The Importance of Converting Equity to Capital

Guy Baker By
Guy Baker

MBA, MSFS

 

  1. Introduction
  2. The Beginning
  3. Why have a business entity
  4. To Pass Through or not
  5. Closed Entities and Pass through entities
  6. The benefits of owning a closed entity
  7. The Three Circles of Wealth – The Common Denominator
  8. The Three Big Questions
  9. I. Creating and Retaining Value
  10. II. Keeping Superkeepers
  11. III. Exit Strategies
  12. Additional strategies to build and retain wealth
  13. Conclusion

 

II. KEEPING SUPERKEEPERS

Most business owners will face, at some time in their business cycle, the pressure to sell stock to key employees. The pressure will be to keep their superkeepers (super performers) – the key people you do not want to lose from your team. I have only one thing to say – don’t sell stock. Don’t sell stock unless you are ready to begin your exit strategy. Why?

I cannot tell you the number of situations where this has been a disaster for the owner. Something happens when stock transfers that turns your cooperative, malleable employee into a different person. When a loyal, dedicated, uninvolved employee is given stock, they become super vigilant, diligent, an audit hawk. What was once a very congenial, “go along with anything” associate now wants to know every detail related to everything going on in your business and will make your life miserable. You can no longer take long lunches; deduct golf games with potential consultants or key accounts.

Your life will change. Your car will come into question, along with your gas card and your salary will become an issue. The bonus program will suddenly become a major sticking point. Maybe you don’t believe me? So go ahead and try it and find out. Many owners have and then have regretted it.

What Is The Solution?

Unfortunately, the real problem with selling stock does NOT solve the superkeeper issue. In fact it often exacerbates it. It also does not answer the question of how to attract and retain top talent. Remember, if you sell stock, you are limited to 100% of it. If you are concerned about your own financial security, giving away value at a bargain price is going backwards. The argument is that by selling stock, the overall value of the enterprise is not necessarily going to go up. This is the business conundrum. If you want to build a valuable business, you have to create an independent management team. If you want to retain your entrepreneurial independence, you can’t build an independent management team. Talk about conflict. So what do you do?

First you have to decide what is important to you? What is your goal? Are you going to build to sell? Or build to hold? Or build to transfer to family? Or build to transfer to key employees?

If you are going to build to sell, then you need to give your superkeepers an incentive to help you make the company saleable. If you are going to build to hold, the superkeepers need to know there is a pot of gold at the end of their rainbow for helping you be an absent owner. If you are going to build to transfer, then the superkeepers need to feel secure about their position and know there is an economic benefit for helping you pass the business to family members. If you are going to pass it on to key employees, who? when? for how much?

But in all of these scenarios, the key question is – do you share equity or income? Income is a lot easier to share than equity. Income is very measurable and can be easily administered. Equity is nebulous and has no real value unless the company is sold to an outside buyer.

If you sell stock to superkeepers but you don’t sell the company, you will ultimately have to buy it back. That is an expensive proposition with no tax benefits. But you can defer that decision until you pull the trigger on a deal. If you are going to transfer the business to internal buyers, you have a bit more latitude on what you can do. But in the end, you will have to decide if you want to compensate your key people with more than income and then be willing to stick with it. Otherwise, the business will be schizophrenic and so will you.

What tools are available to help you, besides selling stock?

Non Stock Alternatives

One of the best tools for building wealth without unleashing the audit monster are Equity Participation Plans sometimes referred to as phantom stock plans, Incentive Stock Plans or SARS – Stock Appreciation Rights. They generally all work the same way.

You allocate a certain amount of shares (phantom shares) to a pool. You then allocate those shares each year based on a formula and the shares are valued based on measurable metrics using the balance sheet. This metric is often just an increase in EBITDA. But it could be based on increases in retained earnings or some multiplier of net profits. By definition, this type of program is unique and distinctive for each business and each industry.

