’s agenda having chosen the PEG Transaction channel is to maximize the amount of money they receive in personal liquidity by giving up the least amount of their ownership and to shift as much of the future business risk (lender personal guarantees, etc.) to the buyer as soon as possible. Accomplishing this by limiting the amount of debt put on the company’s balance sheet post-close is also important as the higher the debt to equity ratio the more exposed the stock retained by the seller is to financial risk. This of course impairs the return on equity of the buyer.

Buyers

The number of new private equity group formations over the last twenty years is nothing short of staggering. It seems that anyone with an MBA, Mercedes Benz and wealthy friends and family is now a private equity professional. While there are several hundred legitimate, well-funded private equity groups (PEGs) in the U.S., many “funds” are assemblages of the aforementioned individuals thinly capitalized with varying levels of capital commitments from investors, rather than true managers of cash.  Discerning this is very important so as to not waste time and money.  The stakes of “going to market” are very high.  Experienced investment banks have expensive databases to research all private equity groups in formation.

Private equity buyers will also work hard to develop rapport and the seeds of a relationship with you and your team. Often PEG professionals will have hailed from you industry, in fact. They will want you to know how successful they’ve been previously, what strengths and experience they can bring to your growth strategy and will want to know that you “are in” for the hard work ahead. A wise buyer, for example, will ask the owner how much vacation time he or she takes in order to gauge the depth of management below the owner(s).  Experienced buyers will be more candid than strategic buyers will be in pointing out faults with your business as they ask you pointed questions to assess the financial risk they are about to take. Because they aren’t merging your operations into an existing, larger organization, they have to know that all of the issues that need to be addressed are out on the table with you.  While they care very much about the economics of the transaction (buying you at the right price), they also are assessing what it will be like to roll up their sleeves and work side by side with you.  Given the complexities of the leveraged private equity recapitalization it is even more important to enter into these discussions with as much experience on your side of the table as possible.  Note: the complexities of a PEG deal are the same level as the ESOP deal.

Bottom Line Agenda: PEG buyers want to buy the greatest percentage of ownership from you as inexpensively (multiple of EBITDA) as they can using as much debt as possible and for you to assume as much risk on the future results of the business as possible for as long as possible. They are about buying low (with debt, which makes future ownership of the company more risky), growing the EBITDA as fast as they can and selling for the highest value as quickly as possible. Private equity returns, sadly, are more the result of paying too little for a company than from “adding value”, which is their mantra.

Attorneys

It is vital that the attorney representing the seller be very experienced with corporate finance and, ideally, private equity transactions. Like in the M&A Sale transaction, knowing what to insist on and what to give away during contract negotiations is very often the difference between closing the deal successfully or not closing the deal and still being stuck with a legal bill that is 80% to 90% the size it would be had you closed and realized your liquidity. Issues that would appall a corporate attorney not accustomed to the rights and preferences typically granted private equity investors are not that controversial to a PE-experienced lawyer. Again, we advise you have a very frank conversation with your attorney as to your motivations and the importance of consummating the transaction, so he or she doesn’t lose sight of this over-arching importance in your life plan.

The attorney may not be as motivated to close the transaction as quickly as you may be. The more issues to negotiate and the longer the process takes, the higher the attorney’s fees will be. Finding an attorney who knows how important momentum is to closing a transaction and managing this carefully is of great import.  There are great, experienced transaction attorneys and your seasoned investment banker is the best source of these referrals.

Bottom Line Agenda: The PEG-experienced attorney has the same agenda as the M&A Sale attorney.

CPAs

Many of the issues identified in the above ‘Attorney’ section apply to the CPA also. The more transaction-experienced your CPA firm the better, but it’s not as important as your deal attorney. Given the unique ‘equity roll-over’ feature of most recapitalizations (seller retains partial ownership post close), the tax planning he or she can provide you in this area pre-transaction is worth more than every dollar you pay for it as you embark down the liquidity event path as this planning drives the ultimate structure your transaction will take.  Many non-tax issues your accountant helps you with are of great importance, as well.  Like with strategic M&A the quality of your assets, liabilities and earnings, as booked, are central to the buyer’s analysis as is objectively calculating the necessary working capital required to operate the business going forward as this calculation can figure prominently into your after-tax proceeds calculation.  One nuance of the private equity transaction your CPA can be particularly helpful with is in modeling various debt to equity ratios and their implications on future earnings and the attendant risk to your rolled over equity.  This assessment, together with similar assessments your investment banker will provide, will aid you in developing your comfort zone for negotiations purposes.  It’s prudent to have a second opinion on this analysis beyond that of only the investment banker, who is financially motivated to close the deal.  Private equity buyers, too, care very much about the quality of your earnings and assets, particularly because they will absolutely be leveraging them with financing. Your CPA is the independent arbiter and presenter of the quality of those items.

Like in the M&A sale process, in the private equity recap process control of the company will be sold and the buyer will bring in their own CPA firm for the future, generally, though not every single time. It is not lost on the incumbent CPA that he or she will be losing a valuable client when the transaction closes. For this reason it is equally important to express to your CPA the importance of your transaction closing for your own personal reasons.

