Harvesting Value From Entrepreneurial Success
John W. Kensinger, John D. Martin, and J. William Petty
September 2000
John W. Kensinger is Professor of Finance, College of Business Administration, University
of North Texas, Denton TX
John D. Martin holds the Carr P. Collins Chair in Finance, Hankamer School of Business,
Baylor University, Waco TX
J. William Petty is Professor of Finance and holds the W.W. Caruth Chair in
Entrepreneurship, Hankamer School of Business, Baylor University, Waco TX
For presentation at the annual meeting of the Financial Management Association, Seattle,
Washington, Session 189 (8:30-10:00 AM—Room 609) Saturday, October 28, 2000.
Harvesting Value From Entrepreneurial Success
Abstract
We recommend ways for an entrepreneur to derive liquidity from the business, with or
without selling it. In today’s financial arena there are a variety of ways in which a private
business can harvest liquidity to meet its own needs for growth, the consumption
requirements of its founder, or the challenges of tax and estate planning. In order to
achieve its full potential, a company should be able to continue through its business
lifecycle, whether or not that matches the human lifecycle of its founder. So long as
leadership succession can be arranged, the business’ lifecycle can determine the course of
the company. Indeed, selling the business is optimal only if there is a strategic buyer
willing to pay a premium above the business’ stand-alone value; or if the founder wants to
withdraw from the business, and has no preferred successor.
Introduction
Many entrepreneurs fail to realize the full benefits of their labors through a
successful harvest. They may earn a living from the firm’s operations, yet remain “asset
rich but cash poor”—chronically short of liquidity from their investment of capital and
effort.
Seeing a clear route toward the harvest—that is, gaining liquidity from
entrepreneurial investments of money and effort—also is of prime importance to outside
investors, who typically have a priori expectations about their investment that include either
taking the firm public or being acquired by another business. We recently conducted a
series of interviews with entrepreneurs, venture capitalists, investment bankers, and
advisors who have been intimately involved in the harvesting process, and this article
reflects our distillation of their experience.1
Harvesting is more than selling a business and leaving it behind.
It is about
unlocking liquidity, reducing risk, or creating options. One commentator advises, “Build a
great company, but do not forget to harvest … keep harvest options open and think of
1
The authors gratefully acknowledge the resources devoted by the Financial Executives’ Research
Foundation in support of this effort. The results are published in Petty, Martin, and Kensinger (1999).
harvesting as a vehicle for reducing risk and for creating future entrepreneurial choices and
options, not simply selling the business.”2
Few events in the life of the entrepreneur, or for the firm itself, are more significant
than the harvest. From the entrepreneur’s perspective, though, selling is about more things
than money, involving personal and non-financial consequences as well.
Even an
entrepreneur who realizes an acceptable monetary value for a firm may be disappointed
with the overall lifestyle consequences of the sale.
Overview of the Harvest
To gain insight into how one might prepare for the harvest, let us first consider the
basic methods for harvesting a business venture, then examine how to prepare well for
each method. These include liquidating the business’ assets, tapping the business’
borrowing capacity, selling the company as a going concern, or establishing a public
market for the stock via an initial public offering.
•
•
•
In some cases the value of the business resides primarily in the assets it
holds—then an orderly liquidation is the route to harvesting the value held in the
business (or, a buyer acquires the firm because it is worth more dead than alive and
can be sold piecemeal).
In other cases the business is worth more as a going concern—then the most
attractive price often arises when another firm in the same or related business
acquires the company (a strategic buyer may envision synergies that enhance the
value of the combined firms).
When no such strategic relationship exists between acquirer and acquisition, the
value typically is based on expectations of future cash flows discounted to present
value. In some cases, the managers or other employees might be the ones willing
and able to make the most attractive offer via a management buyout (MBO), an
employee stock ownership plan (ESOP) or similar leveraged arrangement.
Place Exhibits 1 and 2 nearby
A successful harvest is facilitated by a steady focus on building net worth for the
equity investors—ideally throughout the life of the business (see Exhibit 1 for a listing of
available harvest methods and Exhibit 2 for a summary of entrepreneurs’ reactions to the
2
See Timmons (1994).
Page 2
harvest)). There must be something about the business that someone else would be willing
to pay to acquire—after all; this is about finding what is marketable in the business. Are
the assets the business buys readily marketable? Do these assets have alternative uses? Are
the business’ cash flows stable and comfortably predictable (so they form a sound basis for
borrowing)? Are the cash flows durable (or will they likely dry up soon)?
