Private Company Capitalization, Liquidity, and Shareholder Return
How the private company board can help the company remain financially strong and in control
By Scott Chase
Private companies face some unique challenges and opportunities when it comes to capitalizing for growth, while maintaining enough liquidity to satisfy shareholders. And these were addressed in-depth at the Private Company Governance Summit 2016.
The board and management needs to ask itself why it wants liquidity in the first place, noted Gerry Czarnecki. What is driving the requirement? One of the first reasons, he said, is that you have a desire for liquidity in order to grow the business and set the stage for future success. A lot of businesses reach a point where they are not generating enough cash internally to fund growth, but they — the board and management — can see a clear and reasonable path to profitable expansion. As the old adage goes, “and it’s probably true,” Czarnecki said, “if you’re not growing, you’re dying.”
A second reason for seeking liquidity is the realization that you have no liquidity. You may need cash to rebalance your books and get a restart. Czarnecki is a director of Jack Cooper Enterprises, a company that has grown from $30 million to $800 million by acquiring other companies. “When you do deals, you need cash and you acquire debt,” he said. Yet another reason for liquidity, especially in family-owned companies, is that the managing generation — Mom, Dad, or the founder of a company — are retiring and there needs to be something in the kitty to recognize their contributions and provide fair value for what is transitioning.
Sometimes, as business owners, Czarnecki said, we have a tendency to forget that the best way to build liquidity is to improve your operating margins. “The very best liquidity option, in my mind, is to focus on operating margins and develop your free cash flow,” Czarnecki opined. “If you don’t have that free cash flow, you can’t invest, and eventually you go beyond your ability to grow your business. Then you have to look outside.” Sometimes that quest, he continued, leads to outside investors, and offering equity always brings risks. You have to think long and hard about what happens if you bring in a venture capitalist. What happens if growth slows? What happens when your investors begin to think about their own exits? All of this affects your behavior and your business.
Not having solid governance structures and processes in place, Czarnecki said, will slow you down. “As you seek outside capital, you have to look more and more like a public company. You have to embrace independent directors, and you have to be prepared to have a board that is willing to take on the challenge of robust governance. That’s a tough transition. If a CEO does not know how to use the board as a strategic asset, it’s going to be a failure.”
Raising capital, keeping control
Mary Tanner, Senior Managing Director, of venture capital firm Evolution Life Science Partners, addressed the question of raising money without losing control from a consumer product goods and pharmaceuticals industry point of view which, she said, can be modified to address many if not nearly all markets. One technique is licensing out a product for a payment that represents the development costs and future prospects of that product, and which may include milestone payments as well as royalties downstream. Licensing is the most widely used form of early stage finance, with the exception of venture capital, and is relevant for any product that you believe has a high intellectual property value or is unique enough that it can’t be easily copied and for which you believe a strong growth market exists. You also can sell royalties for these kinds of products in what Tanner described as “a very flexible market,” but one that is heavily dependent on the product itself.
On the “more exotic” front, you also can sell “participating instruments,” Tanner said, either preferred stock or secured debt. If it is preferred stock, this is senior to your common stock but junior to your debt, but just like debt eventually preferred stock comes up against redemption, Tanner explained. Yet another technique, she continued, is recapitalization to increase payouts to shareholders. This approach is particularly well-suited for solving intergenerational wealth issues or family/shareholder disagreements. Care must be taken not to have a taxable event in the recapitalization: “You must be extremely careful as it relates to tax issues,” Tanner cautioned. “I have my own set of tax advisors for these situations.”
Ken Baker, CEO of NewAge Industries, tackled the Employee Stock Ownership Plan (ESOP) technique, outlining how his company sold 49 percent of the firm to his staffers in three tranches over a period of time. “I believe that an ESOP can create strategic value because to make it successful you need to teach your team members, your employees, how to make money.” The ESOP has resulted in productivity gains, new ideas, greater collaboration within the company, and other benefits. Baker said, “By selling a series of share tranches over time to the ESOP, the founder/CEO possibly could receive the same total share value as a strategic buyer. It’s almost a crime.”
One downside to promoting an ESOP and using it as a vehicle to create wealth without losing control is that not all people, particularly young people — “the millennials” — want to be tied down to a savings or retirement structure. “I want my younger workers to get married, to get a mortgage, to have children,” Baker joked. Once they start thinking about retirement, about how to pay for college educations, “I have them!”
Baker said that ultimately his exit from NewAge would be the sale of his shares back into the ESOP. He outlined tax advantages to the approach and said that particularly family business owners need to consider the “hopes and fears” that they have about the business once they exit the stage or begin the process of succession planning. Properly deployed, an ESOP can help in the success of a multigenerational family business over several generations. “Having the rank and file invested in the family business as owners may be just the right formula to bridge management and ownership from one generation to the next,” Baker concluded.
Not all ESOPs work out quite so nicely, Czarnecki noted. He cited a case of an $85 million construction business that went the ESOP route only to encounter a downturn in the marketplace. Czarnecki said businesses that are cyclical in nature may be at greater risk and businesses that have a more mature workforce may have a greater repayment liability downstream. “If you’re going to do an ESOP,” Czarnecki said, “be sure that you know precisely the reasons why you are doing this and what the benefits and pitfalls might be.” He suggested long-term planning and running some scenarios based on less than optimal corporate and, for that matter, global financial performance over time as useful in helping plot a successful ESOP deployment. ν