It’s important to understand your business model and the various outside factors that can affect the execution of an ESOP transaction.
This article serves as a continuation of our Understanding ESOPs series, with the first two articles focused on the tangible and intangible benefits of ESOPs. Our third article discussed the importance of planning for a potential ownership transition. This article will focus on the various outside factors that can affect the execution of an ESOP transaction.
Where we are in the economic cycle. Generally speaking, the debt that enters the company’s balance sheet with the purpose of transitioning ownership does not directly enhance the company’s operating performance. For this reason, it is important to understand your business model and the outside forces that can have both a positive and negative impact on your business’s performance. While many businesses weather economic cycles very well, some businesses tend to cycle with the economy’s general mood. Here are a few common themes we look for to help mitigate potential negative impacts of movements in the economic cycle:
- The management team has experience navigating various economic cycles and remain involved post transition
- The business model has a defensible market position
- Interest rate protection is utilized to preserve cash flow in a rising rate environment
- Patient debt behind our senior financing (seller subordinated debt)
What is the valuation market. Because the ESOP trustee (fiduciary) will hire its own financial advisor, it is important for the selling shareholder to understand the potential value on the front end. For this reason, we strongly recommend an advisor who deeply understands value and the trustee negotiation process. Valuation multiples are derived from many different inputs. As a selling shareholder, it is important to have a baseline understanding of those inputs and the potential impact on value. See below for a few common factors that may influence value:
- Company life stage/growth prospects
- Overall market position
- Customer/market/geographic diversification
- Majority/minority sale
- Pre-transaction debt
- Interest rate forecast – factored into discounted cash flow calculations
- Public comparisons market
How much leverage is being contemplated/capital markets appetite. When transitioning ownership, maximizing shareholder liquidity is often one of many goals of the selling shareholders. This is not necessarily a poor goal, however, it needs to be understood in the context of the stage in the economic cycle, as well as the ability for the capital markets to deliver. Because EBITDA multiples are a commonly understood cash flow identifier, banks frequently utilize this calculation in determining leverage parameters. It is important to note, most business failures result from weakened performance, coupled with an overleveraged capital structure. Maintaining a financing structure that allows some cushion for sub-standard performance is of paramount importance when transitioning your business. Below we have listed a number of items that can affect leverage multiples/financing:
- Customer concentrations
- Consistency and predictability of cash flow
- Sensitization of performance/potential downside modeling
- Free cash flow conversion
- Overall collateral pool
Professionals. As we stated in our previous article, when working through a succession plan such as an ESOP, it is important for a business owner to surround himself with professionals who are experienced in ESOPs. As a relationship focused bank, we certainly appreciate loyalty amongst long-term business partners. However, utilizing attorneys, accountants, advisors, or bankers that are not regularly involved in ESOPs will not only put the transaction at risk, but will likely create elevated costs in completing the transaction.
Executing on a succession plan is typically a once in a lifetime event. Just as a business takes years, often decades, to develop, a succession plan should be well planned for. Surrounding oneself with the appropriate professionals and planning accordingly will position your company for a successful transition to ESOP ownership.
Wintrust Financial Corporation is a $34 billion financial services company headquartered in the Chicago area. With our national niche lending groups, including Wintrust ESOP Finance and Wintrust Construction, Engineering & Architecture, our experts have the knowledge and expertise to provide a business owner in the AEC space with a relationship-focused partner and key trusted advisor. Pat Stoltz and Jim Swabowski can be reached at email@example.com and firstname.lastname@example.org.