This article provides some insight into when (from a risk management point of view) one should sell one’s ownership interest in a business and who to.
When many of the baby boomer business owners contemplate retirement they agonize over whether to continue owning the business post retirement, whether to sell down in stages leading up to retirement or whether to sell the business in its entirety.
Continuing to own a business after retiring invariably gives rise to one having an uncomfortably high proportion of one’s wealth invested in the business. One would have most if not all one’s investment ‘eggs in one basket’ and a high dependence on the fortunes of that business to fund one’s retirement. If the business implodes or suffers a material drop in profitability, whether due to the performance of the new management team or due to issues well outside their control, one would suffer a material drop in one’s financial wealth at a time when one can least afford it – at a time when financial recovery by starting another business or securing employment is not a realistic option. In most cases it is not be prudent to continue owning a business after retiring.
As one gets older it becomes increasingly important to have a well-diversified investment portfolio. If one’s business implodes or suffers a material drop in sustainable profits in the years leading up to one’s intended retirement, it could have material adverse consequences for one at a time when recovery becomes increasingly more difficult. As a result if one has a large proportion of one’s net worth tied to one’s business, it will also not be prudent to hold on to the business and only sell it when one intends to retire.
In order to best manage one’s risk exposure one should sell down one’s ownership interest in portions over time, perhaps over the 10 years leading up to retiring. The question that then needs to be addressed is: Who does one sell to?
Strategic investors could be interested. These parties generally prefer to buy the whole business and integrate it into their existing business. Some however may want it as an ‘add-on’ – another division of their business – in which case they will need a team and team leader to run the business. These buyers may well prefer the current owner and his/her team to continue running the business rather than seconding some of their employees to run the business or recruiting a management team. Strategic buyers also generally want to reduce the risk of making poor investment decisions. One approach is for them to buy an initial minority stake and secure options to purchase further ownership interests over time. In doing so, they reduce their potential loss if the investment decision turns out to be a poor one but can still get control and full ownership if the investment decision turns out to be a good one.
Financial investors would be interested. Financial investors generally have little, if any, interest in managing the business or even in directing management. They are more interested in managing risk with a view to earning an above market return-for-risk and having a clear and agreed exit strategy – such as selling the business at an agreed point in time. One approach they would give favourable consideration to is buying an initial minority interest in the business and securing options to buy further stake holdings over time. This would give the financial investor the ability obtain a controlling interest in the business and so ensure that the exit strategy is implemented. For example, one could give financial investors options to buy 15% of the ownership interest in the business each year – on an agreed formula – for 5 years and agree to put the business up for sale after 7 years. If the financial investors do not exercise any of the options the ownership interest could be offered to other investors, including other financial investors. This passive involvement by financial investors suits many business owners looking to sell down over time but still wanting to run the business in the interim.
Employees could also be interested in buying the business. The major issue they face is finding the capital needed to do so. This may not be an insurmountable obstacle for them, particularly if they get the support of financial investors. Employees could reinvest performance bonuses (or agree to have them paid in shares, not cash), borrow from friends, family and others to invest in the business and reinvest dividends. Financial investors could co-invest with employees, by buying any shares from the business owner that the employees are unable to buy. Having staff own a material share of the ownership interests in the business has a lot of merit, not only as a motivation factor and for aligning the interests of employees and owners but also gives financial and strategic investors comfort that the staff are unlikely to depart in mass post investment.
A fourth alternative is for the company to issue preferred equity instruments to financial investors and apply the proceeds to buy shares from the business owner. These preferred equity instruments could be structured to appeal to financial investors by having minimum returns payable periodically (e.g. quarterly) and a maturity date on which the capital (face value of the instrument) is repayable.
These four options – strategic investors, employee buyers, financial investors investing in ordinary shares and financial investors investing in preferred equity instruments – are not mutually exclusive. A business owner could sell to a combination of such parties and perhaps retain a minority ownership interest in the business post retirement.
By selling ownership interests in stages over the years leading up to retirement and gradually winding down one’s involvement in the business, one would:
reduce one’s risk of suffering a material reduction in wealth resulting from any major drop in the fortunes of the business;
expect to sell down at fair and reasonable prices;
benefit from any expected increase in profitability over the years leading up to retirement and if the business owner continues to hold a minority stake in the business also post retirement;
be much more likely to groom senior staff or employ a senior executive to smoothly transition to in to the CEO / MD role – by taking on more responsibilities as one is winding down one’s involvement in the business, which in turn is likely to lead to one getting higher prices on selling one’s ownership interests in the business; and
by selling some or all of ownership interest in the business to staff, the staff would probably be more motivated in their roles, more motivated to eliminate unnecessary costs (particularly as their shareholding increases) and less likely to seek alternative employment, all of which Are likely to lead to a higher market value for the business.
In my humble opinion: If business owners can be convinced that this approach (of selling piecemeal overtime) is a realistic alternative – in that the ownership interests can be sold at fair and reasonable price – a lot more of them would prefer it. That is, prefer it to the prospect of ‘dying in the job’, losing ‘the lot’ and suffering the psychological trauma resulting from a sudden transition from being the ‘top dog’ to a ‘has been’. Business owners also need to be convinced that their investment income will not suffer a materially reduction. This topic is considered in another blog on the Rogers Morris website – “The triple whammy hit on selling a business”. It deals with the prospect of earning a return on the net sale proceeds that is commensurate with the return one would otherwise have earned by continuing to invest in one’s business.
If you are the owner of a business generating a maintainable EBIT of at least $1,000,000 and interested in selling your business or a portion of your ownership interest in it, Rogers Morris would be pleased to hear from you.
By Mark Morris (July 2017)