Alternative Transaction Structures
The Anatomy of a Deal Newsletter January 24, 2020
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
Here in Anatomy of a Deal, we often focus on just one type of transaction structure: the 100% buyout. It’s a (relatively) simple, common structure that works for a number of businesses. However, it’s far from the only strategy available. So this month, we’d like to introduce you to some of the other transaction structures that might work for your business. However, keep in mind that most of these assume a more mature business with existing actual value.
1. Majority Acquisition
This structure mimics the 100% buyout but with a twist: the sellers (or some subset of sellers) retain a portion of the business after the closing. While the sellers give up control to the buyer, the sellers get the proverbial “second bite at the apple” by participating in the post-closing success (or failure) of the operation.
This structure is very common when there’s a private equity buyer (i.e., a buyer who is in the business of buying businesses, building them up, and reselling them in the next 3-8 years). Most private equity buyers need the sellers’ management team to remain in place. This structure does two important things for the private equity buyer: (1) it aligns the interests of the management team with those of the private equity buyer post-closing, and (2) it validates the valuation that the private equity buyer is assigning to the company. If the sellers are unwilling to re-invest a portion of their sale proceeds in the transaction, that may be a telltale sign to the private equity buyer that the sellers’ management team doesn’t believe in the valuation that the private equity buyer has assigned to the business.
There are some unique considerations that need to be addressed in this type of structure. First, in most cases, the sellers who will “roll-over” their equity participation into the buyer post-closing will want to be sure that they can do so on a tax-deferred basis. Otherwise, they’ll pay tax on 100% of the value of their pre-closing ownership, but they’re only receiving cash proceeds for the portion that is not rolled over into the buyer. Most sellers don’t love the idea of getting a tax bill at a time when they haven’t received a commensurate amount of cash with which to pay the tax. Hard-hitting analysis, I know.
Second, the sellers – who likely had at least some significant degree of control over the business’ operations prior to closing – now must adjust to a minority position in the company. We use a variety of minority-protection tools to help provide some protection to the rollover sellers: protective covenants (e.g., things that the buyer can’t do without some consent of the sellers), employment agreements with severance provisions, etc. While these minority tools are helpful, the buyer’s expectation is that it gets to run the business largely as it sees fit after the closing. So there is some inherent risk in these transactions even if we are successful in using these tools.
While some sellers may prefer the idea of simply cashing out and walking away, the majority acquisition can in many cases yield even greater total value for the sellers. In the case of a private equity buyer, many of them will be acquiring the business with the idea of “bolting on” additional businesses in the same industry and also helping to build operational efficiencies and synergies to generate additional value. In some cases, we’ve actually seen the sellers make more money on the subsequent minority exit than they received on the initial majority transaction. However, they’re also taking the investment risk that the business doesn’t tank post-closing, which is entirely possible when the buyer is using significant debt leverage to finance the transaction (and later transactions), as is very often the case.
In summary, the majority acquisition presents some unique benefits, but it’s not right for every seller. Before proceeding with such a transaction, you’ll want to consider your personal goals (cash-out and walk away vs. stay involved), your appetite for risk, your comfort level with the potential partner and its plans for the business, and the potential partner’s history in operating – and successfully exiting – similar businesses.
2. Minority Acquisition
Many sellers are surprised to learn that there are investment funds that will actually take a minority position in the business. This structure allows the seller to cash out a portion of the business while retaining control.*
* Well, you won’t really have total control. The investor is going to demand the same types of minority rights as described above plus more, and they’ll have more success in getting much more robust minority rights. Otherwise, they simply won’t invest. That means you’ll likely be saddled with a number of restrictions on what you can and can’t do without the investor’s prior consent. Moreover, the investor will probably require some form of preferred return, which is usually in the form of a “coupon” on their investment (i.e., they get a 5% to 10% return on their invested capital before the other owners get anything out of the business).
Perhaps even more significantly, the investor is going to demand some exit rights at some point in time (typically 5 years, but could be as long as 10 years). This is often accomplished by giving the investor an ability to force a sale of the entire company or giving the investor a “put right” that forces the company to buy back the investor’s equity interest. The latter seems more benign, but unless the company has huge stores of cash available, the put right effectively forces the company to find a new debt/equity partner to provide the capital needed to fund the purchase, or sell the company.