Does the
business have growth potential? Would its products fit soundly within the distribution
channels of a competitor (or vice versa)? Does it have established brand identity? Are the
employees more productive in this business than they would be in any other? Can the
entrepreneur convince potential stock purchasers that he or she has a vision that could be
realized with capital from public markets? These questions reflect core issues involved in
the various harvest methods—and just one affirmative answer may be sufficient to indicate
progress toward gaining liquidity.
Financial contracting—the process of determining how cash and risk are to be
shared among owners and investors—requires estimates of a venture’s value and an
assumed horizon date for the harvest.3 Further, founders and early-stage investors can be
viewed as purchasing call options on the harvest proceeds; and the option characteristics are
especially apparent when staged commitments are involved, as in venture capital
arrangements.4 Measuring the value of a firm when the stock is not publicly-traded is
difficult—hence a major advantage from going public is to establish a basis for financial
contracting. It is even more difficult to forecast the value a startup might have five to ten
years into the future (the problem is one of assessing value when information is incomplete
or conflicting).
Crafting a harvest strategy can be done long before the need materializes. Several
of our interviews emphasized the need to begin early for a successful harvest.
One
3
See Sahlman (1988).
Option valuation models require measurement of current value, the potential for the value to change up or
down, and the time span of the option
4
Page 3
entrepreneur said: “If you are raising money to grow your business, the people who put
that money in are always concerned about how to exit; and you need to have that mindset
unless you expect to die in the CEO chair. The worst of all worlds is to realize, for health
or other reasons, that you have to sell the company right now.”
Yet, whenever the offer is based upon what the buyer can borrow using the
business as collateral, the potential yield from the harvest may reflect just the amount that
can be borrowed against expected cash flows for a limited time into the future.
For
example, common practice now limits ESOP loans to terms from five to eight years. Limits
on the time horizon of borrowing may handicap the ability to realize the full liquidity
potential within a business, when using any method based upon borrowing against the
future cash flows of the business. If the cash flows from established operations are the
primary thing someone else is willing to pay for, one cannot expect the offered price to
include a premium for future growth or other intangibles the entrepreneur may believe the
business possesses.
Many entrepreneurs view the initial public offering as the most desired form of
harvest—but its applicability as a harvest strategy depends upon a fortuitous conjunction of
the lifecycles of business and entrepreneur, and upon the personality of the entrepreneur.
An IPO is a transitional event for a growing firm that needs access to the public capital
markets for its expanding capital requirements; but, it may be many years after the IPO
before the entrepreneur will be able to sell a substantial portion of his or her stock. So the
firm must be at the beginning of a sustainable growth phase in its business lifecycle, while
the entrepreneur does not need to retire any time soon. Also, public disclosure demands
and the requirements of investor relations make the life of an executive in a public
corporation sometimes very different from that of a founder in a private company.
In a recent study of computer software CEOs who took their firms public, each
respondent was asked to reflect back to the start-up stage of the company and rank the
probability that the firm would use one of five alternative harvest strategies at some point in
Page 4
the future.5 Thirty percent of the CEOs assigned the highest probability to being acquired
by a larger company; five percent thought a leveraged buyout by employees would occur;
and, despite the odds for such an outcome, sixty-five percent considered an initial public
offering as their most likely harvest strategy. These results are supported by another recent
survey of one hundred chief executive officers of newly-public companies in which more
than half said they planned from the initial start-up phase that they would eventually go
public.6 In fact, though, an IPO rarely comes to pass as a general rule. (Perhaps these
surveys to some extent reflect a self-fulfilling prophecy, as their samples are drawn from
companies that successfully went public.)
Harvest Methods That Do Not Require Publicly-Traded Equity
Most often, the harvest is accomplished without establishing a public market for the
company’s equity. Let us consider these methods first, before considering the possibility
of going public.
Merging or Being Acquired
Indeed, the most potentially lucrative route is an acquisition motivated by strategic
considerations. Then the acquirer is motivated by the value perceived to be added to the
newly-expanded firm by the target’s inclusion—and the perceived synergies may add
substantially to the offer, above the target’s stand-alone value. In our interviews, venture
capitalists consistently touted this as a desirable outcome sometimes preferable to going
public.
Often, the strategic courtship is serendipitous.
