Buying a private business--compensation question

[Wabash02]

Hello all,

 

I have a question about how you would structure the management fee/arrangement when buying a private business with investor money.

 

The general situation is as follows:

 

I have found a private business for sale that I will need to raise money to purchase.  The business is 30+ years old and the two founders (50/50 owners) are looking to sell.  One owner wants out completely, another wants to retain a 10-20% stake. 

 

The owners no longer run the business, the current president and CFO have been there 20 yrs each and are in their early 50's and want to stay on.  Management also wants to participate in the purchase somewhere between 5-20%.

 

Let's assume the business is solid and the deal price is attractive...my question is what is the best/fairest way for me to get paid?  I plan on being Chairman of the Board but not having a day to day role in the company.  I will put in my own capital and raise the rest to purchase the business--I already have several interested investors.  The plan is to hold the company for a long time, not try to sell it PE style in 5-7 years.

 

Also, the company has done roughly 3.4m of EBITDA and roughly 1.6m of net Income over the last 3 years.  The plan is to reinvest capital as long as there is an opportunity for high rates of return but otherwise distribute to shareholders.

 

Thought's I've had

1. establish some benchmark like NI, EBITDA, book value, and have a hurdle rate that once it is achieved the payout is 80-20 or 75-25.

2. get 10% of distributed earnings until 50% of investors capital is returned, 20% until 100% is returned, and 30% going forward (or some mix like that).

3. Since this is a planned long term holding, I would like to be able to have the company offer to purchase up to 5% of outstanding shares each year depending on cash available and based on a fair, pre-set metric.

 

Any thoughts would be greatly appreciated!

[LC]

If you're looking at a very high holding period then management incentives should be in the way of cash.

 

Which metrics would growth in intrinsic value touch? Perhaps it is gross margins above a certain point, revenue growth, etc. Compensate via those metrics.

 

Why would you want less of distributed earnings up front to recoup your investment?

 

Also don't divvy out anything. Just return cash via share buybacks, then split shares, buyback more, etc. More tax friendly I think?

 

 

[JSArbitrage]

My honest view - get a business valuation advisor.  I can point you in the right direction.  There are some real tax related issues if you get to structure an investment at the outset.  For example, by controlling the timing and form of compensation, you can defer or shield cash taxes from your "compensation."  I generally see multiples series of shares created (common, Series A, Series B, etc.) with different payout thresholds, similar to scenario 2 on your list.  If you structure different classes of shares instead of taking lump payments based upon EBITDA targets, etc (like an earnout), you can control the tax implications of your decisions a lot more.

[Wabash02]

Thanks for the thoughts guys.  The company is current structured as an S-corp and my initial thought was to convert to an LLC.  However, it is a very good (a potentially valuable) point that I can structure this investment in whatever way makes the most sense.  I am trying to strike the balance between raising money on attractive terms and aligning fund management(me), company management, and investors.

 

Its really easy to explain/execute a 2 and 20, or the early Buffet/Parbai model of 25% over 6% when your holdings are all marked to market each year.  I was searching for a fair way to do that with a private company, or another model that gets me to a similar place.  Like I said, I am not counting on a sale in a few years to earn 20% on, and I want all interests to be aligned.

 

JSArbitrage, it would be much appreciated if you could point me in the direction of a good valuation adviser. 

Thanks!

[bigbadwolf]

I am a CPA in the US.  I handle corporate tax and would be glad to talk to you about the deal in offline - just PM me.  I only work with private companies up to $250MM in revenue and handle a lot of M&A activity.  There are a lot of tax implications for your proposed deal. 

 

If the target entity is currently structured as an S corp, you have to remember rules about only having one class of stock otherwise you stand to lose the S status and it would automatically be converted to a C corp.  If you a set on S corp, my first piece of advice would be to look at an asset purchase vs. stock purchase unless you make a 338(H)(10) election.  You get a step-up in basis for the assets (goodwill).

 

I would probably recommend a LLC structure based on what you desire - but could discuss in more detail to make sure that is the best option.  You need to consider limitations on S corp like pro-rata distributions, basis from outside debt, multiple share classes, types of investors (no foreign, LLCs), before going with the S corp option.

[Morgan]

I am a CPA in the US.  I handle corporate tax and would be glad to talk to you about the deal in offline - just PM me.  I only work with private companies up to $250MM in revenue and handle a lot of M&A activity.  There are a lot of tax implications for your proposed deal. 

 

If the target entity is currently structured as an S corp, you have to remember rules about only having one class of stock otherwise you stand to lose the S status and it would automatically be converted to a C corp.  If you a set on S corp, my first piece of advice would be to look at an asset purchase vs. stock purchase unless you make a 338(H)(10) election.  You get a step-up in basis for the assets (goodwill).

 

I would probably recommend a LLC structure based on what you desire - but could discuss in more detail to make sure that is the best option.  You need to consider limitations on S corp like pro-rata distributions, basis from outside debt, multiple share classes, types of investors (no foreign, LLCs), before going with the S corp option.

 

Can you recommend a list of books to learn the details and nuances of M&A?

 

Warm regards.

[scorpioncapital]

From reading your situation, this is easy for me to answer if I was in your shoes. I own 80% of the company. My pay is as close to zero as possible.

If I have enough money to put a downpayment on this thing I probably have enough to live. I'm probably OK. Therefore, my goal is to optimize the business and grow it. My reward will come in time via the ownership stake. Do I really need money out? Maybe I do, but probably not a lot. I'd just take the minimum amount out looking at personal tax rates to see the cut-off levels. Often the best way is via dividends since you don't have to file all those forms and pay those employment taxes which can be time consuming or expensive if someone else is doing it. Plus it's your retirement plan anyway so you don't really need social insurance.

[netnet]

A few things:

 

• Good for you, it looks like you are trying to the fair thing for your investors
  
• I'm an investment banker and do M&A in larger transactions, but can give you some advice, pro bono,.  PM me
  
• The tax advice from the CPA is good, but also look into putting some of your equity in a tax advantaged account
  
• The management incentives can be all cash.  But remember to properly target them, with some kind of earn out in future years and a claw back so that the long term health of the business is maximized.  Thus a great year 0, and a disaster year 3 would not be rewarded.
  

[SharperDingaan]

Having been in a few of these ...

 

There is no substitute to having the business valued by an independent professional. They will give you a range of values under 4-5 different methodologies; most often buyer/seller will settle at the average. They are usually re-engaged every 4 years, in sync with the new strategic plan for the firm.

 

There is usually a liquidity mechanism to handle early departures. Insurance policies to cover heart-attacks, etc.; plus an option arrangement to handle limited interim sales until the next independent valuation. Usually at pre-set prices subject to key milestones; ROFR to the firm first, then other partners.

 

Most will devolve ROE into a 5 part Dupont matrix, and incentivise the appropriate variables. Just be very sure that you fully understand how this business makes its money, why, the KSF, & the relevant KPI. Goals should all be SMART.

 

Selling partners are usually required to reinvest 2/3 of the agreed comp in the firm as convertible preferred shares; bought out by the firm over 2 strategic plan cycles. If the firm blows up, they receive nothing; if the firm is subsequently bought out by someone bigger, they benefit.

 

Bankers will generally not lend against the shares, or very little. Most would apply a 40% liquidity discount to every $100 of current independent valuation, and then lend up to a maximum 50%; ie: $30 against $100 of value, at best, & only if they absolutely have to. They may also require a business valuation refreshment every 2 years, which will be at your cost

 

It can be a very rewarding experience; but you should be looking to current year dividends as the primary means of benefit - not resale.

 

SD