Death, it sometimes seems, may be the easiest way out of a family
business. With proper attention to insurance, succession, and estate
planning, those who leave this vale of tears can also depart from their
family firm with limited impact on the business. Other exits are often
decidedly more traumatic for the businesses and the individuals involved.
Nonetheless, many family business owners have to realize there
inevitably will come a time when some shareholders decide they want to do
something else with their time and money. They may want to convert their
investment into assets that are more liquid in order to meet other
personal or business needs; they may want to diversify their assets to
avoid relying too heavily on the company; or they may find themselves
tired of the business - or (perish the thought) their relatives.
When a shareholder in a family business wants liquidity, "Rarely do
these things end up with as much sweetness and light as when they start,"
says Milton H. Stern, a partner in the New Jersey law firm of Hannoch
Weisman and author of Inside the Family Held Business. Agreeing on
a price is difficult when a company is privately held - and when the
buyers and sellers are all related. And the company may have difficulty
raising the cash to pay off the departing owners. Thus, when shareholders
demand to be bought out, the fraying of nerves and the strain on liquidity
can be substantial.
Once there seemed to be few alternatives. Remaining shareholders had to
dig deep into their own pockets or into the corporate coffers for the cash
to buy out those seeking liquidity, sometimes leaving themselves or the
company burdened with debt. Or, if the pockets were not deep enough, the
contented shareholders reluctantly had to join the footloose ones in
selling the company.
One legacy of the financial engineering that Wall Street pursued in the
eighties is a much wider array of alternatives for family businesses
seeking to provide liquidity for some shareholders without undermining the
Dropping out of the picture but not off the
When a shareholder active in the business wants out, says Ronald H.
Drucker, a partner in the accounting firm of Drucker and Scaccetti P.C.,
in Philadelphia, saying goodbye "doesn't have to take the form of a sale
of stock." If the shareholder wants to ensure his or her financial
stability but doesn't need a pile of cash to reinvest right away, Drucker
says, it may be possible to smooth the exit with continuing compensation.
Two devices are frequently employed: One is a consulting contract in
which the departing shareholder is paid to remain available for
consulting, whether or not the shareholder is actually called on to do
anything. The other is a noncompete agreement in which the shareholder is
obligated not to compete with the company in return for compensation. Both
are valuable to the company if the shareholder-cum-employee is
knowledgeable and experienced. But both also provide a handy way of
transferring funds to shareholders with tax-deductible payments from the
Enabling an owner-employee to leave the firm and continue to receive
medical benefits paid for by the employer is also an important option.
Medical insurance coverage is not only less expensive, but usually more
comprehensive under a company plan than it is when bought by an
individual. "This can be important to many individuals," Drucker notes.
Establishing a clearinghouse for buy-and-sell
Another way to head off the problem of shareholders who want to sell a
big block of stock all at once is to enable them to sell smaller blocks
anytime they want. That can be facilitated through a clearinghouse, in
which the company collects and distributes information regarding the
interest of family members in buying or selling shares.
A clearinghouse isn't needed for a company owned by a handful of family
members all living in the same area. It only becomes necessary when
shareholders have multiplied. For example, as ownership in a New Jersey
manufacturing firm spread to several dozen cousins coast to coast, they
agreed to notify the corporate secretary of any interest in buying or
selling company stock.
"For regulatory reasons, the company must carefully avoid any
appearance of dealing in the stock," an investment banker notes. Thus,
once the clearinghouse makes the would-be buyers and sellers aware of each
other, it must step aside and let them negotiate their own transactions.
The problem with clearinghouses is that parties may not agree on a
price, or there may be an imbalance of buyers or sellers. As a result,
some companies become more involved in making a family market for their
shares. They may become buyers of last resort: If someone wants to sell
and no other family members step up, the company itself may buy the shares
and retire them or turn them into treasury stock.
One way to institutionalize this process is to create an annual stock
repurchase program in which money from operations is set aside to purchase
a fixed number of shares once a year. If additional shares are offered,
they can be purchased on a pro rata basis. Whatever the mechanism, the
point is to enable family shareholders to raise cash whenever they need
some. And helping them meet smaller liquidity needs may keep them from
developing big needs.
Selling assets that aren't critical to the
Many companies can raise money by selling or spinning off small parts
of their operations. They identify parts of the business that are
peripheral to the main activity, split them of into separate entities, and
sell them to generate cash for selling shareholders.
Retailing companies offer a clear way to do it. If a company has, say,
eight stores, it could transfer ownership of one store to the shareholder
seeking liquidity, and the shareholder could then sell the store and cash
Often this strategy works even for companies that may not appear to be
divisible. Milton Stern notes that he helped restructure a company so that
the business was placed in the hands of continuing shareholders, while
real estate once owned by the business was given to those who wanted to
get out. They could then sell the real estate, which housed some of the
company's operations, with provisos that enabled the company to keep using
Tax considerations are important in structuring these transactions.