One of the entrepreneurs we
interviewed told of a chance meeting at a trade show when he demonstrated his product to
the head of marketing from a large producer of computer games. The resulting deal was
consummated in a matter of weeks—at a price far higher than the entrepreneur had ever
5
See Holmburg (1991).
Page 5
dared imagine!
This provided the initial investment for his next company.
Other
entrepreneurs told similar stories of fortuitous events.
Can an entrepreneur guide a firm so that it becomes a premium attraction for
addition to another company’s portfolio of holdings? Indeed, to a significant extent a
successful outcome can result from intentional enhancements. Some creativity is required,
of course.
Most important, though, is a thorough understanding of the company’s
products, markets, customers, suppliers, and competitors. Competitors are perhaps the
first group that comes to mind when thinking about potential acquirers; but customers or
suppliers may also be good candidates, with potential synergies from integrating forward
or backward.
In our interviews, investment bankers and venture capitalists alike advised that
more time should be spent analyzing the buyer’s needs than contemplating the attributes of
the seller. Very simply, think about why your company should have value to another firm.
“Don’t hesitate to approach the CEO of the buying firm,” one advised. “Even though the
CEO represents the interests of the buying firm, he has no reason to be anything but honest
with you during the purchase process; for he needs the post-acquisition firm to operate
successfully and for this he needs your full cooperation and good will.”
Beech Aircraft Company, for example, successfully enhanced its attractiveness;
resulting in its acquisition by Raytheon, previously a supplier of components to Beech.
Beech’s primary stockholder at the time was the founder’s widow, who wanted to retire
and had significant estate-planning issues. She also wanted to leave a strong company as a
legacy for her husband, so there were non-pecuniary issues too.
Brand identity was
strong, with a solid reputation for product quality, but the product line was dominated by
aging designs.
In 1979 Beech invested heavily in developing a revolutionary design
(dubbed “Starship”) that used all-composite construction, fully computerized flight
6
See Hyatt (1990).
Page 6
instruments, jet-fan power, and the then-radical canard architecture (on a canard aircraft,
the main lifting wing is at the rear, with the horizontal stabilizer mounted on the nose).
Most of the investment went into computer-aided design facilities and factory automation
for handling composite materials on a large scale (which have many alternative uses). This
effort attracted new engineering talent and revitalized the company to such an extent than
within three years Beech attracted significant attention as a strategic acquisition with several
potential suitors. The result was a successful sale to Raytheon within three years of
launching the Starship project (Raytheon was the primary supplier of cockpit instruments,
communications equipment, and navigation aids for the Starship project). Those familiar
with aviation will know that the Starship itself had a very brief production run, but the
technologies developed during that effort have enhanced the organization in a variety of
ways. Moreover, Mrs. Beech’s goals were met in spades, regardless of what eventually
happened with the Starship design—that product was a springboard into new technologies,
not an end in itself.
A caveat is in order, though: the entrepreneur should think carefully about whether
it will be realistic to stay with the company through the transfer of ownership. The very
qualities that made the business founder a successful entrepreneur often make it difficult for
him or her to work for a new owner. In fact, we found on several occasions that the
entrepreneur quickly became disillusioned and left soon after the acquisition.
Sale With Value Based On Cash Flows
In a sale that does not involve strategic relationships between buyer and seller, most
buyers of private firms rely on some multiple of earnings or cash flow to assess value. The
various approaches may use net income, operating income, or earnings before interest,
taxes, depreciation and amortization (EBITDA), to value the business at the harvest. For
instance, a multiple of EBITDA is commonly used to estimate firm value. Outstanding debt
is then subtracted to determine the value of the firm’s equity. The various approaches can
be generalized to include two basic perspectives in valuation. Both hold that cash flows are
Page 7
the primary value driver. The theoretically correct approach is to discount cash flows to
present value. Common practice, though, is to find a “market” multiple that computes
value as a multiple of annual cash flow. Venture capitalists and investment bankers in our
interviews describe the estimation of cash flow as the “science” part of valuation. They
describe the “art” of valuation as finding the right set of comparable companies upon which
to base their arguments for a particular multiple. A relatively high multiple, presumably,
reflects growth potential; although this is admittedly an imprecise measurement.
Increasing and Stabilizing the Firm’s Free Cash Flows
For firms in their growth phase the free cash flows7 may be negative, requiring
frequent infusions of cash into the firm from owners, creditors or venture capitalists. As a
firm or its industry matures, growth opportunities decline, resulting in increased free cash
flows. At some point, an entrepreneur and other equity investors may recognize that the
potential sales growth has slowed or even halted. This event generally occurs as a natural
consequence of maturing markets where competition has removed any growth
opportunities with prospective returns greater than the firm’s cost of capital.
