The ninth article in this series deals with providing the owner with four alternatives (employee stock ownership plans, recapitalizations, IPO roll-ups and reverse mergers) as opposed to the outright selling of a wholesale distribution company.

by Jane E. Baynard and Scott Benfield

After months of preparation and execution, the sale of your wholesale distribution business is finally over. You, as the owner, can finally sit back and have peace of mind knowing that you have taken the best course of action in your situation by selling your business. Is this the whole truth? 

The previous articles helped explain the rationale, decision making and steps needed in order to effectively sell your wholesale distribution business. (See the links to previous articles at right).

Was this the only course of action as the owner of a wholesale distribution business to capture the value of your investment and create liquidity? Is selling the business the only option for removing capital from the company? On the contrary, there are alternatives to the outright selling of your company that may better suit the needs of the individual(s) that own the business.

In this installment of our series, we will overview some of the alternatives to an outright divestiture.

Employee stock ownership plan
An alternative to transferring ownership of a wholesale distribution business is through an employee stock ownership plan (ESOP). An ESOP is a plan that makes employees owners of the company by distributing common stock.

A company that undergoes an effective ESOP may be able to grow and remain independent during a period of aggressive industry consolidation such as the wholesale distribution industry is currently facing.

How does an ESOP work? In an ESOP, stock must be purchased directly from the company or its shareholders. The stock is then allocated to employee accounts in proportion with a pre-determined compensation ratio and held in a trust. Employees and the ESOP administrator determine the distribution plan. The allocated stock of each employee held in the trust goes to the employee at retirement, termination of employment, disability or death. In essence, an ESOP works much like social security, except, instead of compensation checks at the end of one’s employment, the employee receives company stock.

An ESOP can be leveraged or un-leveraged, but the majority tend to be leveraged. In a leveraged ESOP, money is borrowed in order to purchase employer securities for the ESOP beneficiaries. Money can be borrowed directly from the sponsor company, although banks are most often traditional lenders.

When does creating an ESOP make sense? The two most common reasons for pursuing an ESOP are to purchase the stock of a retiring owner, or as an extra employee incentive/benefit plan. For wholesalers, both reasons may come into play. 

ESOPs benefit owners of wholesale distribution businesses because they can defer tax on the gain they have made from the sale to an ESOP (but, there are restrictions such as only if the ESOP holds more than 30 percent of the company's stock). Thus, distributors can create liquidity in a tax beneficial structure by using an ESOP as an exit strategy in lieu of selling the company in an acquisition. 

ESOPs offer a number of advantages including:
• Owners deferred tax on capital gains realized when shares are sold to the ESOP if proceeds are reinvested in qualified replacement property within a replacement period.
• Owners can retain control of business.
• Provides a “friendly” buyer for the stock.
• Employees participate in the growth of the business.
• According to a 1993 study by the ESOP Association, more than half of its member companies experienced a productivity increase since the inception of their ESOP. So, implementing an ESOP may be “good business.”

However, every rose has its thorns. Some of the rather thorny issues involving ESOPs include:

• High level of administration. Engaging in an ESOP requires taking on an increased level of administrative complexity. ESOPs must file several forms yearly with the IRS and upkeep of these forms could cost close to $1,000. Setup costs range from $15,000 to $20,000 for the most basic ESOPs, and increase as company size and complexity increase.

• Applicable rules are complex. All ESOPs are subject to the rules and regulations set forth by the Employee Retirement Income Security Act of 1974 (ERISA). To view a summary of the ERISA requirements please click here.

• Ownership rights and privileges are limited while stock is in the ESOP. A private company engaging in an ESOP must let the employees direct the trustee in voting shares allocated to them when questions arise dealing with the sale, closing, recapitalization, liquidation of stock, and other basic structural issues of the company. Private companies do not have to grant employees full voting rights. In fact, issues dealing with the governing of the company, such as voting for the board of directors, are granted to employees only at the company’s discretion.

• Valuations are required. This is not a problem but a yearly expense. Valuations range in price from $2,500 to $50,000, so depending on the firm selected, this can add to the expense of administering the ESOP tremendously.

