Exit Capital: the Perfect Buyers
In today's tight credit market, many sellers are stuck financing the sale of their companies to purchasers with dubious qualifications -- if they can find a buyer at all. Bob Griffith came up with a solution
Bob Griffith started Accra-Fab Inc. in 1980, at the age of 50, with a grand plan. "I wanted to be cashed out and clean of any responsibilities by the time I turned 65," he says. In June 1991 he sold his 80% stake in the plastics and metal fabricator, based in Spokane, Wash., for a cool $4.6 million, but as the owner does in most buyouts, he agreed to stay on to smooth the transfer of his company to the new owners. The buyout is ahead of schedule, and Griffith now spends just two days a month at the office. Fishing, traveling, and photography occupy most of his days. Barring catastrophe, Griffith should be living the life of Riley by his 65th birthday.
Sound too good to be true? In today's tight credit market there is a dearth of well-heeled buyers, so many sellers are stuck financing the sale of their companies to purchasers with dubious qualifications -- if they can find a buyer at all. Griffith sold Accra-Fab to its 200 cash-poor employees via an employee stock ownership plan. Congress designed ESOPs to provide a cornucopia of tax breaks for sellers, buyers, and even the bankers who finance such deals; its intent was to preserve economic stability within communities and encourage wider distribution of wealth.
How does it work? The company's ESOP takes out a loan to purchase the owner's stock, and the company, in turn, contributes a portion of its pretax profit to the ESOP, which gradually pays off the principal and the interest on that debt, allocating the paid-for shares to the employees' accounts. Because only half of the interest income the lender earns on ESOP loans is taxable, bankers can charge the ESOP a low interest rate and still make money.
And the seller is exempt from the capital-gains tax, provided the proceeds of the sale are invested in domestic corporate securities within 12 months.
Companies with as few as 6 and as many as 10,000 employees have met Department of Labor and IRS guidelines for ESOPs. Jack Curtis, a San Francisco lawyer who, as an aide to Senator Russell Long, helped write ESOP legislation, explains that companies on the ropes can't consider an ESOP. "Other unsuitable companies include those that would be left with no key management team in place after the owner departed," Curtis adds.
And because an ESOP is a defined benefit pension plan, the paperwork associated with frequently buying back the stock of departing employees could be more trouble than it's worth. So restaurants and other businesses with high turnover are generally not viable ESOP candidates.
Even a company with a stable work force might not qualify for an ESOP if a large number of its employees are near retirement age. Why? ESOPs must reserve funds to buy out exiting employees who are fully vested -- a financial strain on top of the ESOP debt service. Finally, because a company's annual contribution to its ESOP may not exceed 25% of its total payroll, companies with low-paid work forces might also be unsuitable for an ESOP. If more funds are needed to cover ESOP payments in such a company (or in any company, for that matter), employees must vote to cut their wages -- an option of last resort.
To ensure that the future employee-owners aren't getting a lemon, an appraisal of the company's fair market value must be conducted on the buyers' behalf. Valuation determines whether the proposed ESOP can, within a reasonable time, service the debt incurred in buying out selling shareholders.
Kathryn Daly of Willamette Management Associates, a valuation firm in Portland, Oreg., explains, "Without strong potential for future earnings, a company won't qualify for an ESOP." Hard assets, earnings, sources of revenues, the quality of the management team, comparable public companies, and market conditions all figure into the sale price.
Most banks require sellers to guarantee personally a portion of the loan or to take on subordinated debt equal to the amount of the loan the company can't collateralize. Griffith warns, "If there's a downside to an ESOP, it's that the owner isn't really out until the ESOP debt is paid, because banks keep owners on the hook. That's why I got the ball rolling when I was 59."
Legal and appraisal fees can run from $13,000 to $30,000, depending on the complexity of the appraisal and the legal work involved. In addition, if you need the services of a financier like Dick Phenneger, who tools around Spokane with "MR ESOP" vanity plates on his car, count on paying that financier about 1% of the amount of the loan his or her bid proposal secures.