Francois de Visscher, the head of de Visscher & Co., a financial
advising firm in Stamford, Connecticut, cites the case of a manufacturing
company in which a subsidiary was spun off into a trust for the
shareholders who wanted to sell their stock. Those shareholders, in
essence, exchanged their stock for the stock of the subsidiary. "Then," he
says, "we went ahead and sold that subsidiary and had the proceeds go
directly into the trust for the benefit of the selling shareholders." He
says the trust made it possible to avoid double taxation at the corporate
level; since the proceeds from the sale went to the trust rather than
directly to the shareholders, taxes weren't incurred by both the company
and the shareholders.
Selling a stake through convertible preferred
While many families frown on the idea of selling shares to outsiders, a
public sale of stock need not mean the beginning of the end of family
control. Thus, notes Thomas S. Shattan, managing director in charge of
private equity financing at Kidder, Peabody & Co. Inc., a company
should explore private equity financing - generally in the form of
convertible preferred stock or common stock - with institutions or
individual investors to provide the equity to buy out some of the family
Convertible preferred is nonvoting stock that pays a higher dividend
than common stock and is convertible to common at a predetermined price.
Many companies find it advantageous to use convertible preferred as a
financing vehicle because it adds to the company's equity base rather than
piling on more debt, yet it doesn't initially add any voting shareholders.
Shattan warns that outside investors don't want to feel they're being
asked to acquire the interests of family members who are bailing out of
troubled companies.''The key factor" in attracting new investors, he says,
is "if it's an exciting, interesting company with some strong prospects
for some growth."
In fact, Shattan adds, "Often investors like to do these kinds of
financing in conjunction with new money being raised to grow the company.
Investors like to see that their money is going not only to provide
liquidity to shareholders but also to grow the business."
Public equity financing is another option, but companies should
generally have at least $20 million in sales and strong growth potential
before entering that playing field.
Teaming up with a strong partner on the
Like selling equity to outsiders, any talk of joint ventures may seem
to violate the objective of keeping the company in the family. But there
are situations in which this may not be the case.
One is an industrial joint venture with a foreign company. With a
change in corporate structure, a family business becomes a holding company
that owns the operating company. The family then sells a minority interest
in the operating company to a foreign firm, with the cash generated by the
sale used to buy out shareholders without saddling the operating company
Ideally, the new foreign partner in the operating company won't want to
be an active manager. That's all very nice as long as the silent partner
remains silent. But foreigners are increasingly involved as active players
in the U.S. market and few remain content to invest in a company solely
for a bird's-eye view of America.
A safer bet is a financial joint venture, which de Visscher describes
as "a fairly recent technique that combines leveraged recapitalization
with a joint venture. In this process, a bank or other financial
institution would purchase a minority position in the operating company,
generating cash to buy out shareholders. But then, over a period of four
to six years, the financial partner would be bought out, and the family
would be back to 100 percent ownership."
For tax reasons, de Visscher says, a financial institution buys all of
a family's stock with a combination of equity and senior debt. The family
reinvests part of the money back into the new operating company in return
for a majority stock position, and uses the rest to buy out family
shareholders who want to leave the company. Over a period of years, the
family uses a portion of the company's cash to buy out the financial
institution's stake, re-establishing complete family ownership. De
Visscher emphasizes that "the motivations of the financial partner are
purely financial." Unlike a foreign industrial corporation, a financial
institution will not suddenly decide to run the business in a new way.
As a means of raising money, he notes, "this gives a high valuation. It
approaches the valuation of selling 100 percent of the stock." It also
facilitates the tax-free reinvestment of the proceeds. But it increases
leverage, and, therefore, may introduce a new degree of risk in running
Utilizing tools developed for the big
Leveraged recapitalizations, a major Wall Street phenomenon of the
eighties, are now an intriguing tool for family businesses seeking to
provide shareholders with liquidity. Although the tool comes in various
shapes and sizes, it essentially is a change in the capital structure of a
company whereby some of the existing family shares are exchanged either
for cash or a different form of security.
A leveraged recapitalization involves a tender offer for the company's
stock in which the original group of shareholders in a company essentially
sells the company to a new set of shareholders consisting of those
original shareholders who still want a stake in the company. The
transaction is typically completed through the sale of senior or
subordinated debt or through the issuance of preferred stock.
The company could offer to pay for the stock with cash or a combination
of cash and securities. The advantage of a noncash offer is two-fold: it
limits the amount that has to be borrowed to finance the purchase, and
"you can actually do an estate freeze with the issuance of that paper, as
long as it's non-voting stock," says de Visscher.