If free cash flow from established operations forms the primary basis for the
business’ market value, actions aimed at stabilizing cash flows could enhance the harvest.
Then the focus becomes efficient use of resources, with innovation limited to upgrades
necessary to keep established products competitive.
Employee incentives aimed at
promoting efficient use of capital—such as Economic Value Added—reach their maximum
potential at this phase in the business’ life.
Cash flow stability is particularly important if the potential buyer is able to pay little
more than the amount that can be borrowed against expected future cash flows of the
7
A firm’s free cash flow represents the amount of cash that could be distributed to its investors after all
business needs (for operations and expansion) have been met. Free cash flow equals operating profits, plus
depreciation, minus positive NPV investments. Interest, debt repayment and corporate income taxes are
Page 8
business, with loan terms restricted to a limited number of years into the future. (In current
practice, terms from five to eight years are common—with terms longer than ten years
being rare unless physical collateral is pledged.) If potential loan proceeds define the offer
price, there is little potential for value to reflect growth opportunities or any other intangible
things that cannot be used for collateral.
If the best offer price clearly reflects a limited segment of expected future cash
flows, the entrepreneur need not sell unless he or she is ready to retire with no preferred
successor; or simply wants to move on to other activities. Access to the same liquidity
could be obtained by tapping the borrowing potential in the business’ own name. This is
the value-maximizing path for the entrepreneur, who then has access to the same amount of
liquidity as would come from a sale, while retaining whatever residual value might remain
after the repayment period has elapsed.
Also, when growth slows or halts, free cash flows could be harvested gradually.
This course would accomplish the harvest more slowly than could be done via borrowing,
but might reduce the cost and ease the challenges of tax planning. The goal of harvesting is
to maximize the after-tax proceeds for the company’s owners and investors. Tax planning
may be challenging when substantial amounts are withdrawn from the business over a
short time horizon; although retirement accounts, trusts, family corporations, and other
remedies may be helpful. (Indeed, the business may be effectively converted into an
investment trust without going through a tax event such as a sale or cash withdrawal, a
potentially desirable course if all equity owners are family members.)
Borrowing or withdrawing cash have two potential advantages. First, the owners
who are not ready to sell can begin harvesting while still retaining ownership. Second, the
strategy does not depend on finding an interested buyer and spending time and energy
negotiating the sale. A potential disadvantage for the entrepreneur who is simply tired of
considered to be part of the free cash flow, because they could be made available to investors through
financial restructuring.
Page 9
day-to-day operations, though, is that retaining ownership and working to maintain
competitive advantage for an extended time may be asking for too much patience. If other
qualified leadership not is available, the strategy may be too emotionally draining and
ultimately be less advantageous than a sale.
Recognizing the opportunity for creativity in this area, some investment groups are
developing financing approaches that more fully recognize the needs of exiting owners
within firms that have potential long-term value.8 In such cases, a standard leveraged sale
might fall short of potential value. To capture a portion of this niche, these investors have
created the so-called “Private IPO”—despite the name, these are not public offerings at all,
but are more like leveraged buyouts. They involve institutional investors taking equity
positions in partnerships that acquire and operate carefully selected private companies. In
order to be a candidate, the business must be perceived as possessing sustainable
competitive advantage with stable cash flows, or substantial growth potential. A good fit
with other business units and asset pools of the partnership would also be attractive.
Orderly Liquidation
An orderly liquidation does not necessarily mean the business would be shut down
in the immediate future. Even if growth has stalled, competitive advantage may continue
for a time. Shutdown need not occur until economic rents have ceased, and the continuing
return from the investment in the business is no longer competitive.
Assets such as equipment or real estate might be sold and replaced with leased
assets—allowing the business to continue operating after the owner has partially harvested
its accumulated value. Financial contracting to accomplish this would be straightforward
once cash flows have been stabilized. Indeed, it might be good preparation for this stage if
the entrepreneur initially established the asset pools as legal entities separate from the
8
One such group is Heritage Partners, of Boston.
Page 10
business, thus facilitating tax management and estate planning.9 One of the estate-planning
issues often encountered, in fact, is the need to provide liquidity for estate taxes and other
distributions after the owner’s death when there is a preferred successor for the business.
