Jean Stack

COMMENTARY

Think twice before selling your company

There are alternatives that could be more lucrative

Jean Stack is managing director of the Aerospace, Defense and Government Group at Houlihan Lokey. She can be reached at JStack@HL.com

The foundation of the government services sector consists of thousands of owner entrepreneur-built businesses. When considering liquidity and succession planning strategies, these owners usually focus on the sale of their business as the means to achieve their financial and other objectives. Given the vibrant government services M&A market, on a pace of about 100 deals a year, an exit via sale is often the logical path.

However, based upon the attributes of the business and the overall objectives of the owners, there are a number of alternatives that might be a better fit. These alternatives – including dividend recapitalization, leveraged buyout (LBO) and employee stock ownership plan (ESOP) implementation – can be attractive to shareholders from both a valuation and qualitative outcome.

In addition, these alternatives provide the opportunity to re-position ownership, incentivize employees and set the framework for solid growth.

Dividend recapitalization provides shareholders with the ability to take cash out of the business by raising bank debt to support a special dividend. For a single owner, a dividend recapitalization simply trades equity for debt on the balance sheet. With more than one shareholder, this strategy can result in a redistribution of ownership, with a reduction in ownership for the founder and increasing ownership for others shareholders, including management and outside investors.

This strategy was particularly popular in 2010 in anticipation of expected capital gains tax increases in 2011. It is also a widely employed strategy for private equity investors looking for investment returns in advance of an exit from the business.

A second strategy, the LBO, can be accomplished through management and/or professional investors deploying a combination of debt and equity to acquire either a minority or control position in a company. An LBO is a very flexible alternative that can be designed to meet the individual objectives of the shareholders, including investment horizon, valuation, succession planning, and continuity of business operations.

Also, an LBO can be an excellent way to gradually transition ownership and management of the business over time. This type of transaction will result in greater liquidity than a divided recapitalization, as considerably more debt capital can be raised with new equity or equity-like securities coming in.

In addition, a leveraged buyout can potentially result in greater total proceeds than an outright sale, as it gives the owner a second “bite of the apple”; that is, participation in a higher exit value from a downstream sale of the business.

A minority LBO can be structured creatively to maintain S Corp status and also preserve small business or other set-aside status until a change of control occurs. With dramatically improved lending markets, an LBO may be accomplished at a valuation competitive with many strategic M&A transactions. There are more than 50 private equity funds with current control or minority investments in government services companies, with dozens more looking for companies in which to invest.

While a minority or control LBO can be an excellent liquidity solution in many circumstances, it often will require ongoing equity participation by the current owner and will result in meaningful protective rights and provisions for the outside investor.

A third liquidity alternative is the leveraged ESOP. It involves the creation of a qualified retirement benefit plan that borrows money to acquire stock in the company. The debt is collateralized by company assets and the proceeds are used to purchase stock from existing shareholders and/or from the company. Principal payments on the debt are made through tax deductible ESOP contributions. There have been many examples of employee-owned companies in the government services market, including Science Applications International Corp., Parsons and Alion Science and Technology Corp.

A leveraged ESOP is an excellent mechanism for an owner to achieve partial liquidity immediately and full liquidity over time. In addition, a minority ESOP allows the company to continue to pursue small business or other set-aside contracts. Moreover, ESOPs are exempt from federal income taxes.

With no federal tax payments, a 100 percent S Corporation ESOP company has incremental cash flow available for debt service or other purposes. Clearly an ESOP has many complexities with numerous pros and cons, but it can be an excellent path to achieving liquidity for founders while retaining business continuity and providing an employee retention tool.

Unlike a strategic sale, each of these transaction alternatives allows the company to maintain its name, organization, culture, management, compensation and benefits. By providing liquidity at attractive valuations, these alternatives to an outright sale should be considered as part of any exit planning.

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