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In this presentation, Chris Mercer of Mercer Capital discusses the important concept of managing the wealth tied up in illiquid assets, mainly your ownership in a privately held business. Also discussed are pathways to liquidity without selling the business, including dividend policy, leveraged recapitalizations, and esops among others.
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Options for Transitioning
the Business Understanding Baby Boomer
Business Owners
Z. Christopher Mercer, ASA, CFA, ABAR Mercer Capital August 15, 2014
The Society of Financial Service Professionals
Our Journey Today #1
§ Ownership Timeline
§ Key Valuation Concepts
§ Ownership and Management Transitions
§ The One Percent Solution
§ Buy-Sell Agreements
§ READY for Sale
2
Between the Bookends of “Status Quo” and “Third Party Sale” (or Other Planned Disposition)
3
The Ownership Timeline
The Ownership Transfer Matrix
5
ESOP / Management Outside Investor(s) Sales to Insiders / Relatives
Combination Merger / Cash Out Going Public
Gifting Programs Buy-Sell Agreements
Death Divorce Forced Restructuring
Shareholder Disputes Buy-Sell Agreements
Sale of Business Stock Exchange w/ Public Co. Stock Cash Sale to Public Co.
Installment Sale ESOP / Management Buyout
Liquidation Buy-Sell Agreements
Death Divorce Forced Restructuring
Bankruptcy Shareholder Disputes
Buy-Sell Agreements
Things That
Happen to You
Things You Make Happen
Partial Sale / Transfer Total Sale / Transfer
Buy-In
Gift-In
BSA
Business and Strategic Cycles
Divorce
Shareholders
Neighbors
Suppliers
Sell-Out
Gift-Out
BSA
25 to 35 35 to 55 55 to 65+
The General Ownership Timeline
6
The Ownership Timeline
§ Where are you in the ownership timeline?
§ Where is your business?
§ The challenges of cross-generational ownership
§ Valuation events can affect all parts of the ownership timeline
7
Overview of Key Valuation Concepts
Valuation Methods
Valuation Standards
Sane, Rational
Fair Market Value
Unique Compulsions
What is Valuation?
9
Strategic Value
9
Valuation Methods
Valuation Standards
Sane, Rational
Fair Market Value
Unique Compulsions
What is Valuation?
10
Strategic Value
10
The Real World
Appraisal World
The “GRAPES” of Fair Market Value #2
G It is a growth world § Price, Volume
R It is a world of risk & reward § Capital, Three-Tiers, Investment, Returns
A It is an alternative investment world § Markets, Economy, Uniqueness, Industry Integration
P It is a present value world § A dollar today is greater than a dollar tomorrow
E It is an expectational world § Most business value is prospective, not historical
S It is a sane and rational financial world § Fair Market Value versus Strategic / Synergistic Value
11
Intro to Valuation
Earnings x Multiplier = Value
Financial Statements
Management Discussion
Other Company Information
Company Data
Market Pricing
Industry Expectations
Economic Outlook
Market Data
Investment Decisions
Transaction Requirements
Death & Taxes
Information
12
Approaches to Value
INCOME APPROACH
Future Focused
MARKET APPROACH
Hindsight, Anecdotal, Unreliable?
ASSET APPROACH
Company- Specific
PRESENT VALUE
13
Equity Value vs. Enterprise Value
§ Enterprise value (industry experts’ focus)
- The value of your total “assets”
- Conceptually familiar to many owners
+ Rules of thumb
+ Representative of virtually all transactions
§ Equity value (primary valuation focus)
- Equity value + debt = enterprise value
- Obscure to most business owners
- Requires more disciplined modeling and considerations to develop
14
14
Basic Levels of Value
15
Control (Strategic) Value
Control (Financial) Value
Marketable Minority Value
Nonmarketable Minority Value
Strategic Control Premium
Financial Control
Premium
Minority Interest Discount
Marketability Discount
Basic Levels of Value
Fair Market Value
Levels
(Equity Perspective)
16
Control (Strategic) Value
Control (Financial) Value
Marketable Minority Value
Nonmarketable Minority Value
Strategic Control Premium
Financial Control
Premium
Minority Interest Discount
Marketability Discount
Basic Levels of Value
Direct Value Methods
Deal-specific; Enterprise Multiples
17
Indirect Value
Control (Strategic) Value
Control (Financial) Value
Marketable Minority Value
Nonmarketable Minority Value
Income Approach Methodologies
§ Direct Capitalization
- Converts a singular performance measure to a value
§ DCF Analysis
- Converts projected future benefits to present value
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The Income Approach
Value = Profit x Multiple
§ Equity value vs. Enterprise value
§ Which profit measure is used?