Then structures that facilitate asset liquidation without jeopardizing the business’ viability
could be very important. In certain cases it might even be possible to spin off or sell some
of the business’ assets into a special-purpose limited partnership capable of borrowing
against its own expected cash flows. (When such an entity is able to obtain debt on terms
that give the lender no recourse to the cash flows of the parent, the arrangement is called
“project finance.”)10
For example, we talked with the president of a pharmaceuticals company that had
recently gone public, asking for insight into the company’s decision to use R&D Limited
Partnership (RDLP) financing to fund human clinical trials for a new compound. “That’s
simple,” he said. “We needed $80 million for the clinical tests.
Our total equity
capitalization is only $20 million so we couldn’t issue enough new stock; and we don’t
have the cash flows to support that kind of debt. The institutional investors are comfortable
with RDLPs, and we don’t have to start paying until the new drug goes to market.”
If growth opportunities have dried up, and declining sales are anticipated,
inventories become an additional focus for the harvest. An entrepreneur we interviewed
related his experience in such a situation. He told us, “I was amazed to see how much cash
you can get out of a business.”
His company had been in aggressive growth mode for several years when the
business environment shifted suddenly due to a competitor’s innovation. The company
9
For example, the entrepreneur might purchase real estate in his or her own name, and rent it to the
business. Rents can even be defined as a percentage of business revenue (this is common, for instance, in
restaurant properties). Such separation of asset holdings could have significant tax and estate planning
advantages, compared with keeping these assets in the business’ name and later seeking ways to distribute
the proceeds from their sale as dividends or taxable business profits.
Page 11
could not raise the funds needed to completely redesign its microcomputer products, and
the investors decided to accomplish an orderly liquidation. The chief marketing officer was
the first senior executive to leave. Cost control became a primary focus, with the chief
financial officer and chief operating officer played critical roles.
The chief executive
brought in a liquidation specialist recommended by the company’s primary bank lender.
Asset sales proceeded. All operating decisions were aimed at generating cash. Many of the
customers who had installed the product wanted to continue using their equipment and
valued product support. This provided a viable market for inventory at the business to be
converted into spare parts and sold for stockpiling. A year later all debt had been repaid,
with enough left over so the equity investors earned a profit. The entrepreneur used his
proceeds to start another business.
This entrepreneur told us: “In this phase, your checkbook is the most important
management tool. Forget the balance sheet, income statement, and that sort of thing. All
that matters is what you can put into your checkbook.”
Management Buyout (MBO)
Given the empirical evidence of increased efficiencies produced from an MBO and
the proven longevity of these benefits, an MBO should be considered a potentially viable
means for transferring firm ownership—both for small businesses as well as large ones.11
While the managers within many entrepreneurial businesses frequently have a strong
interest and incentive to buy the business, they often lack the financial capacity to do so. A
leveraged MBO can provide the needed liquidity.
If an MBO is used to consummate the sale, the seller may be asked to provide loan
guarantees, or accept debt as part of the payment package.
The deal must then be
10
Project financing offers many opportunities for providing private companies with liquidity. For an
extended discussion of the many possibilities in real estate, energy, minerals, forestry, R&D, and other
applications, see Kensinger Martin (1988).
Page 12
structured to minimize potential conflicts of interest. Specifically, if the new owners have
placed little of their own money in the deal, they may be inclined to take risks that are not in
the best interests of the selling entrepreneur; they very simply have nothing to lose if the
company fails. Also, if the terms of the deal include a so-called “earnout” in which the
payments depend in part on the subsequent profit performance of the company, the buying
owners have an incentive to do things that lower the firm’s profits during the earnout
period. Thus, the entrepreneur needs to take great care in structuring the deal; otherwise,
there may likely be a disappointing outcome.
In addition to their recent popularity in the U.S., management buyouts have come
to be used in Europe as well. In Europe, the venture capital industry has had a significant
role in management buyouts, especially for smaller firms. A study of 182 venture-backed
MBOs of European firms found the same improvement in operating efficiencies and
longevity as did researchers in the U.S. Also, European managers who undertake MBOs
typically anticipate their exit to be in the form of a public offering, but almost invariably the
firm is sold to a third party.12
Employee Stock Ownership Plan (ESOP)
Small and middle-sized firms have been the primary sponsors of ESOPs.13 There
are tax advantages with ESOPs that are not available in other harvest methods.14 Also, the
research to date suggests that ESOPs have been effective in increasing productivity by
linking employee compensation to company performance, and by giving employees a role
in management through their voting rights as shareholders.