Bottom Line Agenda: The CPA firm cares about keeping their clients for as long as they can.

Investment Bankers

Because the private equity community is largely unregulated and rather opaque, the investment banker can bring more informational value to this process than he or she can in the M&A process. The old adage remains, however, if an investment banker cannot add more value (after-tax sale proceeds) to the transaction by virtue of being involved, then he or she should not be involved, generally. As a general rule if you have never sold a business to a PEG, then regardless of how many PEGs are contacting and seducing you, it’s prudent to hire an investment banker to guide you through the process.  Again, an experienced investment banker’s compensation should be structured properly – so as to be almost entirely aligned with the seller’s interests, then an investment banker can almost always add more value than they cost in running the process.  If the strategic M&A buyer is experienced, the private equity buyer is uber-experienced.  This is all they do.  While it is invaluable to have a highly transaction-experienced expert quarterbacking your professional team and matching the experience that is sitting across the table with the buyers, in reality most of the value an investment banker brings to a private equity transaction is in managing the competitive auction that, when executed properly, yields multiple bids for the company.  Fostering this competition, globally, without angering the bidders results in price maximization and terms optimization.  Tasking yourself and/or management with managing this process often results in an earnings drop for the company at exactly the wrong time.  The reason every bankruptcy sale, for example, must legally be an auction is that an auction is the only way for all constituents to the transaction to know beyond the shadow of a doubt that “the market” truly valued the asset at its highest point.

Bottom Line Agenda: The investment banker whose compensation is not aligned with the seller’s agenda cares only about actually closing the transaction. The investment banker whose compensation is aligned with the seller’s agenda cares only about closing the transaction at the highest purchase price possible.  The only thing they care about after that is being able to brag about what they did in the form of their “tombstone” announcements and whether you’ll provide a great reference to his future prospective clients.

Employees

In the private equity transaction the same issues exist as do with the M&A transaction which are explained below, however, there are some nuances. The private equity group will absolutely want a stock options pool set up for your employees, whereas they are rarely in place when you go to market. So, your employees view this positively.  With the new financial buyer on board your higher quality employees will likely enjoy more upward mobility than they would have under the old ownership, while your lower quality employees will not last as long as they might of under the old ownership structure given the new owner’s acute focus on EBITDA growth.

As with the M&A sale process, your employees should not be told the company has new controlling shareholders until you can look them in the eye and answer the following questions your employees will, justifiably, have for you: (i) What does this mean to my job security and compensation, (ii) Who do I report to, if changed, and, (iii) how is my retirement plan affected by this transaction? If your employees come to you during the unfolding sale process asking if the company is for sale your answer should laughingly be, “Not a month goes by that I don’t get an offer from somebody to buy this company – why are you interested in buying it”? This always deflects and diffuses any anxiety.  The fear that employees will leave if they discover the company is for sale is just that.  A fear.  The only employees that we’ve seen leave, and it’s very rare, are the ones that should leave and it’s a blessing.  Your employee just wants to know what to tell their spouse when they get home that day.

CPAs

Many of the issues identified in the above ‘Attorney’ section apply to the CPA also. The more transaction-experienced your CPA firm the better, but it’s not as important as your deal attorney. Given the unique ‘equity roll-over’ feature of most recapitalizations (seller retains partial ownership post close), the tax planning he or she can provide you in this area pre-transaction is worth more than every dollar you pay for it as you embark down the liquidity event path as this planning drives the ultimate structure your transaction will take.  Many non-tax issues your accountant helps you with are of great importance, as well.  Like with strategic M&A the quality of your assets, liabilities and earnings, as booked, are central to the buyer’s analysis as is objectively calculating the necessary working capital required to operate the business going forward as this calculation can figure prominently into your after-tax proceeds calculation.  One nuance of the private equity transaction your CPA can be particularly helpful with is in modeling various debt to equity ratios and their implications on future earnings and the attendant risk to your rolled over equity.  This assessment, together with similar assessments your investment banker will provide, will aid you in developing your comfort zone for negotiations purposes.  It’s prudent to have a second opinion on this analysis beyond that of only the investment banker, who is financially motivated to close the deal.  Private equity buyers, too, care very much about the quality of your earnings and assets, particularly because they will absolutely be leveraging them with financing. Your CPA is the independent arbiter and presenter of the quality of those items.

Like in the M&A sale process, in the private equity recap process control of the company will be sold and the buyer will bring in their own CPA firm for the future, generally, though not every single time. It is not lost on the incumbent CPA that he or she will be losing a valuable client when the transaction closes. For this reason it is equally important to express to your CPA the importance of your transaction closing for your own personal reasons.

Bottom Line Agenda: The CPA firm cares about keeping their clients for as long as they can.

