When fund managers approach the end of a deal cycle and start considering how best to capitalize on their investment, they often discover that a traditional third-party sale might not be the most lucrative exit strategy.
For example, taking the company public through an IPO could provide a more accurate market value for the portfolio company. Or selling to an employee stock ownership plan could produce a more favorable return as a result of the tax treatment for ESOP companies and their investors.
Despite the potential advantages, these strategies are also likely to complicate the company’s regulatory environment, increasing both risk and compliance costs. If fund managers believe an IPO or ESOP might be a viable strategy, they should start evaluating these options early to allow time to prepare for and execute the deal while maintaining regulatory compliance.
To realize value from an IPO, timing is critical. Deciding to take a company public triggers a variety of accounting, financial reporting and regulatory requirements, which almost invariably take more time and effort than expected.
As well as meeting the various corporate governance, financial statement and disclosure requirements mandated by the Securities and Exchange Commission and the exchange where the stock will be listed, public companies must comply with the testing and documentation requirements in Section 404 of the Sarbanes-Oxley Act of 2002, known as SOX 404. These demand all publicly traded companies establish internal controls and procedures for financial reporting, and requires them to document, test, and maintain those controls and procedures.
Companies going public are exempt for the first year, but they must certify compliance by the time they issue their second Form 10-K. This means they have a maximum of 24 months, but often considerably less, to achieve compliance. Many companies underestimate the scope of the evaluation, testing and documentation efforts involved, as well as the staffing and technology capabilities needed.
A similar challenge for newly formed public companies is meeting the requirements of a recognized framework for their annual assessments and reporting of internal control. The vast majority of publicly traded companies use the 2013 version of the Committee of Sponsoring Organizations of the Treadway Commission Internal Control – Integrated Framework, commonly referred to as COSO 2013. As a result, the investor community almost always expects an IPO to meet the requirements of COSO 2013.
Reporting for duty
In addition to these measures, other financial reporting standards and regulatory requirements also have grown more complex in recent years. Two recent updates by the Financial Accounting Standards Board will need attention: Revenue From Contracts With Customers spells out detailed guidance on the amount and timing of revenue recognition for financial reporting purposes.Â
With these implementation dates rapidly approaching, any strategy for taking a portfolio company public must include a plan for compliance.
Private equity groups assume significant reputational and other risks if their portfolio companies do not have sound internal financial reporting controls before going public. Apart from the potential legal and regulatory consequences stemming from non-compliance, weak internal controls also increase the likelihood that financial and registration statements might include inaccurate data.
Questions over the accuracy of financial statements invariably cause problems with the SEC, which can seriously affect the market’s interest. Acknowledgment of a material weakness in a company’s internal control can produce a drop in share value, and when this occurs close to an IPO the reactions can be particularly volatile.
Strong internal controls and sound corporate governance can also offer positive benefits. These include better risk management, reassured stakeholders and reduced cost of capital. Because strong corporate governance can also help attract new investors, firms should require their portfolio management teams to establish good governance and compliance initiatives well before an IPO is launched.
Even as they work to address these increased requirements, most companies’ management teams will still want to maintain an entrepreneurial spirit and a responsive corporate culture. To achieve the right balance, senior management should set an appropriate tone early in the process.
Communications from the C-suite emphasizing the importance of the compliance program can help smooth the transition. The effort should also include a strong emphasis on training to those affected to recognize the need for and purpose of the new controls. Empowered and trained employees can help create better and more effective controls.
As noted, all these steps will take time and effort. Management should begin establishing corporate governance and compliance programs for a portfolio company at least 18 months before it will be required to file its second SEC Form 10-K, and it should manage the transition proactively to see that adequate resources are allocated.
Retirement plan
Although they are used far less frequently than IPOs, secondary buyouts, or recapitalizations, ESOPs can offer some attractive advantages for exiting a portfolio company. In many instances, the structure could provide a more favorable return compared with a dividend recap or even a traditional leveraged buyout, due to the structural and tax efficiencies it can offer.
ESOPs were established by the Employee Retirement Income Security Act of 1974 as a type of qualified retirement plan. They give owners a way to transition out of a business by selling shares to a tax-exempt trust, in which employees can earn a vested interest. In fact, ESOPs could be characterized as the original form of LBO, because the trust is specifically allowed to fund its stock purchase by using debt.
Much of the appeal of using an ESOP to recapitalize a portfolio company is due to the potential tax benefits it can offer, as it is tax-exempt. So if the company being sold converts to an S corporation, and the ESOP owns 100 percent of its stock, the company’s federal income tax obligation effectively is eliminated.
And when a private equity firm sells to an ESOP, the sellers often finance all or part of the sale by taking back a note plus a warrant or stock option with an appropriate strike price. With the additional free cashflow provided by the ESOP’s tax-exempt status, debt can be paid down more quickly, increasing the equity value of the company. The warrant gives the investor the potential of an additional and significant economic upside, which is an appropriate and market-based incentive given the continued investment of capital.
What’s more, if certain requirements are met, selling or recapitalizing into an ESOP structure could allow the seller to receive the proceeds free of capital gains tax. Those criteria are quite detailed, specific and complex, so qualified tax counsel should be consulted in every instance.
ESOP’s foibles
An ESOP is subject to specific US Department of Labor and IRS laws and regulations. While the preparatory phases of an ESOP sale are generally somewhat shorter than those in an IPO, the process does require adequate planning. The firm will need to engage experienced sell-side professionals for accounting and legal support.
Then, as the deal matures, an independent third-party trustee should be engaged to act as the ESOP’s fiduciary. In addition, an independent financial advisor and attorney must be hired. The ESOP be represented by these independent third parties for purposes of negotiating an arms-length transaction that reflects fair market value; the ESOP must always act for the primary benefit of the employee beneficiaries.
Firms contemplating a sale to an ESOP should prepare economic models that compare the potential returns of all viable exit strategies. There could be situations in which the tax advantages of an ESOP sale at fair market value might be outweighed by the equity value offered by other strategies. The vehicle is most likely to be advantageous for an entity with a moderate growth rate, stable earnings, a relatively high effective tax rate and a corporate environment where employee incentives are valued.
The various regulatory and compliance issues associated with non-traditional exit strategies will undoubtedly grow in complexity over the coming years. As they do, it becomes increasingly important that management teams get an early start on preparing for an exit. These first steps should include a complete determination of scope and risk assessment to identify, evaluate, and prioritize any vulnerabilities that could affect the choice of strategy.
Early intervention and a strong, positive tone from the top not only can help reduce wasted effort in pursuit of a non-viable strategy, they also can help launch the chosen strategy more effectively, setting the stage for future performance and ultimately helping investors maximize their return.
Marc Baluda is a shareholder with Greenberg Traurig; Tony Klaich is a partner with Crowe Horwath; Simon Little is a senior manager with Crowe Horwath.
This article is sponsored by Crowe Horwath. It was published in a supplement with the October issue of pfm magazine.
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