For instance, using both
Tobin’s q and accounting performance variables, a recent study found that average
11
For an analysis of the operating effects of smaller-firm MBOs, see Wright, Thompson, Robbie, and
Wong (1992). For a discussion of large-firm MBOs, see Kaplan (1989) and Kaplan (1991).
12
See Wright, Robbie, Romanet, Thompson, Joachimsson, Bruining, and Herst (1992).
13
See Englander (1993).
14
For a detailed discussions, see Chen and Kensinger (1985) and Bruner (1988).
Page 13
performance significantly increases after establishing or expanding an ESOP.15
Finally,
sale to employees sometimes results from the entrepreneur’s desire to see the firm continue
with as little change as possible after the founder has taken a reduced role.
Insert Exhibit 3 nearby.
The basic arrangement for a leveraged ESOP is shown in Exhibit 3. There need be
only three principal participants in the arrangement: the employer corporation, the lender,
and the ESOP. An ESOP trust borrows from the lender on behalf of the ESOP and buys
common stock from the employer corporation or from the exiting owners.
The trust
subsequently services the debt from dividends and contributions that the employer pays
into it. Such dividends are fully tax-deductible, and other contributions are deductible up to
a maximum of 25 percent of payroll.16 So it is possible for principal as well as interest
payments to be tax deductible for the employer corporation. As the debt is retired, shares
of stock are taken out of the trust and credited to the participants’ accounts in the ESOP.
The employer corporation has equity financing and will be making tax-deductible
payments to service it. In case the employer corporation is unable to make sufficient
payments into the trust to service the debt, the lender would have recourse only to the
assets held in trust for the Employee Stock Ownership Plan.
While an ESOP benefits the entrepreneur by providing a market for selling stock, it
also carries with it some tax advantages that make the approach attractive to owner and
employee alike. The benefits include the following:
•
•
15
16
If the ESOP owns at least 30 percent of the firm after purchasing its shares, the
seller can avoid current tax on the gain by using the proceeds to buy other
securities. Thus the business can be converted into a diversified investment
portfolio without capital gains taxation (this is often referred to as the “rollover”
feature).
The dividends that a business pays on the stock held by the ESOP are allowed as a
tax-deductible expense; that is, the dividends are treated like interest expense for tax
purposes.
See Park and Song (1995).
Internal Revenue Code, Section 415, paragraph 19,566.
Page 14
Employee ownership is not a panacea, and shouldn’t be
prescribed
indiscriminately. Selling all or part of the company to the employees works only when it
resolves conflicts that otherwise would exist between the owners and employees in such a
way that both groups are better off.
While advocates argue that employee ownership
provides improved motivation, leading to greater effort and reduced waste, the value of
greater effort varies significantly from firm to firm depending on the situation.
Transferring Ownership Within the Family
Most transfers of ownership within family-owned companies relate to an older
generation exiting the firm at retirement and/or to facilitate estate-planning needs of the
older generation. A secondary reason for ownership transfers is to give incentives to other
family members. Three factors must then be kept in balance: liquidity for the exiting family
members, continued availability of capital for company growth, and maintenance of
control.
In a recent study, a sample of entrepreneurs who had already transferred
ownership or were planning to do so were asked to indicate the relative importance of these
three issues in making their decisions. Eighty-five percent of the respondents viewed
maintaining control of the company as very important. About 45 percent considered
providing capital for the firm’s future growth and meeting the personal liquidity needs of
family members as being very important.17 The survey also asked how the transfer would
be financed, with the following responses:
Method of Financing Inter-Family Transfers
Gift:
Seller Financing:
Acquirer’s personal financing:
Third-party financing:
Other:
17
Prevalence
38%
24%
14%
12%
12%
See Upton and Petty (1998).
Page 15
The owners indicated that their financing of choice leans more to debt than equity.
The right to convert from debt to equity on the part of the investor, either through
conversion rights or warrants, was essentially non-existent in the transitions that had
already occurred. For the planned transfers, 23 percent of the respondents expecting to use
third-party financing thought such features would be part of the financing arrangement.
For the firms having been involved in a transition, however, such sweeteners for investors
were for all practical purposes non-existent.