Feasibility
Is an ESOP feasible for your company? Here are some questions to help an owner decide whether an ESOP is the right choice:

• Is the payroll large enough? Companies engaging in an ESOP can enjoy tax benefits. These benefits are not without bounds though. Congress allows for companies to deduct up to 
25 percent of the total plan participants’ payroll to cover the principal portion of the loan. This constriction of payroll puts some buyouts and transactions out of reach for ESOP companies. For example, let’s assume a company with a $100,000 payroll wants to make a $1 million purchase. Annual contributions could be no larger than 25 percent of payroll or $25,000 yearly. This amount is not enough for the company to repay a loan for a $1 million purchase.

• Can the company afford the contributions? Companies incur a non-productive expense when they use their ESOP to buy existing shares. Does the company have the available earnings to take on this expense?

• Is management comfortable with the idea of employees as owners? Management must accept the fact that people who were employees before the ESOP will now become employee-owners after the ESOP. Management may not want to grant ESOP employees the information and say-so in the company that employees may desire, but this could lead to a loss in motivation.

ESOP process
Some of the basic steps in the ESOP process include:
• establishing a process to operate the plan;
• obtaining funding for the plan;
• conducting a valuation;
• determining whether other owners are amenable;
• hiring an ESOP attorney; and
• conducting a feasibility study.

Recapitalizations
A second alternative to selling a private company is a recapitalization, otherwise known as a recap. Recaps allow a wholesale distributor to gain some of the liquidity of an outright sale and also retain ownership and some operating control. A private company recapitalization is the partial sale of a company to a financial partner. A recapitalization gives the owner of a company a mechanism to receive a portion of the company’s value in cash and the ability to retain some equity and ownership in the company. If you are an owner who wants to enjoy some capital gain and liquidity now, but don’t want to sacrifice all control and ownership, a recap may be a viable alternative.

However, recaps are only feasible for companies that offer significant return to the new investors. As such, wholesalers must be top performers and offer more than typical returns on investment in order to be candidates for recaps. 

However, should your company qualify for consideration, the main advantages afforded to an owner who engages in a recapitalization are significant:
• personal liquidity;
• operating autonomy while maintaining substantial equity;
• elimination of personal risk (borrowing guarantees are erased);
• non-diluting capital for future growth.

Financing the recap
Recaps are dependent on company performance. Most companies do not have the capital to fund a buyout because the value of shares being sold is greater than their cash on hand.

So what should be done?

One option may be to raise additional debt or equity from financial sponsors to finance the share buyout. Which is prudent for your company undergoing a recapitalization will depend on your balance sheet and income statements – they, like tea leaves, can predict your future recap success…or not!

For example, a company could finance the buyout with debt if the company’s cash flows or assets can support additional debt. A quick look at the balance sheet and calculation of some key ratios can determine if this is an achievable option. Financing the payout through debt is preferable to an equity-financed payout because debt costs less, and for the most part, is less complicated to arrange than equity.

The recapitalization gets more complicated, however, if the company is apathetic or unable to fund the transaction by taking on debt. If a company cannot execute an equity investment, it must find an equity investor. The process of finding an equity investor in a recapitalization mirrors the process needed in a buyout or acquisition. In order to find potential investors, the company will need to spend time and produce paperwork in order to circulate a plan or offering memo to investors. Of late, this has not been a tremendously successful endeavor for wholesalers because of the relative performance of the distribution industry vs. other industries.

Example:

Other alternatives: Roll-ups and reserves
ESOPs and recapitalizations provide an alternative to the outright sale of a wholesaler with the company remaining private. The IPO roll-up and reverse merger are two other alternatives, but unlike the ESOP and recapitalization, the wholesale distributor may gain a greater degree of access by tapping the public capital markets.

Roll-ups
A standard IPO roll-up occurs when a group of small to mid-size private companies, known as founding companies, merge into one larger holding company. This newly formed holding company now undertakes an IPO in order to become public.

The number of roll-ups is increasing yearly. The roll-up is gaining popularity because it grants smaller companies the opportunity to first, stay alive and second, compete through the merger in a highly competitive market. Five to 10 small private companies that might have been swallowed up by the bigger players in the market now have the chance to become one of the big fish.

Rationale behind roll-ups
Roll-ups are usually executed by companies with revenues ranging from $5 million to $20 million on average that, for the most part, would have stayed underneath the public’s radar. These companies are ideal for a roll-up because they lack the size and capital to go public by themselves. Making an IPO roll-up transaction is becoming a more viable option for conventional wholesale distributors as opposed to the traditional initial public offering.