Here again, the minority acquisition structure is a potentially useful alternative, but you must know your potential partner very well and have a strong level of trust and confidence in their plans and outlook for the business. You also need to assess the non-monetary value they can bring to the table and their historical track record. Picking the right partner can be a huge win for both sides; picking the wrong partner can be a total disaster.
3. Debt-Financed Recapitalization
The debt-financed recapitalization is a classic way to “take some chips off of the table” while retaining ownership and control of the business. In this case, you use the current value of the company to borrow from a lender (often a traditional bank, but could be a less traditional financing source) and put at least a portion of the loan proceeds in the owners’ pockets, by way of a dividend or by a purchase of their ownership in the company.
The debt-financed recapitalization has many of the benefits of the minority acquisition, but avoids the forced sale or put right – though failure to pay back the loan could put you in the same position. In many cases, the interest rate may also be lower than the “coupon” that you would pay to the investor in the minority acquisition. On the flip side, you now have a whole host of loan covenants that are similarly restrictive on the operations of the business. More significantly, you’ll have periodic loan payments that must be made, rather than merely the accruing return that gets paid only if and when the company is in position to distribute cash to its owners. These near-term loan payments could have a very significant impact on the company’s growth plans.
For many business owners, their retirement and long-term wealth strategy is heavily dependent upon the business’ performance. The debt-financed recapitalization is an option worth considering for owners who want to diversify their risk profile, but the strategy requires a significant amount of financial analysis to ensure that the business is able to satisfy its debt service obligations without hamstringing the business’ future growth and success. Keep in mind also that many lenders may be more rigid in making credit decisions than some outside investors might be in making investment decisions, so this option may not be available for some businesses.
4. Joint Venture
The joint venture takes on a number of different forms, but at its most basic level, it’s simply an agreement among multiple individuals or companies to engage in a common activity for shared profit or loss.
While the joint venture comes in nearly an endless number of different flavors, the unique benefit of the joint venture is that it allows the participants to continue to own and control their own business and only share the portion of the business and/or specific project covered by the joint venture. For example, if Skywalker Corp. makes Jedi lightsabers and X-wing fighters, and Palpatine, Inc. makes Sith lightsabers and TIE fighters, Skywalker and Palpatine could agree to enter into a joint venture to make and sell all lightsabers without involving their existing X-wing and TIE fighter businesses.
In addition, the participants in the joint venture have more leeway to define the extent and duration of their relationship. For example, they could establish a joint venture where the lightsaber business continues only for 3 years. At that point, they either agree to renew or to “simply” walk away and go back to what they were doing before the joint venture.
While this almost infinite amount of flexibility gives the participants a great deal of leeway to establish a relationship that works for them, the flip side is that there are enough questions and issues to work through to fill an entire galaxy. For example, during the joint venture, how will decisions be made? What happens if they don’t agree? Who’s responsible for bringing what to the joint venture?
After the joint venture ends, it’s easy to say both participants can simply resume what they were doing, but it’s an entirely different question as to how exactly they do that. What if one of them had been sharing the other’s facilities? How do we deal with the confidential information that was previously shared? Who owns the customers that the joint venture served?
So the joint venture is a flexible and potentially compelling option, but joint ventures should be approached with great care at the outset to ensure that as many of these potential issues are addressed before the joint venture starts operating. If you enter into the joint venture without careful planning at the outset, you’ll be saying “I have a bad feeling about this” in no time.
And we hope you enjoyed the timely pop culture references for which Anatomy of a Deal has become so well-known.
5. Sale to ESOP
This one deserves its own topic entirely – and will get one! In short, the sale to an ESOP is an alternative for certain sellers to exit and provides a willing buyer available to take ownership: specifically, a special type of employee benefit plan wherein the company’s employees become the owners of the business.
ESOPs offer a number of very unique advantages, but they also require the right company and culture. Sometimes people think of ESOPs as a back-up plan to find liquidity for the owner when no one else is willing to buy the business. This type of thinking is extremely dangerous.
And with that, we’ll leave it there so that you’ll be eagerly awaiting our next episode.
Next month: ESOPs
Read last month’s piece : Interactions with Third Parties