Private Capital Markets: The reality

The Overview:

It has long been understood, but never discussed, that the public capital markets operate differently than the private capital markets. Publicly traded companies, especially those with revenue over $1 Billion, have access to a limitless amount of debt and equity capital. In fact, the main assumption used in business finance theory is that capital is plentiful and it is up to the CFO to determine which products are going to be used by his company to reduce the overall Weighted Average Cost of Capital ("WACC"). As we all know, privately held businesses very rarely, if ever, have the luxury of access to unlimited capital. This fact has a profound affect on how a privately held business and its owners think and act. For example, publicly held companies focus 100% of their business' effort on improving profit and ultimately increasing the dividends paid to shareholders with little or no regard as to the taxes paid by the Organization. While privately held business owners are only concerned with increasing their personal net worth and reducing their business and personal income taxes. Having a deep understanding of just that difference, and how it drives business financial decisions, is critical when working with private businesses and their owners. The book Private Capital Markets; written by Robert T. Slee, published by Wiley Finance, does an excellent job of explaining the private capital marketplace and how private business owners can thrive if they understand how it works. Before we begin, we must review some truth's in corporate finance for privately held businesses.

Corporate Finance Truth's in Business:

The following represents some of the unspoken, yet intuitive, truths in business as it relates to the "private capital markets"

1. Every privately held corporation pays tax and no private corporation ever pays double tax.
2. Privately held "S" Corporations are no more valuable than its "C" counterpart.
3. Every business "pays" for itself.
4. Every seller wants to sell stock, every buyer wants to buy assets and the buyer usually wins.
5. There are only two places to get stock in a privately held business.
6. There are three types of potential buyers for a privately held business.
7. Every business owner wants to leave a legacy behind for their business.
8. Very few business owners have an exit strategy for them and their business.

External vs. Internal Transfers: The differences.

When deciding if, and how, you are going to transfer the ownership of your privately held business you must first decide what your motives are; both financial and non-financial. This is critical for two reasons; first your motives are going to ultimately determine the transfer channel you take and; second that transfer channel will determine the value,or range of values, of your company. You must then calculate and decide, with your CPA or personal financial planner, if that transfer channel and its likely value outcome will support your personal financial and non-financial goals. Most advisors will ignore, or will not take the time to determine, what your motives are before trying to take you down a transfer channel only to find that you do not, nor have you ever, desired that result or understood the consequences of that decision. For example, at first blush you may want to sell your company to a publicly traded company but once you understand the process and the restrictions placed on the transaction by the Securities and Exchange Commission, you may change your mind. You may want to transfer your company to your children, but don't want to have to take an annuity payment based on valuation rules outlined by the IRS because it may not support your current lifestyle. This is why corporate finance, the transfer of ownership, and personal planning represent three separate yet closely integrated moving parts that must be examined before determining the process you are going to undertake.

External Transfers: A Closer Look!

The presumed and preferred method of transfer of most business owners is the external transfer which includes; Initial Public Offering ("IPO") and Reverse Mergers (going private), Consolidation "Roll Up" most often executed by "Private Equity Groups", and Negotiated One and Two Step Private Auctions, the most common type of sale by M&A Advisors, AKA Investment Banker or Business Broker. The external transfer process, although initially desired by most business owners, is successful for a very small number of businesses. Factors to consider when determining if your Company is a candidate for an external transfer:

• Do you have a 'niche' product or manufacturing process that your competitors do not have? Is it reasonably protected? Can it be transferred to other product lines?
• Have you made adjustments to allow you to compete in the 'global' economy?
• Have you removed unprofitable product lines?
• Are you taking advantage of importation as a part of your non-critical manufacturing processes?
• Are you creating Economic Value Added ("EVA") in your business?
• Have you addressed or removed "Key Man Issues", can the business continue without you present daily?
• Are you positioned to be 'attractive' to a private equity group?
• If you desire to be purchased by a Publicly Traded Company, have you begun the process of becoming Sarbanes-Oxley (SOX) Compliant?
• Do you have above industry average critical ratios, such as Return on Equity and Return on Assets?
• Have you been able to grow the Company with equity (after tax profit), or have you been forced to used debt that you personally guarantee?
• Is your EBITDA increasing, decreasing or has it remained steady over the last five years? Where is it going over the next five years, and how can you assure a buyer that your estimate is reasonable, defendable?

Lastly, and most importantly, if you are successful in completing a third party or external transfer, what is the tax impact? Will the proceeds from the sale, after taxes and commissions, sustain your lifestyle? Have you prepared for the lifestyle change that will result because you are no longer going to work each day? Is your family prepared for the change? These questions. and many more must be explored before the process can begin. Do you want an independent advisor knowledgeable about the marketplace, the tax impact, the cost, and the probable outcome advising you about these issues, or do you want someone with an agenda advising you about these issues? Don't let a commission driven sales professional promote their motives, you have to live with the consequences regardless of the outcome!

Internal Transfers: A Closer Look!

Just like external transfers, internal transfers are not for everyone. There are even more issues to consider when undertaking an internal transfer of your privately held business. Before we examine them, let's look as just some of the possibilities. If you have multiple partners you may want to consider buy\sell arrangements, "Dutch Auction" or "Right of First Refusal". These internal transfer methods have many unintended negative consequences such as; they only consider one option, for example buy\sell only deals with a death of an owner, right of first refusal assumes that you can find an outside buyer and if the partners or corporation exercises their\its rights the buyer will have access to the capital. Other options as it relates to internal transfers with family members includes outright gifts of equity units, sale of equity on an annuity basis or sale to a family trust. The problem with this process is that it is fraught with IRS rules and regulations and it may not generate the amount of cash flow to sustain your life style, forcing you to remain active in the business long after you can contribute to its growth. This process can be very costly to set up and maintain, cause resentment by the family members that have to work to pay off the debt with after tax dollars and/or pay a salary continuation long after you have left the business. Factors to consider when determining if your company is a candidate for an internal transfer:

• Is your company's cash flow increasing? Is there excess cash flow after consideration is given to working capital needs.
• Have you passed up business opportunities for fear of taking on any additional debt or risk?
• Have children in the business been able to explore new markets, 'niche' opportunities or cost savings ideas?
• Does the management team have the training and experience to run the business without you there on a daily basis?
• Is it important for you to pass the company on to the next generation of management and keep the jobs you have created in your community?
• Would you like to stay on as the CEO and help the next generation grow the Company?
• Are you willing to begin divesting your self of control of the company over time, or do you want to cash in and leave?
• Are the members of your key management team ready, willing, and able to step up?

Only by going through a detailed process with a feasibility study, that calculates the value of your company under multiple transfer channels, can you begin to properly plan your transfer of equity interest in the business for value. Do you want this to be a process or an event? Do you know the consequences of your actions, financial and non-financial? Lastly, do you want your current trusted advisor imposing his\her motives and values on you, based on his/her limited knowledge of the possible transfer channels and its natural outcomes, or do you want an independent financial professional working with a team of experts analyzing your options and letting you decide which course of action best serves you, your company, its employees and your family?