§ What is the relevant multiple?
19
Key Factors § Mark expenses to normalized or pro forma levels
- Non-recurring or unusual events
- Differentiating return on labor from return on capital
+ a.k.a. compensation adjustments and other benefits
- Strategic vs. financial adjustments/considerations
20
Intro to Valuation
Value = Multiple x Performance Measure
Equity Value
Total Capital Value
Equity Value
Total Capital Value
P/E (1/(R – G)
Weighted Average Cost of Capital
Equity Return
Market Multiple
Net Earnings
Debt-Free Net Income
Net Cash Flow to Equity
EBITDA Gross CF to Invested Capital
21
What’s the Big Deal About EBITDA?
§ Gross cash flow of an enterprise providing for six critical things
§ Reinvest in capital expenditures or other investments
§ Working capital needs from growth
§ Interest payments on debt
§ Principal payments on debt
§ Taxes
§ Returns to shareholders
22
Levels of Value Meets Basic Valuation Equation
Strategic Control Value
Financial Control Value
Marketable Minority Value
Nonmarketable Minority Value
Conceptual Math Relationship Value
Implications
CFe(c,s)
Rs – [Gmm + Gs]
CFe(c,f)
Rf – [Gmm + Gf]
CFsh
Rhp – GV
CFe(mm)
Rmm – Gmm
CFe(c,s) ≥ CFe(c,f) Gs ≥ 0 Rs ≤ Rf
Ve(c,s) ≥ Ve(c,f)
CFe(c,f) ≥ CFe(mm) Gf ≥ 0 Rf = Rmm (+/- a little)
GV = Rmm
CFsh ≤ CFe(mm) Gv ≤ Gmm Rhp ≥ Rmm
Ve(c,f) ≥ Vmm
Vmm
Vsh ≤ Vmm
23
What Is a Multiple?
§ Required rate of return - Equity
- Total Capital (WACC)
§ Growth rate
§ 1 ÷ (Rate of Return – Growth Rate)
§ No magic § R -15%
§ G = 5%
§ 1/(15% - 5%) = 10x
24
Reconciling the Value Conclusion
§ Averaging of methodologies
§ Adjustments
- Discounts and premiums
- Non-operating assets
- Contingent assets & liabilities
25
Tests of Reason
§ Relative value analysis
§ Reconciliation of current value with past value
§ Reconciliation with broad market financial measures
§ Reconciliation with transaction activity (internal and external)
§ Reconciliation to rules of thumb?
26
Last Look at Basic Levels of Value
$20-$22 MM
$30 MM
$14 MM
Control (Strategic) Value
Control (Financial) Value
Marketable Minority Value
Nonmarketable Minority Value
Strategic Control Premium
Financial Control
Premium
Minority Interest Discount
Marketability Discount
27
Approaches to Value #3 INCOME
APPROACH Capitalization
DCF
MARKET APPROACH
Public Cos
Internal Transactions
Market Transactions
ASSET APPROACH Net Asset Value
Excess Earnings
Methodologies
28
Ownership and Management Transitions
www.ChrisMercer.net
Truth in Advertising? – Not!
Understanding Baby Boomer Business Owners????
Z. Christopher Mercer, ASA, CFA, ABAR August 15, 2014
The Society of Financial Service Professionals
Buy-In
Gift-In
BSA
Business and Strategic Cycles
Divorce
Shareholders
Neighbors
Suppliers
Sell-Out
Gift-Out
BSA
Die in Saddle?
