Stakeholders in mature professional service firms nearing retirement are bombarded with ideas from many advisors for the “best” exit option. Owners need to contemplate several key considerations of a solid and successful exit plan:
- Creating a strong retirement package for exiting owners
- Finding the right buyer with financial strength and expertise to run their specialized firm
- Building a solid succession plan for key employees
- Maintaining a “legacy” for the future of their firm
Legacy can be very important to owners of professional service firms as their lifework is embodied in their companies. Finding the best exit solution for stakeholders and owners alike will take a different path than it does in other industries.
Profile of Typical Professional Service Firm
By the nature of the work they do, the prototypical professional service providers are hard-working, highly-motivated and both goal- and career-oriented. They are accustomed to being part of a small group working toward a common goal to deliver high-quality work. The knowledge of their specialty disciplines and hard work are embodied in their work product or services; there is significant pride and ownership in the services that they provide to their client base, customers with whom they have worked during several decades.
How Is Fair Market Value (FMV) Determined? What Are the Major Drivers of Value?
The value of professional services firms is highly impacted by the quality of intangible versus tangible assets of the firm. Factors that are significant and that impact value include:
- Quality/depth/tenure of employee base
- Goodwill of the company in the marketplace (reputation, name recognition, etc.)
- Depth of management/relationships beyond exiting shareholders
- Quality/dispersion of client base
- Level of repeat customers
- Expertise in niche versus commoditized services
- Backlog and sustained profitability
Although not exhaustive, these seven factors impact the value of any professional service firm. The process of determining a range of FMV for any given professional service firm is not simple. Qualified valuation professionals provide valuations of professional service firms that are typically expressed as a multiple of revenues or earnings. For example, multiples of revenue that range from 0.6 to 2 of revenues or multiples of EBITDA that range from 3x to 6x are reasonable for illustration purposes. However, where the value of any professional service firm falls in either of these ranges is highly correlated to the risk factors a valuation professional sees in the aforementioned factors.
Typical Exit Options
While stakeholders in other industries face a similar dilemma as they near retirement, there may be other options more viable to them due to their business models. They tend to have an abundant supply of willing buyers in the marketplace eager to invest in firms entrenched in the manufacturing, distribution, technology, medical or other industries. This article provides an understanding of why Employee Stock Ownership Plans (ESOPs) offer an ideal exit alternative for professional service firm owners by examining the profile of a typical professional service firm, providing solutions to the four considerations listed above and demystifying ESOPs.
There are three typical successful exit plan options for business owners:
1. Sale of company to a strategic buyer: In many industries, owners can consider selling the business outright to a strategic acquirer. Sales to these buyers may often result in the highest price available to a seller. Industry statistics reveal that, historically, professional service firms have not been great candidates for a strategic sale. This is due largely to several factors, including:
a. Cultural mismatch between the buying and selling firm
b. Difficulty in realizing economic synergies
c. The lack of contracts that will assure both key employees and clients will stay with the firm post-acquisition
d. The fear that an acquiring firm will tarnish the legacy of the firm
2. Sale of company to a financial buyer: Private equity (financial) buyers are often a great liquidity option for a partial or full sale. Private equity buyers possess the capital required to acquire the firms and have strong management teams to operate. However, professional service companies are not typically a target investment for private equity firms due to a cultural mismatch and the lack of skilled expertise to run professional service firms. If outside funding (to the PE firm) is necessary, they may also find it difficult to obtain this, limiting the credit facilities available to structure a transaction.
3. Sale to a closely held group of key employees (management buy-out): Owners often turn to key employees (typically key members of their management team) to structure a management buy-out. This option, while possible, often faces three primary challenges:
a. Affordability for the new ownership team
b. Difficulty of selecting certain key people that can shift from employees to a collaborative owner/management team
c. Potential for losing strong employees who were not chosen as successor owners
ESOP As An Ideal Exit Option
A popular alternative for exiting owners of professional service firms has been to sell the company, either as a partial or complete sale, to an ESOP.