Drawbacks
Roll-ups got a bad name, and rightly so, early in the 1990s as they were used to create value through a transaction vs. a business. In addition to this potential downside, there are a few other drawbacks that have kept the roll-up from becoming a widely accepted alternative as opposed to the outright sale of a company.

The first is the operating risk involved. The lack of operating history among all the consolidated companies poses a few very important questions to a company thinking about pursuing a roll-up. Will a group of private companies that have never worked together be able to gel as one entity? Should the company roll-up with companies that share the same industry or diversify industries? Which of the private company’s management will head the new entity and which will take a back seat?

Another drawback to the roll-up is the dependence of new acquisitions. Will the new company be able to locate new acquisitions in order to facilitate growth? Will the public company be able to survive based on internal growth alone if it does not find new acquisitions to aid its growth?

Finally, unlike the private companies that formed it, the new holding company is highly dependent and vulnerable to the public marketplace. Along with all the benefits enjoyed by a public company, the holding company must face all drawbacks. A bad quarter combined with fickle investors could cause a drop in the company’s stock price. A low stock price depletes the supply of currency available for acquisitions, employee benefits and decreases the overall worth of the holding company.

Given the spotted history of roll-ups, particularly in the wholesale distribution industry, it’s not the most advantageous alternative but one we thought worthy of inclusion and discussion in this article.

Reverse merger
Along with IPO roll-ups, another alternative that allows a private company access to the public markets is a reverse merger. In a reverse merger, a company goes public using the back door. The typical reverse merger usually involves two entities, the shell company and private company. The shell company is a public company that, for the most part, has no operations or assets. The private company is bought by the shell company. Soon after the acquisition, the shell changes its symbol and name to the private company and the private company begins to use the symbol and trading privileges of the defunct shell to access the public market.

Advantages
For companies that lack the size or capital to execute an IPO, the reverse merger offers the ability to go public. Reverse mergers can be executed for a fraction of the cost ($100,000 to $400,000) and have a very short time table (30 to 60 days) vs. an IPO. A potential tax shield might also be available to the newly formed public entity. Finally, in most cases, a reverse merger allows for a retention of control. The president of the pre-merger private company usually becomes the CEO of the post-merger public entity.

Disadvantages
Even with all these advantages, a reverse merger is still not the most popular alternative for distributors interested in options to an outright sale of their business. The track record of reverse mergers is shaky to say the least. Companies executing a reverse merger tend to realize only short-term success and investor confidence. Reverse mergers still are not as widely accepted in the investing community as the traditional IPO.

When deciding whether to undergo a reverse merger, you face some crucial decisions. The liquidity which could be realized from an outright sale is certain in a reverse merger because reverses are not transactions that create liquidity, only the potential for liquidity. If you choose a reverse merger and succeed, you will realize a higher gain, as the value of each individual share increases in parallel with an increase in demand for those shares. However, if the reverse merger fails, the value may not increase, in which case your ownership value can decrease precipitously. There may be little you can do to regain the value you could have had if you just sold the company outright.

In conclusion, a distributor’s desire to obtain capital is not a one way street. In fact, there are many sound alternatives to the basic absolute sale of a company. The options discussed above are varied, yet they all grant the owner one thing not available in the outright sale of the company: control. These alternatives may not afford the same immediate liquidity as an outright sale, but all of them allow the owner some degree of control after the sale. Which is best for your company is not an easy decision. 

An owner must ask critical questions such as:
• Why am I selling the company?
• Do I still have a vested interest in the company or am I ready to cash in my chips and call it quits?
• How much ownership do I want to retain after the sale?
• Does my company have the potential to realize gains in the future or should I call it quits while my company still has some salvage value?

If you’d like to learn more about reverse mergers and the results of this type of transaction, request a copy of The Baymen Group’s new study via e-mail. Send us an e-mail request and we will forward it straightway. In the final edition of our series, we’ll introduce the NASD’s new Tier III exchange launching in early 2003, what it offers distributors desiring to capture value and enjoy some liquidity from their businesses, and how wholesalers can take advantage of this new exciting market. 

Jane E. Baynard is an investment banker and Scott Benfield is a consultant for distribution. They have co-authored three books on wholesale distribution, including Pricing Management: Capturing Value for Distributors, and can be reached at their respective e-mail addresses: Jane E. Baynard at and Scott Benfield at . Research analyst for this article was provided by Neal Reddy.

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