Griffith figures Phenneger earned his 1% fee by securing the $4.6-million bank loan that made it possible for Accra-Fab to buy all of Griffith's stock at once, providing him with the maximum tax benefits without imposing a difficult payment schedule on the ESOP. Accra-Fab shelled out about $100,000 in appraisal, legal, and financial-consulting fees to install its ESOP.
Griffith knew that administering an ESOP would require financial expertise beyond that of the bookkeeper who had been overseeing the financial life of the then $9-million company. So in November 1989 he hired Don Hemmer as controller. A certified public accountant, Hemmer had been an accountant for a bank and was also familiar with the books of manufacturing companies.
About a year later, comfortable with his choice, Griffith gave 20% of his stock to Hemmer and three other key managers. The board named Hemmer president last May. Who better, after all, to protect Griffith's personal guarantee on the debt than Accra-Fab's financial wiz, who had his own stake in the company?
Griffith designed Accra-Fab's ESOP to survive a worst-case scenario. "We were looking for a $5-million loan when, normally, we carried only about 10% of that," says Griffith. The company's loan for machinery was being retired, and that freed money that Accra-Fab was used to setting aside for payments. Profit-sharing contributions that had been averaging about 8% of pretax profits annually could be diverted to the ESOP fund if profits were tight.
Griffith also plugged into Accra-Fab's 10-year projections a paltry 10% growth rate, despite several years' history of 30% sales growth. In addition, Griffith set the sale price at $1.32 per share -- the low end of the appraiser's recommended range, $1.30 to $3 -- and he bargained hard for a conservative 10-year payout schedule of the $4.6-million bank note. IRS guidelines require that owners be paid out in a "reasonable amount of time" -- usually 5 to 7 years. Sums up Griffith, "I knew we could afford to pay back the ESOP loan in 5 years and still have a cushion. The 10-year term gave us twice as much cushion, so the chances were remote that we would have to dip into capital expenditures or profit sharing, or take payroll cuts."
Four banks bid on the loan to the highly profitable, nearly debt-free company. In addition to the lengthier payout schedule, Accra-Fab locked in an 8% interest rate -- later refinanced to 6.15% -- and a monthly rather than quarterly payment schedule. There was, however, no way Griffith could wriggle out of guaranteeing 55% of the loan's declining balance.
In the two years since Accra-Fab installed the ESOP, the company's sales have grown 45%, to more than $17 million, and it is already two years ahead of schedule on its ESOP loan payments. Currently, monthly ESOP payments of $56,745 account for a model 33% of Accra-Fab's pretax profits.
It's been a good deal for everyone. Today an Accra-Fab employee earning $25,000 owns equity worth $4,100. By next year that stock should be worth $6,600, and as the ESOP pays down the loan, the bank will continue to transfer stock to the ESOP, and that employee's account will be issued an additional $4,600 worth of new shares. At that rate, Griffith's management obligation to Accra-Fab will be fulfilled by June, and he will be home free.
"I was never a person driven by maximizing the dollar," Griffith explains.
GOOD THINGS COME TO THOSE WHO PLAN
Accra-Fab's experience is an enviable exception to the rule, according to Rick Rose, principal with Menke & Associates, a San Francisco-based firm that has installed around 1,000 ESOPs. "In a plain-vanilla ESOP, an owner sells 30% to 50% of his or her stock to the ESOP," he explains. That's an amount companies can afford to finance out of cash flow or collateralize with bank debt. Over time the owner cashes out his or her remaining shares. In such cases, the closely held company's value is discounted an average of 25% because the owner is selling less than a controlling interest to the ESOP.
How owners can insulate themselves from seller-financing risk:
1. Pick and groom key managers who can manage not only an ESOP but on-going operations as well.
2. Reserve a portion of stock for those key managers to make them extra loyal.
3. Build a "war chest" within the company to finance as much of the ESOP as possible.
4. Shop around for your ESOP loan.
5. Educate employees about the ESOP, and show them how their efforts contribute to the company's overall well-being and make their stock more valuable.
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