The ownership generation exiting the firm in many cases apparently had sufficient
personal liquidity not to require external financing. For others, the transition was financed
from the firm’s operating cash flows, but that can only come at the expense of limiting the
firm’s growth opportunities. Moreover, for those that did seek out third party financing,
the primary source of financing was the traditional banker. For many, there is no other
option; but possibly some owners assign a high priority to maintaining control, at the
expense of future growth.
Mezzanine Financing
Mezzanine loans are similar to convertible bonds, although there need not be a
public market for the stock at the time of the financing. The lender makes an intermediate
term loan (five to eight years) and receives warrants to purchase common stock. In the
case of a company with attractive growth potential that has not yet established a steady cash
flow, the lender may extend an additional line of credit upon which the borrower can draw
to make interest payments. In such a case, the mezzanine loan is like a zero-coupon
convertible bond. A mezzanine loan is also very much equity, even though it is called debt
(hence the term “dequity” has been coined to describe it).18
A mezzanine loan can provide a substantial infusion of capital to finance growth on
terms very similar to equity financing, without incurring the costs associated with going
Page 16
public. Indeed, it has been demonstrated that selling common stock with a money-back
guarantee is exactly equivalent to issuing debt with warrants attached.19
Going Public
To appeal to the public markets the firm must have a compelling business story.
Furthermore, to be a good IPO candidate a firm must possess potential for great success,
that requires funding from the public capital market. Perhaps the greatest misconception
held by entrepreneurs is that the IPO is the end of the line. They often take the view that by
taking their firm public through an IPO they have “made it”. The fact is that going public is
but one transition in the life of a firm, and it isn’t right for every firm.
One of the
entrepreneurs we interviewed said, “Maybe the biggest surprise is that the public offering is
a beginning, not an end. Use the best experts you can, at an early stage. Don't try to do it
alone, because it's a demanding process that can distract you from your business.”
Why Go Public?
Taking the company’s stock public provides immediate capital, plus facilitating
future capital accession. A recent study polled CEOs of firms that had gone public to query
the importance of seventeen possible motivations for the public offering.20 These CEOs
clearly consider financing future growth as the primary impetus for going public. The
factors receiving the highest percentage of “very important” responses are as follows:
18
The term “dequity” is attributed to Williamson (1988).
See Chen and Kensinger (1988).
20
See Holmburg (1992).
19
Page 17
Reasons for Going Public
Factor
Raise capital for growth:
Raise capital to increase working capital:
Facilitate acquiring another firm:
Enhance the firm’s ability to raise capital:
Establish a market value for the firm:
Response of
Very Important
85%
65%
40%
35%
35%
While the process of going public may be frustrating, the eventual outcome
generally is positive. In a survey of firms listed on the French Second Marche (Secondary
Market), most CEOs expressed great satisfaction with their decision to go public.21 The
owners thought the external image of the firm was improved in the eyes of the suppliers,
customers and others after the offering, along with an increased effectiveness in the level of
communications, strategy and other internal management-related factors. They disliked,
however, the fluctuations in the firm’s share price, which they did not believe reflected firm
performance. Despite evidence to the contrary, many perceive that the capital market is
myopic, management is pressed for short-term performance, and so can not look to the
shareholder’s long-term best interests.22 In our own interviews, we also heard strong
endorsement of the enhanced standing conveyed by the fact that the stock is publicly
traded. One entrepreneur said that going public was his intention from the very beginning
of the company, and that the status of being a public corporation in the United States
greatly facilitates his company’s interactions with Asian suppliers (and these suppliers
closely follow the stock price as an indicator of the company’s success).
Pitfalls of Going Public
The IPO process can be one of the most exhilarating, but frustrating and exhausting
experiences an entrepreneur will encounter. Entrepreneurs frequently discover that they do
21
22
See Desroches and Belletante (1992).
See Jones, Cohen, and Coppola (1992).
Page 18
not like being exposed to the vicissitudes of public capital markets and to the prying
questions of public market investors.23 We learned that going public takes much time and
energy from the firm’s management team and can be very distracting, frequently resulted in
a loss of managerial focus and leading to slumping performance. Furthermore,
uncertainties accompanying the impending sale of the company often lead to lowered
employee morale. Many entrepreneurs underestimate the time and energy involved in
selling their company. This stress leaks down throughout the organization, as employees
become anxious about the prospect of a new owner.
One of the entrepreneurs we
interviewed told us that he and his team “took our eyes off the ball” and let earnings drop,
resulting in their first attempt to go public being aborted. They waited another year before
their subsequent successful attempt, and counted themselves very lucky to have had a
second chance.