As I stated, you can only sell 100% of your stock. If you have 100,000 shares and you sell 20,000 shares, you have 80,000 shares left (80%). So by selling, you dilute your ownership. But if you allocate by formula 20% of the income, based on the salary of each participant, you will still retain 100% of the stock. You don’t give away control. You don’t have the audit hawks looking over your shoulder and the money is not payable except by the terms of the agreement. Plus it is deductible. You can also put limits on when you pay and how much. So a contribution can be withheld if the company does not hit certain growth metrics. Once you sell stock, it is virtually impossible to ever take it back and if you try, it will be very expensive.

What are the terms of an EPP? You tell me, you write the rules. You could cliff vest them at 100% when they retire, or upon sale of the business. This means they have no vested value until then. Now frankly, this approach won’t work with highly competent, transient executives – so you probably are going to have to give up something sooner than retirement. But the point is, you control the rules.

Stock Sale

Against all odds, let’s assume you decide you want to sell stock. There are good ways to do this and bad ways. Most every superkeeper is deficient in one important ingredient when it comes time to buy in – money. Unless they can borrow at the bank, mortgage their homestead, or liquidate their inheritance, they are usually month to month. So for them to buy stock, guess who has to help them? You.

There are two axioms that are ever present when discussing business succession strategies. The first is – there is NO SUCH THING as NEW MONEY. Every owner will get bought out of their own business with their own money. Don’t believe me? Think about this. If you want to sell your business to an outside strategic buyer – how is the price determined? There are various methods – appraisal, capitalization of net income, multiple of sales, comparison to other companies that have sold recently and the book value. There are at least five methods. A good appraiser will often weight all five methods to give you a value. But when you get down to it, no one buys a business for an amount greater than 4-5 times net income. They want to pay off the purchase within a few short years.

Where does this number come from – 4 to 5 years? If you have substantial capital and you are money wise, you probably feel you can make 10-12% annually. Most equity buyers are thinking 20%. If we use 20%, that is a pay back in 5 years. The higher their expected return, the fewer years to pay them back.

So let’s say you pull the trigger and sell your business to outside money. If the buyer gives you cash, it is really just an advance of money they expect to earn. Whose money do they expect to earn? If you had not sold the business, you would have earned the money they are going to turn around and give back to you. Sometimes, however, they make it a contingency sale. They give you money up front but hold back value to see how the company performs. Their payment is contingent upon performance. This gives you an incentive to make the deal work. But regardless, where did the money come from to buy you out? Once again, it was your money. They earned it from the company but they turned around and gave it back to you.

So in every instance, whether the payment is cash from liquidation of assets, borrowed funds, a private offering or an installment sale funded from cash flow, the results are always the same. It is a reflection of the income the company would have earned. The outside buyer is a facilitator. All they did was turn around and give you your money back. Granted, they may have taken some of the risk out of it, but in the final analysis, it was your money. And when it is over, what do you have? Nothing but the net proceeds from the sale.

If you sell to an internal buyer, the economics are exactly the same except you will give the internal buyer the money as salary first. So now what happens? They will pay tax at their top bracket and then turn around and give it back to you. This brings the second axiom into play. We call it the $1.82 story. The taxes on the sale of a business can be more than the fair market value of the company. This is especially true when you sell to an internal buyer.

Think about it. The taxes are going to be 100%+ of the fair market value. How is this possible? Let’s suppose you are to receive $1.00 of net proceeds. The internal buyer must earn $1.82 in the 45% bracket to net $1.00. (Proceeds divided by (1 – tax bracket)). So you pay the superkeeper extra income and they then, turn around and pay tax of $.82. What happens next? They now give you back your dollar. Now what happens? You have to pay capital gains tax at 25% on your dollar. Add those two taxes together. It adds to 107% of the sale price. You read that right – 107% of the sales price. Done wrong, the sale of a business is the MOST HEAVILY taxed transaction in the Internal Revenue Code.

There must be a better way. Fortunately, there is.

LastNext