By David S. Cohen, Esq., ASA
Anecdotally, merely about one-in-three founder(s) are able to transition their ownership to the second generation and only one-in-ten make it to their third generation. The remaining nine firms either decide to close up shop or find an external transition plan by becoming a part of another firm through mergers and acquisitions. So how do you create a firm ownership transition program that would facilitate you to be one of the 33% and then one of the 10% to stay independent? The following is what we are hearing at seminars, conferences, and from our clients about where the challenges are and how to resolve these items to create a successful ownership transition program.
Plan early
First, there is no such thing as starting your ownership planning program too early. It typically takes about ten years to transition 100% of the firm by utilizing the company’s cash flow while continuing to re-invest in the business and following through on the strategic plan. As such, it is unreasonable to think that you will be able to transact 84% of ownership in the firm with a window of a three year retirement timeframe, while receiving a market level of value. In order to accomplish such a task, something would have to give, either the timeframe or the value at which you are willing to transact your shares. There are still so many firms out there who continue to wait, with the belief that the major shareholder can simply sell all of their stock back to the firm when they retire and walk out the door.
A program that would facilitate the example provided above would create a tremendous legacy cost (a cost associated with someone who is no longer with the firm) and risks for all parties (including the company) involved. We are seeing a trend where the next generation of buyers are saying “no thank you” to the idea of this type of legacy cost (another example of a legacy items would be a deferred compensation program).
Buyers typically like the selling shareholders to transition their ownership while that person is still working at the company and contributing to generate the revenue and profits that will be utilized to fund and finance the transaction. They are not interested in working for the next seven-to-ten years only to have most, if not all, of the company’s profits be utilized to pay off a promissory note to the retired shareholder. And the risk, for the seller, is that the note payments aren’t made and that they would have to come back to the company. Typically, the most successful transactions have the bulk of the stock paid for before the shareholder retires.
Setting timeframes
Why are the shareholders so apt to hold on to their stock so late in the game? Part of the rationale for these sellers for holding on to their ownership is that we are seeing a trend of owners planning on working longer. Retirement timeframes are increasing with life expectancies and an emphasis on maintaining healthy lifestyles. Furthermore, the world of design is a “calling”, and many who practice in this industry see it as part of their life and do not view it as work. It is not about ego, or not just about ego, but this profession has a way of defining a person.
However, firms need to keep the ownership transitioning within reasonable timeframes. We are seeing more and more, shareholders’ agreements with divestment age clauses governing when a shareholder has to start selling their shares. However, there should be no forced retirement. In fact, many of these clauses allow a shareholder to hold some percentage of their shares until they are ready to retire. The remaining percentage helps them stay connected and continue to drive shareholder value while, at the same time, not creating too much burden for when they do decide to ride off into the sunset.
Incentives and valuation
With the timeframe in mind, the next step is creating an incentive for the shareholders who are getting closer to retirement to begin to sell their shares earlier. This is where valuation comes into play. If your firm is relying on book value and the shareholder return is based on annual profit distributions/dividends/bonuses, then there is very little incentive for these shareholders to sell their shares earlier as there will be a dramatic impact to their annual compensation. But if you are relying on a market valuation for the stock, which could be 1.5 – 2.5 times your book value, this higher valuation drives greater capital gain returns for the shareholders giving them an incentive to begin selling down earlier.
The stock has to be a dual-fold investment where there is both appreciation in the stock price and annual yields to shareholders. If all the value is tied to the annual yield you run into the disincentive to sell shares, or if all of the value is tied to the stock price, the investment becomes a retirement benefit only, which is not of interest to the next generation and their continuously increasing annual cost of living expenses.
However, it is imperative that this market value is based on a reasonable multiple of cash flow as it is the cash flow that will support the transaction. A complaint that we often hear from the buyers is that the stock price is too expensive. Thus, any transactional value must relate to how profitable the firm is after normal operating expenses, including retirement plan contributions and performance-based bonuses. It is the remaining free cash flow that will be available to fund the ownership transactions.
In addition, it has to be made clear to the buyer that the investment is not one that is meant to be completely painless. There should be some “skin-in-the-game” and if it takes the buyer three or four years to pay for their stock, it should be viewed as reasonable from an investment perspective. If the stock is too easily purchased or given away, then there really isn’t an investment decision on the part of the buyer and this will create a disconnect between ownership, leadership, and motivating shareholder behavior.
Conclusion
It is not always the easiest path to follow, but it can certainly be rewarding to transition your firm from one generation to the next. If you balance the goals and objectives of the sellers and buyers against what the company can afford, taking into consideration timeframes, cash flow, and the number of buyers being included in the process, you will improve your odds of successfully transitioning your firm and remaining independent. The examples and the issues presented above are certainly not applicable to every firm or situation and we work with our clients to formulate a plan that is catered to the firm’s specific ownership transition needs. Please feel free to reach out to me if you have any questions or anything to add.
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David Cohen is a Managing Director with Matheson Financial Advisors, and the firm specializes in business valuations, ownership transition planning, ESOPs, and mergers and acquisitions as part of exit strategies and strategic plans. They also conduct seminars on these financial management topics for design industry organizations, as well as leading in-house educational programs for firms nationwide. David can be reached at dcohen@mathesonadvisors.com or 508-655-9700.
(Return to the cover of the 2016 PM Digest: Ownership Transition)