Investment Bankers

Because the private equity community is largely unregulated and rather opaque, the investment banker can bring more informational value to this process than he or she can in the M&A process. The old adage remains, however, if an investment banker cannot add more value (after-tax sale proceeds) to the transaction by virtue of being involved, then he or she should not be involved, generally. As a general rule if you have never sold a business to a PEG, then regardless of how many PEGs are contacting and seducing you, it’s prudent to hire an investment banker to guide you through the process.  Again, an experienced investment banker’s compensation should be structured properly – so as to be almost entirely aligned with the seller’s interests, then an investment banker can almost always add more value than they cost in running the process.  If the strategic M&A buyer is experienced, the private equity buyer is uber-experienced.  This is all they do.  While it is invaluable to have a highly transaction-experienced expert quarterbacking your professional team and matching the experience that is sitting across the table with the buyers, in reality most of the value an investment banker brings to a private equity transaction is in managing the competitive auction that, when executed properly, yields multiple bids for the company.  Fostering this competition, globally, without angering the bidders results in price maximization and terms optimization.  Tasking yourself and/or management with managing this process often results in an earnings drop for the company at exactly the wrong time.  The reason every bankruptcy sale, for example, must legally be an auction is that an auction is the only way for all constituents to the transaction to know beyond the shadow of a doubt that “the market” truly valued the asset at its highest point.

Bottom Line Agenda: The investment banker whose compensation is not aligned with the seller’s agenda cares only about actually closing the transaction. The investment banker whose compensation is aligned with the seller’s agenda cares only about closing the transaction at the highest purchase price possible.  The only thing they care about after that is being able to brag about what they did in the form of their “tombstone” announcements and whether you’ll provide a great reference to his future prospective clients.

Employees

In the private equity transaction the same issues exist as do with the M&A transaction which are explained below, however, there are some nuances. The private equity group will absolutely want a stock options pool set up for your employees, whereas they are rarely in place when you go to market. So, your employees view this positively.  With the new financial buyer on board your higher quality employees will likely enjoy more upward mobility than they would have under the old ownership, while your lower quality employees will not last as long as they might of under the old ownership structure given the new owner’s acute focus on EBITDA growth.

As with the M&A sale process, your employees should not be told the company has new controlling shareholders until you can look them in the eye and answer the following questions your employees will, justifiably, have for you: (i) What does this mean to my job security and compensation, (ii) Who do I report to, if changed, and, (iii) how is my retirement plan affected by this transaction? If your employees come to you during the unfolding sale process asking if the company is for sale your answer should laughingly be, “Not a month goes by that I don’t get an offer from somebody to buy this company – why are you interested in buying it”? This always deflects and diffuses any anxiety.  The fear that employees will leave if they discover the company is for sale is just that.  A fear.  The only employees that we’ve seen leave, and it’s very rare, are the ones that should leave and it’s a blessing.  Your employee just wants to know what to tell their spouse when they get home that day.

Pros and Cons of the Private Equity Recapitalization

Pros:

Relative Price Maximization. While an auction is also used when approaching only private equity groups (or private equity groups and strategic buyers simultaneously) and while it will maximize valuations amongst the private equity groups it should be noted that private equity bids are rarely as high as bids from strategic buyers. So, if partnering with a private equity sponsor is important for other aforementioned reasons don’t expect to maximize value or to shift all of your business risk in this transaction form.  The private equity business model is based on borrowing as much as possible against the cash flow and assets of the target, deploying as little of their own equity as required, thus maximizing their return on equity invested.

Risk Shifting. The seller may believe the company is poised for wonderful growth if the proper financial and human resources were infused in the company. He or she may also be at a point in their lives where “taking enough chips off the table” to diversify their financial risk for retirement is very attractive.  Particularly is they can participate in the future growth of the equity of the firm via their retained equity.  Typically, the seller is also removed from personal guarantees to lenders, so the risk shifting, while not as significant as in an M&A transaction, is quite significant, indeed.

Cons:

‘Being Done’. It is not always certain that the PEG will want the leader of the business to remain the leader. An employment agreement ranging in time from one to three years, cancellable at any time by the buyer, will almost always be insisted upon by the buyer.  But it’s relatively rare for professional management to not eventually be brought in.  Non-critical family member employees won’t last long.

Debt-Fueled Future Growth. Central to the LBO leveraged recapitalization transaction favored by private equity groups is leverage, or debt. Debt amplifies success and failure.  The failure rate of highly leveraged buy out companies is notoriously high, so the risk to the equity you retain in the recapitalized company hoping for a “second bit on the apple” is fairly high.

Lack of Control. It is very rare for a private equity group to buy less than a controlling stake in your business in this transaction form. Investors will listen to you when things are good, but if things turn bad you will realize just how much control you ceded in the private equity transaction.  While private equity sponsors say they’ll do minority stake investments, the terms and conditions of these investments are quite restrictive setting “trip wires” at varying (negotiated) levels of performance.  The rights and preferences of a minority stake investor should be scrutinized and negotiated aggressively, which is more easily done while maintaining negotiation leverage as long as possible through the managed sale process.