Inside the alternatives to traditional M&A

The founder of Linxx Global Solutions wanted to exit the company, but he didn’t want to leave his management team and employees high and dry—so he opted to convert the company to an employee stock ownership plan, or ESOP, to allow the company to continue on in the hands of its own.

What founder Frank Cucci did in April was find an alternative to a traditional sale, and ran with it. “When you say alternatives to [mergers and acquisitions], I think about trying to achieve liquidity,” said Jean Stack, managing director at the investment bank Houlihan Lokey, and there are a number of these alternatives.

As far as timelines go, both the traditional and non-traditional M&A transaction take about the same amount of time. “It’s not dissimilar to the regular transaction time. Transactions can typically be as short as possible as 60 days to 6 month. I’d say our average is around 90 days,” said William Hayes, managing partner at Mosaic Capital Partners, the firm that helped Cucci convert Linxx to an ESOP.

There are more alternatives than just the ESOP, as well.

“We certainly have seen some non-ESOP sales to employees, and usually that involves the company taking out debt to buy out the shares of the owner so that minority shareholders then own a larger percentage of the company’s equity, but the company now bears additional debt,” said Mitch Martin, principal at the McLean Group, the investment bank that advised Linxx Global Solutions on its transition to being an ESOP.

Another option, in certain cases, is taking the company and going public, Martin said, but usually the company has to have reached a critical mass with respect to size for that to work, particularly because this option can be very expensive.

Although these are different approaches, there does exist some commonality between them.

“There’s some companies where a [traditional] sale becomes extremely difficult, and that’s when there’s a lot of either small business set aside work or another form of set aside,” Stack said. These could be 8(a) companies or service-disabled, veteran-owned small businesses, for example.

“A lot of the alternatives, more often than not, rely on the company’s ability to assume debt, so it has to be a company that has very healthy cash flow,” Martin said. “It’s not going to be a company who is trading at 20 times EBITA, so you’re not going to see many of the cybersecurity companies in things like this.”

There is also a trend with companies that go the alternative M&A route that their owners usually have some motivation beyond just maximizing value, Martin said. ESOPs, for example, are “a great way to maintain the legacy of the founder and provide the management opportunity to, in effect, do a management buyout without having to come up with the capital themselves,” said Hayes.

But converting to ESOP is more than just wishing for the well-being of your employees. “There are some potentially pretty enormous tax advantages both on the front end and going forward depending on how you structure it,” Martin said. “There’s the ability to defer capital gains taxes potentially indefinitely.”

To achieve this, a company would convert to a C corporation—a corporation that is taxed separately from its owners—prior to changing the ownership structure, which Martin said allows for the 1042 rollover and deferral of capital gains taxes.

The company will then pay off the debt that was taken out to support the conversion, and then afterward, the company will convert back to an S corporation—a corporation that is not taxed separately from its owners. At that point, the company’s cash flows going forward are non-taxable, Martin said. “That extra cash can be used to grow the business,” Hayes added.

While the investment bankers don't see a rush of companies opting for alternatives to traditional M&A transactions, in the end, it just comes down to "what is the seller’s objective with their company," Hayes said.