25 to 35 35 to 55 55 to 65+
The Ownership Timeline
31
10 Reasons That Businesses Change Ownership
1. A primary owner dies unexpectedly
2. A key employee leaves
3. The owner gets “tired” and decides to sell
4. Unexpected offers come along
5. Business reversals happen
6. The primary owner divorces
7. Life-changing experiences occur
8. Gift and estate tax planning
9. The second (or third) generation is not up to the task
10. Normal lifetime planning dictates timing
32
10 Thoughts on CEO Management Succession for Private Companies
1. Transition before it is necessary
2. Transition before you are ready
3. Link leadership development into succession planning
4. Share knowledge with your senior team
5. Consider potential successors
6. Set an emergency plan into place
7. Succession planning is a risk management function
8. Avoid the “just like me” trap
9. Develop a succession plan and don’t wait on events
10. Figure out the ongoing role for the old CEO
33
5 Ownership Transition Mistakes to Avoid
1. No Buy-Sell Agreement
2. Delay or Avoidance in Making Desired Gifts/Transfers
3. Patriarch Won’t Let Go of Control
4. No Strategic Thinking in Transfer of Ownership
5. Failure to Transition Ownership to Next Management Generation
34
7 Questions for Highly Effective Business Transitions
1. Is your business _________ for sale?
2. Are you _________ for your business to be ready for sale?
3. What is _________ all about?
4. Do you treat your ______ as the ______ that it is?
5. Will your buy-sell agreement _________?
6. Are you _________ to make a successful transition happen?
7. What will you _________ after you sell/transition/graduate?
35
7 Questions for Highly Effective Business Transitions
1. Is your business _________ for sale?
2. Are you _________ for your business to be ready for sale?
3. What is _________ all about?
4. Do you treat your _________ as the _________ that it is?
5. Will your buy-sell agreement _________?
6. Are you _________ to make a successful transition happen?
7. What will you ___ after you sell / transition / graduate?
36
ready
perform
readiness
prepared
investment
ready
business
do
10 Questions to Ask Yourself
1. How much is my company _________?
2. What has been the shareholders’ _______ for:
§ The last year? _____%
§ The last five years? _____%
3. What portion of your _________ is tied up in your closely held business?
4. Is your wealth adequately _________ (including your business)?
5. Does your business make _________ in excess of taxes each year?
§ What is your _________ of _________ on reinvestments in the business?
§ Are you accumulating excess ______?
37
10 Questions to Ask Yourself
1. How much is my company _________?
2. What has been the shareholders’ _______ for:
§ The last year? _____%
§ The last five years? _____%
3. What portion of your _________ is tied up in your closely held business?
4. Is your wealth adequately ___________ (including your business)?
5. Does your business make _____________ in excess of taxes each year?
§ What is your _________ of _________ on reinvestments in the business?
§ Are you accumulating excess ________?
38
worth
return
wealth
diversified
distributions
capital
rate return
10 Questions to Ask Yourself
6. Are you personally reinvesting distributions in a plan to _________ your wealth?
7. What is the _________ to obtain liquidity from your ownership of the business?
8. Is your business _________ for sale?
9. Are there things you know _________ for your business to be ready for sale?
10. What is the _________to transfer ownership and/or management of your business?
§ Is the plan _________?
§ If it is not _________, it does not _________.
39
10 Questions to Ask Yourself
6. Are you personally reinvesting distributions in a plan to _________ your wealth?
7. What is the _________ to obtain liquidity from your ownership of the business?
8. Is your business _________ for sale?
9. Are there things you know _________ for your business to be ready for sale?
10. What is the _________to transfer ownership and/or management of your business?
§ Is the plan _________?
§ If it is not _________, it does not _________.
40
maximize
plan
ready
plan
Would you be interested if I could tell you how to…
§ Accelerate cash returns
§ Enhance returns on equity
§ Enhance value growth
§ Develop shareholder liquidity
§ Optimize capital structure
§ Enhance company performance
§ Shareholder diversification
§ Reduce overall portfolio risk
§ Focus management attention
41
Would you be interested if I could tell you how to obtain liquidity and diversification without selling ALL of the business?
§ Dividends
§ Special dividends
§ Dividend recapitalizations
§ Stock repurchases
§ Leveraged stock repurchases
§ Combined special dividends and redemption (with leverage)
42
Would you be interested if I could tell you how to obtain liquidity and diversification without selling ALL of the business? #4
§ Partial management buy-in (installment sale)
§ Management buy-in with outside equity
§ Private equity investment
§ Private equity recapitalization
§ ESOP (Service Companies)
§ Private merger with partial redemption
43
The One Percent Solution
Pre-Liquid vs. Liquid Wealth: Things to Remember
1. The definition and importance of the concept of pre-illiquid (i.e., liquid) wealth
2. Pre-liquid wealth is always in a process of becoming liquid wealth. Business owners should focus on and accelerate this process where reasonable to manage all their wealth
3. Buy-sell agreements are a critical tool for managing and protecting pre-liquid wealth
45
The One Percent Solution
§ Consider an annual budget for managing your illiquid private company wealth (defined as your ownership interest in your private company) similar to the fees paid to manage your liquid wealth (stocks, bonds, or other liquid assets). It costs money to manage wealth whether liquid or illiquid, so create a budget for managing your illiquid private company wealth.
