Carmen Calzacorta, The Daily Record Newswire
In the film "Other People's Money," starring Danny DeVito, a corporate raider threatens a hostile takeover of a mom-and-pop company. Then the raider becomes enamored with the lawyer trying to protect the company and all sorts of legal maneuvering occurs as he tries to win her heart. In that film, using "other people's money" was a financial game.
However, in business succession, using "other people's money" is a viable alternative to selling the business. Owners get liquidity or money to invest and still maintain independence and control over the business and its future legacy. There are several ways to do this, and some involve debt, equity, profit interests, and other financial vehicles. However, it must be done correctly.
Consider the following:
1. Options
Many private companies that are transitioning from one generation to another or to a new management group want to remain independent and not sell, but liquidity is an issue for the owner. There are a variety of alternatives, including:
- The inside buyout In this case, the owner sells all or part of the business to the next generation or to management by financing the buyout and holding a note paid over time and/or combining with bank debt. With proper estate planning and structuring, this approach can provide tax advantages.
- The outside mezzanine debt option Mezzanine debt capital is that layer of financing between a company's senior debt (usually a bank) and equity. It can take the form of convertible debt, senior subordinated debt or private "mezzanine" securities (debt with warrants or preferred equity). Mezzanine capital is often used by private owners to take money out of the company or to enable management to buy out the owner for succession purposes. Generally, mezzanine financing is more flexible in structure, terms and amortization than bank and senior debt providers. It can also be less dilutive and less expensive than equity.
- The outside recapitalization option There are alternatives to access liquidity through a minority or a majority recapitalization. In the "minority equity recapitalization," the owner is selling less than 50 percent of the business to an investor (usually private equity), which allows the owner to gain equity diversification without ceding operating or board control. In the "majority equity recapitalization," more than 50 percent of the business is sold, often as a management buyout. In either case, the investor will eventually need liquidity, so an exit mechanism will exist.
2. Structures
Whether or not an option is viable depends on whether the company is a C corporation, an S corporation, a limited liability company (LLC), a partnership or another structure and whether real estate is in or out of the company. Structure is important not only for tax considerations but also for the nature of the equity. For example, LLCs allow for profit and capital interests and for elaborate waterfall provisions on distributions and liquidations. Corporations have their own benefits and limitations.
3. Securities laws
In evaluating any option and any time that a company uses "other people's money", there are issues tied to compliance with federal and state securities laws. The laws are intended to protect the investor by: 1, requiring disclosure i.e., understanding the risk factors, the business, etc.; 2, requiring regulatory compliance i.e., determining whether the transaction is exempt or must be registered; and 3, requiring the people "selling" the investment to be registered or exempt. Compliance with these laws can be straightforward and provide an "insurance policy" against future claims. The failure to comply can be disastrous the investors can get their money back with interest and attorney fees and there may be criminal or civil charges. And attempting to comply and doing it wrong can also cost time and money and may preclude future deals. If taking "other people's money" is a consideration, make sure proper securities advice is obtained. Each of the options discussed above has to be analyzed for securities laws issues.
4. Taxes
Depending on the structure and the option, many different tax structuring opportunities and challenges exist. This is an area that needs to be explored not just for the financing but also for the business owner's overall goals for the business, the estate and the owner. Although taxes are not the only consideration, it can be a major driver in some transactions.
5. Another consideration
The selection of the "other people" is a big part of choosing any option and determining whether the option is a truly viable mechanism for the company and the owner. These investors will be long-term "partners" and need to be compatible with the company's business plan, owner and management. They can provide funds as well as invaluable knowledge and guidance. They will also have exit plans, and those need to be part of the financing expectations.
The film "Other People's Money" ends on a happy note with the raider getting majority control and the suggestion of a pending romantic relationship. In the real world, "other people's money" can be a valuable alternative to finance liquidity for an owner. But it must be done correctly or legal and business ramifications will result.
-----
Carmen Calzacorta is a shareholder with Schwabe, Williamson & Wyatt and chairwoman of its business transitions practice group. Contact her at 503-796-2994 or ccalzacorta@schwabe.com.
Published: Wed, Feb 10, 2016
