Harvest Options

There are seven principal avenues by which a company can realize a harvest from the value it has created. Described below, these most com­monly seem to occur in the order in which they are listed. No attempt is made here to elaborate on the brief descriptions, since entire books are written on each option, including their legal, tax, and accounting intricacies.

Capital Cow

A "capital cow" is to the entrepreneur what a "cash cow" is to a large corporation. In essence, the high-margin profitable venture (the cow) throws off more cash for personal use (the milk) than most entrepre­neurs have the time, opportunity, or inclination for spending it. The result is a capital-rich and cash-rich company with enormous capacity for debt and reinvestment. Take, for instance, some of the largest fran­chisees of Dunkin' Donuts. With ten or more mature restaurants there is usually enough free cash flow to sustain a very comfortable lifestyle and build one or two new restaurants every year! Many franchisees diversify by owning the real estate as well as the business, providing the opportunity for many years of personal cash flow even after they sell the business.

Employee Stock Ownership Plan

Employee stock ownership plans (ESOPs) have become very popular among closely held companies as a valuation mechanism for stock for which there is no formal market. They are also vehicles through which founders can realize some liquidity from their stock by sales to the plan and other employees. And since an ESOP usually creates widespread ownership of stock among employees, it is viewed as a positive motiva­tional device as well. A leveraged ESOP borrows money from the com­pany or another financial institution to buy the company's stock, whether all at once or in parts. The entrepreneur may or may not exit the company, but in either case he or she gets a large amount of money - in essence, the annualized stream of free cash flow in one or a few payments.

ESOPs were initially created to provide for the retirement benefits of a firm's employees. However, about half of all ESOPs are used to create a market for the shares of current owners wishing to harvest.

Where most retirement plans limit the amount of stock in any one company the plan can own, an ESOP is designed to allow employees to invest primarily in the firm's stock. The U.S. government encour­ages this by providing significant tax advantages for ESOPs. ESOPs can be either leveraged or unleveraged. In an unleveraged ESOP, the com­pany makes an annual contribution to the ESOP for the employees' retirement. The ESOP then uses the money to purchase shares of the company. An unleveraged ESOP usually provides a slower harvest for the entrepreneur.

Also, an ESOP covers all employees and the company has to disclose a great deal of confidential information. And the government changes the rules for ESOPs all the time. Always be sure to check the current rules and take financial advice from the appropriate legal and financial professionals.

Management Buyout

Another avenue, called a management buyout (MBO), is one by which a founder can realize a gain from a business by selling it to existing part­ners or to other key managers in the business. If the business has both assets and a healthy cash flow, the financing can be arranged via banks, insurance companies, and financial institutions that do leveraged buy­outs (LBOs) and MBOs. Even if assets are thin, a healthy cash flow that can service the debt to fund the purchase price can convince lenders to do the MBO.

Usually, the problem is that the managers who want to buy out the owners and remain to run the company lack the capital to do so. Unless the buyer has the cash up front - and this is rarely the case - such a sale can be very fragile, and full realization of a gain is questionable. MBOs typically require the seller to take a limited amount of cash up front and a note for the balance of the purchase price over several years. If the purchase price is linked to the future profitability of the business, the seller is totally dependent on the ability and integrity of the buyer. Fur­ther, the management, under such an arrangement, can lower the price by growing the business as fast as possible, spending on new products and people, and showing very little profit along the way. In these cases, it is often seen that after the marginally profitable business is sold at a bargain price, it is well positioned with excellent earnings in the next two or three years. Clearly, the seller will end up on the short end of this type of deal.

Management buyouts are typically classified as "financial engineer­ing" strategies. In an MBO a small group of senior managers within the firm will attempt to purchase the company from the existing share­holders. These transactions often include some form of leveraged financing, but the team may be able to raise the necessary funds from their own resources. So, like 1980s takeover artists Carl Icahn and T. Boone Pickens, management will seek some equity and usually heavy debt financing to consummate these deals. A heavily leveraged deal puts pressure on the company to increase free cash flow for debt service.

A leveraged buyout or management buyout (LBO/MBO) strategy can make sense when the acquirer uses the base income stream to secure debt and infuses significant equity capital into the company. That is a very difficult task for an acquirer if there is an ongoing need to funnel free cash flow into growth plans. Another tactic of the LBO/MBO is to sell off assets of the company to reduce debt. This usually occurs where there are parts of the business that are not relevant for the new owner. For some people an LBO/MBO signals a retreat from growth.

Merger, Acquisition, and Strategic Alliance

Why would someone give you a lot of money for your company? Because they believe they can make more money than you did. The sale of one company to another, or the merger of two companies, occurs because the players believe the combined entity will better create wealth for the own­ers. Merging with another firm is still another way for a founder to real­ize a gain. For example, David Townsend owned a tractor-trailer sales, repair, and parts company. Faced with more and more competition, he believed only larger firms would survive. Townsend, therefore, posi­tioned his company, Fleet Pride, as the platform for an industry roll up by aggressively modernizing his business systems and processes. He took most of the value offered by the financial buyers in cash and left a little in the new firm's stock. He stayed with the company for two years during the transition. But his lifestyle was secure and he had a stake for another new venture.

