Should I Sell or Should We Grow

Let’s Explore Doing Both!

Thomas founded Light Industrial Manufacturing Co., Inc. over 35 years ago, just before he and Nancy were married. Together they have built the company to over $23MM of annual revenue and $5MM of EDITDA. At 63 years old Thomas isn’t sure he’s ready to let go of the reins, but Nancy wants the flexibility to start spending more time with their growing brood of grandchildren, and they both want to buy that dream beach house to spend time with the kids at the beach.

There’s also the unresolved question whether selling the business today will allow them to duplicate their current income and maintain the lifestyle to which they have become accustomed and want to be able to maintain in retirement. On the other hand, what if something were to happen to them, the business or the economy and they can’t sell it in 4-5 years. They’ve heard horror stories about business owners who have engaged active, formal sales processes only to find after 18-24 months that the business effectively couldn’t be sold.  

If Thomas and Nancy tried to sell the company today, they would hope to get around 5x EDITDA or $25MM +/-. Since their cost basis is effectively zero, they expect to owe at least $7.5MM of Federal and state capital gains taxes. After paying taxes and transaction fees that should leave them with roughly $16.5MM net. If they were to immediately purchase the $2MM dream beach house and do the long overdue refurbishment to their primary home for another $500,000 it will them leave about $13MM -- $14MM of investable assets. While that substantial investment portfolio would be able to create around $500,000 of annual income and some modest investment portfolio growth, that financial scenario pales in comparison to their current salaries plus annual bonuses and the tremendous immediate growth potential for Light Industrial. There has to be a better way!

They could explore selling part of the company now to an ESOP to create some immediate liquidity and take some chips off the table. Then they could keep growing the whole company for a few years and sell it to a strategic or financial buyer through a traditional sales process. How could that work?

1. 1) Sell part of the company now to an employee stock ownership plan to create immediate liquidity. News flash: ESOPs are consistent buyers of stock regardless of economic conditions. At least 30% would need to be sold to qualify for a 1042 exchange, and at least 51% would need to be sold to eliminate a minority discount by selling less than controlling interest. Hence, the optimal partial sale scenario is likely to fall between 30%-51%.


2. 2) A 1042 exchange is very similar to real estate 1031 exchanges and insurance policy 1035 exchanges. Congress created the 1042 qualified replacement property (QRP) rule in 1982, less than a decade after passing the ESOP legislation, to enhance the utilization of ESOPs. It allows sellers of privately held companies to defer capital gains taxes if the proceeds are reinvested in qualified replacement property within a 15 month period beginning 3 months before the sale and 12 months afterward. QRP can be equity or debt and includes common stock, preferred stock, corporate fixed rate bonds, convertible bonds and floating rate notes. However, it does not include mutual funds, ETFs, CDs, REITs, Gov’t debt or municipal debt.


3. 3) The capital gains tax deferral can effectively become permanent if the QRP is held until death when it receives a step up in basis.


4. 4) In the interim, the QRP can be used as collateral for a securities based lending line of credit to withdraw cash and create liquidity (e.g. for Thomas and Nancy’s beach home purchase and primary home remodeling project). Ideally, the income generated by the QRP would be used to pay the interest expense on the SBL loan. The goal would be for the underlying collateral to sustain the cost of borrowing, hence the amount borrowed is informed by the solution to the specific variables in this equation.


5. 5) Since the goal and expectation for Light Manufacturing Co., Inc. is to continue its substantial growth trajectory, Thomas and Nancy would keep working, grow the EBITDA 1.5x - 2.0x over the next several years and then sell the company, hopefully, at an enhanced multiple, due to Industrial Manufacturing being a much larger company than it is today.


6. 6) If the company grows to $10MM of EBITDA and sells for 6.5x, it would imply a total sale price of $65MM. If Thomas and Nancy had sold 40% to the ESOP, they would receive $39MM now and their employees would receive $26MM. Further, by focusing on tax mitigation strategies during the post ESOP sale years, they hope to substantially reduce their tax exposure. If they were able to drive their tax liability down to 20% from 30%, they would net roughly $31MM. 


7. 7) They would use $2.5MM of the cash to pay off the SBL line versus the QRP portfolio. If the QRP return and SBL interest were a push, Thomas and Nancy would end up with $8.5MM in QRP, a $2MM+ beach house, an improved primary residence and $28.5MM in new cash.


8. 8) The total value comparison of the two scenarios makes the ESOP/1042 solution look like a viable alternative to explore in more detail. If they were to successfully execute a traditional M&A sale of the company now for $25MM, they would net roughly $17,500,000 after tax. On the other hand, if they opted to sell 40% of the company now to an ESOP using a 1042 exchange and sell the remaining 60% of the company later for $31MM net - $2.5MM SBL loan + $8.5MM QRP + the $2MM beach house = $39MM +/- excluding any value for the home improvements. That would be $21.5MM more than selling the company today!

*This is a hypothetical illustration and is not intended to reflect any actual outcome.  Individual circumstances will vary. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Please consult with your financial advisor.

Any opinions are those of the speaker and not necessarily those of Raymond James. This material is being provided for informational purposes only and is not a complete description, nor is it a recommendation. There is no guarantee that these statements, opinions or forecasts provided will prove to be correct. Investing involves risk and you may incur a profit or a loss regardless of strategy selected. No investment strategy can guarantee your objectives will be met. Past performance is no guarantee of future results. Every investor's situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment decision.

A line of credit backed by securities, such as a securities based line of credit or Margin account may not be suitable for all clients and investors. Borrowing on securities backed lending products or Margin accounts and using securities as collateral may involve a high degree of risk including unintended tax consequences and the possible need to sell your holdings, which may lead to a significant impact on long-term investment goals. An investor can lose more funds than he or she deposited in the account. Market conditions can magnify any potential for loss.