An estate freeze essentially locks in shareholder values for the
purpose of computing taxes and removes future appreciation in the value of
the business from tax calculations. By using preferred stock redeemable at
a specified price, or some other kind of fixed-value security, "the
seller, in effect, freezes the estate because the value is set and future
appreciation won't go into the estate any more."
While a leveraged recap enables a group of shareholders to cash out,
its estate-freeze feature makes it particularly useful in passing control
to a new generation. It could be used, for example, to buy all the stock
of the older generation in return for nonvoting preferred stock or
"The convertible preferred allows you to bring a layer of equity into
the company that may not necessarily be voting equity, which allows you to
take on more debt on top of it," says de Visscher. If the company only
needs to buy out small shareholdings, it may just borrow the money to pay
for the stock. "But, ifyou're dealing with 30 or 40 percent of the
shareholders," he says, "the company may not be in a position to borrow
that much money, so it needs to have other ways to finance it."
That's when the convertible-preferred option becomes useful.
Convertible debt initially costs the company less than straight debt, and
it provides an upside kicker for the investor in the form of the right to
turn it into stock.
Leveraged recaps may be too expensive to implement for companies with
sales of less than $5 million. Jonathan D. Scott, vice-president in charge
of the closely held business and real estate group at Provident National
Bank in Philadelphia, warns,''There are fewer banks out there doing LBOs."
As a result, "an LBO for a small company tends to involve very expensive
money." However, if it can be done, it fetches good prices for the selling
Welcoming workers as shareholders of the
A good alternative to selling out or going public is to bring in
employees as shareholders through an employee stock ownership plan.
ESOPs are trusts that hold company stock for the benefit of employees.
Each year, the company can make tax-deductible contributions of stock or
cash up to 25 percent of its payroll. The cash is used to purchase shares
from family members. An ESOP can also be leveraged. The company provides a
loan, or guarantees a loan, to enable the ESOP to purchase shares; in some
instances, the company can deduct both interest and principal payments
from its taxable income. Because many banks derive tax benefits from ESOP
loans, the financing may be relatively low-priced.
For family members ESOPs offer a great tax break. If the ESOP acquires
at least 30 percent of the company's stock, family members can defer the
capital gains on the sale of their stock if they invest the proceeds in
qualified securities - typically, publicly traded stocks and bonds -
within 12 months after the sale. Taxes are deferred until these securities
Scott notes that the ESOP helps provide a valuation of the company's
stock. ''This makes a nice way for family members to get out because
there's not a fight over the price."
ESOPs can also help improve employee relations. Families who not only
share ownership but also provide information to employees and involve them
in decision making often see big improvements in productivity. "One
manufacturing company I know of," says Scott, "has a very active ESOP, and
it currently holds nearly 25 percent of the company. Since it was
established, we've seen an incredible jump in productivity because the
shareholders are now the people out there on the plant floor."
ESOPs can cost $20,000 or more to set up. Companies considering a plan
should have a minimum fair market value of $1.5 million, a payroll of
about $500,000, or at least 40 employees.
Harvey D. Shapiro is a contributing editor to
Finding a fair price
The question of how much to pay exiting shareholders is often as thorny
as how to pay them. Obviously, those shareholders who are selling want to
maximize the price and put it in their pocket, while the remaining
shareholders want to minimize it, not only to keep the money in the
business but also to avoid establishing a high valuation on the stock for
their own estate-planning purposes.
Moreover, the price per share for a portion of the company is far lower
than the price per share for the whole company. This is because a minority
stake in a company is worth less than a stake that is large enough to give
its owner control. A risk faced by exiting shareholders is that the entire
company could be sold the next year, which means that everyone but them
would share in the control premium. That's why sellers sometimes want a
"look-back" or other provision ensuring that if the company is sold within
a specified period of time, and if the price paid per share is more than
they received, they will share in the increment. ln assessing prices,
there are also very different perspectives, depending on whether
shareholders are active in the business. Ronald Drucker, a partner in
Drucker & Scaccetti P.C., notes that active shareholders often tend to
attribute the success of the business to their labors, while distant
non-employee shareholders tend to ascribe the success to the founders and
feel that family members currently in the business have been granted
sinecures. These views lead to rather different perspectives when
non-active shareholders want active ones to buy them out.
François de Visscher, the head of de Visscher & Co., says it's
clear that "in any kind of private company, the best way to get the
maximum value is to sell the company." Short of that, he adds, joint
ventures and leveraged recapitalizations "often get you very close" to
these kinds of values.
The leveraged recap may put the company deeply in debt, however. And
valuations can be zero-sum games in which the sellers' gains are viewed as
losses by everyone else."The main thing is that both parties have got to
be willing to compromise," says Drucker.
By permission of the publisher from Family Business (March-April, 1991). Family Business Publishing Company, http://www.familybusinessmagazine.com.