In a strategic alliance, founders can attract badly needed capital, in substantial amounts, from a large company interested in their tech­nologies. Typically, a strategic alliance involves some exchange of value. For example, Exabyte, a storage device company out of Colorado, agreed to a strategic alliance with Sony. In exchange for Asian distri­bution rights, Sony opened up its manufacturing facilities to make the Exabyte product, greatly saving on capital needed for rapid expansion. Such arrangements often can also lead to complete buyouts of the founders downstream.

Outright Sale

Most advisors view outright sale as the ideal route to go, because up­front cash is preferred over most stock (even though the latter can result in a tax-free exchange).6 In a stock-for-stock exchange, the problem is the volatility and unpredictability of the stock price of the purchasing company. Many entrepreneurs have been left with a fraction of the orig­inal purchase price when the stock price of the buyer's company declined steadily. Often the acquiring company wants to lock key man­agement into employment contracts for up to several years. Whether this makes sense depends on the goals and circumstances of the indi­vidual entrepreneur.

Public Offering

Probably the most sacred business school cow of them all - other than the capital cow - is the notion of taking a company public.7 The vision or fantasy of having one's venture listed on one of the stock exchanges, even over-the-counter trading, arouses passions of greed, glory, and greatness. For many would-be entrepreneurs, this aspiration is unques­tioned and enormously appealing. Yet, for all but a chosen few, taking a company public, and then living with it, may be far more time and trouble - and expense - than it is worth.After the stock-market crash of October 1987, the market for new issues of stock shrank to a fraction of the robust IPO market of 1986 (and even the markets of 1983 and 1985, as well). The number of new issues and the volume of IPOs did not rebound - instead they declined between 1988 and 1991. Then in 1992 and into the beginning of 1993 the IPO window opened again after a long dormant period. During this IPO frenzy, "small companies with total assets under $500,000 issued more than 68 percent of all IPOs."B Previously, small companies had not been as active in the IPO market. (Companies such as Lotus, Com­paq, and Apple Computer do get unprecedented attention and fanfare, but these firms were truly exceptions.)9 The SEC tried "to reduce issu­ing costs and registration and reporting burdens on small companies, and began by simplifying the registration process by adopting Form S-18, which applies to offerings of less than $7,500,000, and reduced dis­closure requirements."10 Similarly, Regulation D created "exemptions from registration up to $500,000 over a twelve-month period."1'

This cyclical pattern repeated itself again during the mid-1990s into 2002. As the dot-com, telecommunications, and networking explosion accelerated from 1995 to 2000, the IPO markets exploded as well. In June 1996, for instance, nearly two hundred small companies had ini­tial public offerings, and the pace remained very strong through 1999, even into the first two months of 2000. Once the NASDAQ began its collapse in March 2000, the IPO window virtually shut. In 2001 there were months when not a single IPO occurred, and for the year IPOs numbered well under one hundred! In the United States in 2002 and 2003 IPOs again numbered less than one hundred. As we write this book in mid-2004, it appears that the IPO market is starting to open once again. The lesson is clear: depending upon the IPO market for a harvest is a highly cyclical strategy, which can cause both great joy and disappointment. Such is the reality of the stock markets. Exhibits 9.1 and 9.2 show this pattern vividly.

There are several advantages to going public, many of which relate to the ability of the company to fund its rapid growth. Public equity markets provide access to long-term capital, while also meeting subse­quent capital needs. Companies may use the proceeds of an IPO to expand the business in the existing market or to move into a related market. The founders and initial investors might be seeking liquidity, but it is important to note that SEC restrictions limiting the timing and the amount of stock that the officers, directors, and insiders can dispose of in the public market are increasingly severe. As a result, it can take several years after an IPO before a liquid gain is possible. Additionally, some entrepreneurs believe, a public offering not only increases public awareness of the company but also contributes to the marketability of the products.

However, there are also some disadvantages to being a public com­pany. For example, 50 percent of the computer software companies sur­veyed by Steven Holmberg (American University) agreed that the focus on short-term profits and performance results was a negative attribute of being a public company12 Also, because of the disclosure require­ments, public companies lose some of their operating confidentiality, not to mention having to support the ongoing costs of public disclo­sure, audits, and tax filings. With public shareholders, the management of the company has to be careful about the flow of information because of the risk of insider trading. When weighing the positive and negative attributes, you may find it useful to review the Boston Communications Group, Inc., website (bcgi.net) to identify the key components of the IPO process and to assess which investment bankers, accountants, law­yers, and advisors might be useful in making this decision.

Exhibit 9.1   Number of Recent IPOs

90 C

SOC   -

70 C   -

60 C  -

50 C  -

40 C  -

30 C  -

20 C  -

10C  "

199/       1998                    000

Years ;QQ«thr,. ,gh 20C;

jacked IPC

Source: Thomson Financial, May 2004.

Exhibit 9.2  Recent IPO $ Millions

20,000 15,000 10,000

"c:dl venture-backec offer size ($ Til lor)

Source: Thomson Financial, May 2004.

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