Source: Unlocking Private Company Wealth
46
The One Percent Solution
+ Allocate a percentage of value for the illiquid assets under management to provide the budget necessary to manage wealth
+ Liquid Assets
- 1% of assets under management, +/-, depending on asset category
+ Pre-Liquid Assets
- 0.5% to 2% of value (AUM) for businesses depending on value
47
48
Asset Allocation of a Business Owner with $5 Million of Liquid Assets
49
The Reality if that Business Owner Has a $20 Million Closely Held Business
50
Why Should You Care?
Are you working to manage ALL
your wealth, both liquid and pre-liquid?
Baby boomers are transitioning their wealth and seeking to begin the next phase of
their lives
51
Wealth Management Principles Phase Investment Principles
1 Set Objectives 2 Establish Strategies 3 Regular Monitoring 4 Constantly Enhancing 5 Review re: Reallocating
52
What is the Yield/Return … …on an investment?
(Dividends + Change in Price)
Beginning Price
53
…from your business?
(Dividends
+ Above Normal Compensation
+ Change in Price)
Beginning Price
54
What is the Yield/Return … #5
Valuation is an Essential Element of Monitoring Performance
Critical Valuation Issues
Growth Margin Activity
Financing
Yield
Return on Capital
Value = Earnings x Multiple
55
One Percent Solution Activities
§ Life insurance funding
§ Wealth manager compensation § Annual valuations and
monitoring value growth § Buy-sell agreement pricing (per
annual valuations) § Annual legal reviews
§ Estate planning
§ Financial planning
§ “Make ready” consulting projects
56
Buy-Sell Agreements
What Is a Buy-Sell Agreement?
§ Buy-sell agreements are agreements by and between the shareholders (or equity partners of whatever legal description) of a privately owned business and, perhaps, the business itself that establish the mechanism for the purchase of stock following the death (or other adverse changes) of one of the owners. In the case of corporate joint ventures, they also establish the value for break-ups or for circumstances calling for one corporate venture partner to buy out the other partner
58
Buy-Sell Agreements
Require agreement at a point in time
Relate to transactions that will or may occur at future points in time
Define the conditions that “trigger” the buy-sell provisions
Determine the price(s) at which the specified future transactions will occur
59
Potential “Trigger Events”
Q Quits
F is Fired
R Retires
D Disabled
D Death
D Divorce
B Bankruptcy
Others?
60
The 20 Ds
§ Departure
§ Discharge
§ Death
§ Divorce
§ Disability
§ Default
§ Disqualification
§ Disaffection
§ Disagreement
§ Disclosure
61
§ Dispute resolution
§ Dilution
§ Dividends
§ Distributions
§ Drag-along rights
§ Double entities
§ Differential pricing
§ "Don’t compete" agreements
§ Donate
§ Distributions after a trigger event
Three Kinds of Buy-Sell Agreements #6
§ Fixed price
§ Formula
§ Appraisal process
§ Multiple-appraiser processes
§ Single appraiser processes
62
Three Questions to Ask Yourself
Do you have a buy-sell
agreement?
If so, what type of agreement is it?
Do you know what your buy-sell
agreement says?
There are six defining elements that must be
in every process agreement if you want the valuation process
and, therefore, the agreement, to work
How is your buy-sell agreement
funded?
How life insurance proceeds are treated
can make a big difference in the valuation of the
company
1 2 3
63
The 6 Defining Elements of Process Buy-Sell Agreements #7
Standard of Value Qualifications of Appraisers
Level of Value Appraisal Standards
The “As Of” Date Funding Mechanism
64
How Is Your Client’s Buy-Sell Agreement Funded? #8
+ The company will issue a promissory note…
65
Potential Funding Sources
» Life insurance
» Cash
§ Corporate assets
§ External borrowings
§ “Sinking fund”
» Selling shareholder notes
» Combination of cash and shareholder notes
66
Funding the Buy-Sell Agreement
» Life insurance typically purchased by company for corporate buy-sell agreements
» Key question: Is life insurance intended as a
Funding Vehicle
Corporate Asset or
67
True Story: Life Insurance
Dead
WHAT HAPPENS NOW? 68
Funding Mechanism What about Life Insurance Treatment for Valuation Purposes?
