The Entrepreneurs Dilemma: Capturing Liquidity in a Closely Held Business

By Damien Vira

Transitioning out of a closely held business presents many challenges to a founder-owner. It is very difficult to objectively view a family business as an asset when—over the years—it has become more a way of life than anything else. Owners of closely held businesses have poured so much of themselves and their energy into building the business that emotion and other factors can hinder the succession-planning process. The previous article discussed the importance of developing a succession planning timeline and giving oneself ample time to identify and develop the next generation of leaders. Here we will briefly describe liquidity options and the major factors that should be considered when deciding which one, or which combination of options can best meet the seller’s objectives.

Risk Mitigation
Entrepreneurs have an above average appetite for risk. They put most or even all their eggs in one basket, and have toiled endlessly to even be in the position to think about succession planning. It is not uncommon to then find that as retirement approaches that the clear majority of one’s assets reside in this closely held business. This fact is analogous to reaching retirement and realizing that 75 percent or more of one’s 401(k) is invested in a single small cap firm. The reality of owning a closely held firm near retirement is not quite as jolting, but it is not far off from the truth. If owners want to ensure their objectives in retirement and the lifestyle they want to lead are met, then diversifying assets is an imperative.

Goals and Objectives
Any succession planning process should begin by outlining one’s objectives. An owner’s goals, and timetable need to be written down and constantly referenced throughout the succession- planning process. Typically, those objectives are communicated to one party or adviser, but rarely referenced throughout the process or discussed with all relevant parties. This is a major mistake that must be avoided. Never stop questioning how one versus another option will maximize the objectives. Major succession planning considerations to weigh, include: the role of family and children in the business, how the business fits into overall estate planning, legacy and determining who will be the next generation of business leaders, the impact on employees and other stakeholders, the implications of any planned charitable giving, lifestyle and retirement considerations, and tax consequences. By far the biggest pitfall in the succession planning process is to let the tax consequences be the primary driver. The idiom: don’t cut your nose off to spite your face applies here.

Liquidity Vehicles
Most closely held firms do not have the option to go public. Therefore, owners are left to select between four other options. The first vehicle is the third-party external sale. These sales are typically handled by an investment banker or business broker. The buyers are usually competitors, but also can be firms in the same industry looking to expand into a new niche. Most of the sale proceeds are realized immediately after the transaction closes, and taxes are paid at capital gains rates. The second liquidity vehicle is the sale or gifting to family members. There could be significant tax consequences involved in the transfer of stock to family members and there are typically fewer proceeds available to the seller, but the transactions are relatively simple and leadership continuity at the firm is maintained. The third option is the management buy-out. Typically, key managers will use their after-tax earnings or cash from savings to purchase stock directly from the founder. This kind of transaction is perhaps the most straightforward and least costly in terms of adviser fees, but it usually results in a lower price paid for the stock and all of the proceeds may not be available at the transaction close. Lastly, an employee stock ownership plan (ESOP) can serve as the succession or liquidity vehicle. The net proceeds from a sale to an ESOP are often very near or equal to the net proceeds from a third-party sale. Additionally, the ESOP is the most patient of all investors; an ESOP transaction allows for a good deal of flexibility in terms of exit timing since stock sales to an ESOP can take place in stages. Like any other liquidity vehicle, an ESOP has its tactical limitations and is usually the most difficult to wrap one’s head around. It is usually less costly than a third-party external sale, but costlier than the other two options.

It should be noted that aside from a third-party external sale, the options briefly mentioned above do not exclude one another. For instance, even though a 100 percent ESOP owned S-Corporation is often touted as the end goal for most sellers, a partial ESOP coupled with a management buy-out may better meet one’s objectives and be a better outcome for all stakeholders. Again, it is important to keep goals and objectives top of mind throughout the succession-planning process. Remember, there are pros and cons to any liquidity vehicle and the path an owner chooses to go down must be weighed against all other options. A carefully considered holistic approach is the only one that will result in a satisfactory outcome.

Go Back