An ESOP is initiated when a legal entity, a trust, is formed to hold the stock for the benefit of the employee base. It uses the resources of the company’s own balance sheet to fund either a partial or full buy-out from the exiting shareholder. With an ESOP, an owner is able to gain the desired liquidity from a “ready market” (the ESOP) to a buyer who, through certain financing alternatives, can back the purchase of stock for the exiting shareholder. Further, the legacy of the firm stays with the people who have helped build that legacy – the employees. Finally, should an owner wish to retain control of the business or simply continue with the operations, the ESOP provides a structure that allows an owner to step back based on a timeframe under his or her control.
An ESOP is an attractive alternative for many exiting shareholders of professional service firms, addressing many of the pitfalls of the previously mentioned exit options that may be more viable to other types of businesses.
Strengths and Weaknesses of an ESOP
The advantages of an ESOP for the right candidate include:
• Liquidity and timing. When there are issues with other liquidity alternatives, the ESOP provides a ready financing vehicle for the owner. The owner can control the timing of the sale (they can do a “partial” sale, and still stay engaged in the business) and be able to continue to operate with current trusted, key personnel of the firm should the selling shareholder choose to retain an ownership position.
• Tax benefits. Immense tax benefits can result in increased cash flows:
o As a sanctioned retirement plan, an ESOP is technically a tax-free trust. For S Corporations, the pre-tax income of the company attributed to the pro rata level of shares (of total outstanding shares) that the trust owns, is non-taxable income. At its maximum benefit, an ESOP trust that owns 100 percent of the company stock pays zero federal income taxes.
o For those companies where the ESOP does not hold 100 percent of the stock of the S Corporation, there is a tax benefit related to ESOP leverage. With an ESOP, both principal and interest debt payments (related to an ESOP loan) are tax deductible items. Thus, as a financing vehicle the ESOP provides significant tax breaks to the company.
Both of the tax benefits give the company a tremendous competitive advantage as management now has excess cash flow due to the avoided tax that can be used for other purposes such as expansion, key employee retention, re-investment in the company or reduction of debt.
• Tax incentives for selling shareholders. Shareholders can sell their stock to an ESOP Trust and defer – or possibly eliminate – federal income taxes on the gain from the sale if the sale qualifies as a tax-free rollover under Section 1042 of the Internal Revenue Code. The principal factors to determine whether the sale qualifies are: (i) the ESOP Trust must own at least 30 percent of the company’s stock immediately after the sale, and (ii) the proceeds must be reinvested in Qualified Replacement Property within a 15-month period, beginning three months prior to the date of the sale.
• Benefits for employees. Every year that stock is allocated to the account of an ESOP participant, employees receive additional compensation in the form of a retirement benefit. This may become the only retirement vehicle offered or it may be offered in conjunction with other retirement benefit options. Research done by the National Center for Employee Ownership (NCEO)1 shows that ESOP companies on average contribute approximately six to eight percent per year for all eligible participants and often offer a secondary retirement plan. Finally, according to the study, ESOP participants have approximately 2.2 times as much account value (based on defined contribution plan assets originally contributed by the company) over a similar time period as participants in comparable non-ESOP defined contribution plans.
Overcoming Misperceptions When Setting Up the ESOP Plan
The perceived complexities of setting up an ESOP are worth attention and discussion. Below are a few misperceptions of ESOPs:
• You will not be able to achieve “maximum price” when the buyer is an ESOP. It is true there are other exit options that can often offer higher prices to owners of certain businesses.2This may not be a viable option for exiting shareholders of professional service firms due to the challenges of finding a strategic or financial buyer. ERISA mandates that an ESOP as a retirement plan cannot pay more than FMV in a transaction. As an example, FMV typically excludes any synergies that a seller may expect to receive when selling his or her shares to a strategic buyer. However, if there are no such viable strategic buyers, then the FMV is a very attractive option.