Harry Proceeds are a Funding Vehicle Company (Estate) Sam
1 Stock Ownership (Shares) 100.0 50.0 50.02 Stock Ownership (%) 100.0% 50.0% 50.0%3 Pre and Post Life Insurance Value ($m) $10,000.0 $5,000.0 $5,000.04 Life Insurance Proceeds $6,000.05 Repurchase Liability ($5,000.0)6 Post-Life-Insurance Value $11,000.0
7 Repurchase Stock ($5,000.0) $5,000.08 Retire / Give Up Stock (50.0) (50.0)9 Remaining Stock 50.0 0.0 50.0
10 New Stock Ownership (%) 100.0% 0.0% 100.0%11 Post-Life Insurance Value of Co. $11,000.0 $0.0 $11,000.012 Post Life Insurance Proceeds $5,000.013 Net Change in Value from Repurchase $1,000.0
69
Corporate Asset What about Life Insurance Treatment for Valuation Purposes?
Harry Proceeds are a Corporate Asset Company (Estate) Sam
1 Stock Ownership (Shares) 100.0 50.0 50.02 Stock Ownership (%) 100.0% 50.0% 50.0%3 Pre-Life Insurance Value ($m) $10,000.0 $5,000.0 $5,000.04 Life Insurance Proceeds ($m) $6,000.0 $3,000.0 $3,000.05 Post-Life Insurance Value ($m) $16,000.0 $8,000.0 $8,000.06 Repurchase Liability ($8,000.0)7 Post-Life-Insurance Value $8,000.0
8 Repurchase Stock ($8,000.0) $8,000.09 Retire / Give Up Stock (50.0) (50.0)
10 Remaining Stock 50.0 0.0 50.011 New Stock Ownership (%) 100.0% 0.0% 100.0%12 Post-Life Insurance Value of Co. $8,000.0 $0.0 $8,000.013 Post Life Insurance Proceeds $8,000.014 Net Change in Value from Repurchase ($2,000.0)
70
Be Prepared #9
§ Life is unpredictable
§ Protect yourself
§ Protect your business
71
Is Your Business READY for Sale?
Is Your Business READY for Sale?
+ R
+ E
+ A
+ D
+ Y
isk
arnings
ttitudes, Aptitudes, Actions
riving Growth
ear-to-Year Comparisons
73
“Ready” vs. “Up for Sale”
+ Not a discussion of why or when you might sell your business
+ No encouragement whatsoever to sell your business
+ No judgment that you should sell your business
+ Simply encouragement to get the business “ready” so that when you are ready, the business will be ready, too!
+ Or when something unexpected happens and you need to sell, you will also be ready!
74
Compelling Logic for Readiness
+ Most businesses do not make it to the second generation
+ They go out of business
+ They are sold or merged
+ Non-family/original shareholders run (and likely own) the business
+ A generation is roughly 20 years
+ Logic suggests that on average, business will “change hands” every 10 years or so
+ “Half-life” less than 10 years
75
Observations on Readiness
+ Business life seems to present one non-recurring event following another following another (“Yes, buts” in waiting…)
+ Why is it that most of the surprises that occur in business are adverse to earnings and value?
+ If you understand the nature of business value and the value of your business, you will enhance your focus on planning and readiness for life’s unexpected as well as expected events
76
The End of Our Journey Today
§ Ownership Timeline
§ Key Valuation Concepts
§ Ownership and Management Transitions
§ The One Percent Solution
§ Buy-Sell Agreements
§ READY for Sale
77
Between the Bookends of “Status Quo” and “Third Party Sale” (or Other Planned Disposition)
78
#10
Resources
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Z. Christopher Mercer, ASA, CFA, ABAR [email protected] 901.685.2120 www.mercercapital.com www.ChrisMercer.net www.linkedin/in/zchristophermercer
MERCER CAPITAL 5100 Poplar Avenue, Suite 2600 Memphis, Tennessee 38137
80