• Management will be forced to share financial statements with employees. The law does not require financial statements be shared with plan participants. The only required financial disclosure is that each participant be furnished annually with a benefit statement documenting the number of shares allocated to his or her account and the FMV of those shares.
• ESOPs are risky retirement vehicles. Data from the Department of Labor shows ESOPs with more than 100 participants outperformed 401(k) plans in 15 of the 20 years between 1991 and 2010. The mean rate of return was over two percent greater during this period for ESOP companies versus companies that carried only a 401(k) retirement plan.
• The firm is not large enough or performing well enough to be an ESOP company. While there is a cost/benefit analysis that should be performed (see below for more on costs), ESOPs have proven effective for companies with as few as 20 to 50 employees. In 2014, there were nearly 3,000 ESOPs with 50 participants or fewer.3,4
• Acquiring the debt to finance a sale from an exiting shareholder will be difficult and risky to the company. This can be true if approaching conventional lenders that are not seasoned ESOP lenders. Experienced lenders in the ESOP field understand the significant tax-related cash flow benefits an ESOP company receives that can lower its risk. In fact, according to a 2009 study conducted by the NCEO, the historical default rate for ESOPs is significantly lower than default rates on other commercial loans. According to this study, the default rate on ESOP loans was less than 0.5 percent. Moreover, a Moody’s study found that in comparison, private equity-owned companies logged a 19.4 percent default rate between January 2008 and September 2009, while 186 private equity-owned companies and non-sponsor-owned companies defaulted at a rate of roughly 18.6 percent over the same period.5
• If obtaining a loan is difficult or costly, there are options for the selling shareholder who is confident with the future performance of the company. A selling shareholder can choose to take back a seller note, also known as a promissory note, from the company. Although ERISA dictates that the terms of the loan must be at FMV, the company can potentially issue warrants to the selling shareholder. This will provide some upside value to the exiting shareholder should the stock price increase beyond the strike price of the company as of the date of the initial transaction.
• There is a post-transaction decline in stock value, thereby hurting the ESOP participants. This is a true statement in most transactions when the stock of a key employee or founding shareholder is bought by the company and financed with debt. If leverage is needed to finance this shareholder exit option, then there will be debt on the balance sheet that did not exist before (consistent with other buy-out options). However, the ESOP has just bought stock of (hopefully) significant value and, as the debt is repaid, the Trust and its participants are left with a valuable asset from which the employee base will benefit into retirement.
• High-level or key employees will not be incentivized sufficiently as the ESOP will dilute firm value. Adopting an ESOP can be dilutive to the value of the company stock, due to the increased level of debt on the balance sheet, but there are common alternative management incentives that provide enhanced returns to key employees or the exiting shareholder that are considered at the time of the initial ESOP sale transaction. For an in-depth discussion, please contact Patrice Radogna at PRadogna@ValuationResearch.com.
• Having an ESOP is costly. Achieving liquidity for an owner as well as providing retirement benefits for employees requires expertise of certain key professionals. When compared with the fees of an investment banker or private equity in alternative exit scenarios, the fees are quite reasonable. The fees that need consideration are those of a Trustee (should the company desire to hire an external trustee, versus keeping that role internally), an ESOP attorney, an accountant and an independent business valuation professional. The value an ESOP brings to an exiting shareholder coupled with the ongoing retirement benefits to the entire employee workforce should be evaluated prior to deciding the ESOP route is too expensive.
An exiting shareholder of a professional service firm has worked a lifetime to build a company that is often the most significant asset in his or her investment portfolio. The ESOP is an attractive exit solution for professional service firms, but is often not considered due to a lack of understanding.
VRC performs fairness opinions in connection with newly forming ESOPs and annual ESOP valuations. Our valuations include both those for plan initiation and those required annually under federal law. For a more in-depth conversation about how we can work with your firm’s ESOP, please feel free to contact a VRC professional.