Besides the cost in time, stress, and underwriting fees, the underpricing of IPOs is
a long-recognized concern in the finance literature (on average, the price of the stock rises
rapidly after the initial sale, stabilizing at a level that averages 15% above the price received
by the issuing firm—this on top of underwriter spreads and fees).24
In a survey of the Inc. 100, the CEOs who had participated in public offerings
indicated they spent thirty-three hours per week on the offering for twenty weeks; many
consider the cost of the IPO process to be excessive and exorbitant. Several found
themselves not being understood and having little influence in the decisions being made.
Several expressed disillusionment with investment bankers, and the entire process.
At
some point, the owners wondered where they had lost control of the process.25 Our own
interviews with entrepreneurs include a mixture of sentiment, with several expressing
admiration for the investment bankers’ professionalism; yet others relating the impression
23
24
See Sutton and Beneddetto (1990).
See, for example, Brealey, Myers, and Marcus (1999): pp. 373-375.
Page 19
that investment bankers are too “deal oriented”—overly focused on getting the deal done,
regardless of what that entailed.
These concerns may reflect the shift in power that occurs during the IPO process.
When it begins, the entrepreneur is in control. After the prospectus has been prepared and
the road show is underway; however, the entrepreneur is no longer the primary decisionmaker.
The investment banker is now in control—on turf that is foreign to many
entrepreneurs. Finally, the financial marketplace takes over, and ultimately it is the market
that dictates the final outcome.
In addition to the issue of who controls the events and decisions in the IPO process,
one other matter is important—understanding the investment banker’s motivations in the
IPO process. Stated differently, who is the investor banker’s primary customer? Clearly,
the issuing firm is rewarding the underwriter for the services being performed through the
fees paid and a participation in the deal. But, the investment bank also working for its
customers on the other side of the trade—who it will deal with in many subsequent
issues.26
The High Cost of Going Public
The empirical evidence on the pricing of IPOs is puzzling for those who otherwise
believe in efficient capital markets (see Exhibit 4 for a summary of the major findings).
Anomalies are interrelated in the following sense: periods of excessive investor optimism
appear to create “windows of opportunity” during which many firms rush to market
(lending some credence to the impression expressed by several entrepreneurs in our
interviews that timing and luck are important elements of successfully going public).
Yet another cost of going public arises from the underwriter’s need to meet the “due
diligence” rules established by the Securities Act of 1933.
25
26
These rules mean that the
See Brokaw (1993).
See Sahlman (1988).
Page 20
underwriter must not only incur the cost of becoming informed about the fledgling
company, but also face the threat of a lawsuit from disgruntled stockholders if the fledgling
fails. The underwriter, then, is offering a kind of “soft” money-back guarantee.
Another explanation for the high cost of going public is the expense investors must
incur to become well informed about the fledgling company. They will pay the price of
becoming informed only in anticipation of a sufficiently large expected profit. The problem
can arise with any form of external financing, and its essence can be explained fairly
simply. Managers often possess valuable information about the business that cannot be
unambiguously communicated to the capital market.27
Several studies, identify informational asymmetry as a significant contributing
factor for the high cost of going public.28 ) In initial public offerings, informed investors
will submit more purchase orders for underpriced offers than for overpriced offers, with
the result that uninformed investors (who wind up with the residual) will receive a
relatively larger portion of shares in overpriced offers and a relatively smaller portion of
shares in underpriced offers. Over several offers, therefore, the uninformed investors can
expect to receive more than their fair share of dogs and less than their fair share of good
deals.
To fully subscribe an issue when a large proportion of investors consider
themselves to be uninformed therefore requires a greater degree of underpricing than would
be the case if ignorance were less widespread.
Reducing the Cost of Going Public
Innovators have experimented with arrangements that reduce the downside risk
normally associated with equity investments by providing a “money-back guarantee.” In
27
Leland and Pyle (1977) first described informational asymmetry cost. One potential barrier to
communication is the need to keep competitors in the dark in order to maintain the competitive advantage
that makes the firm potentially profitable. Whenever such an informational asymmetry exists, managers
face a problem. If new claims against the firm are sold in the capital market, they will be undervalued due
to the lack of complete information. That is, their market value will be less than their fair value.
28
See Ritter (1987), Rock (1986), and Beatty and Ritter (1986).
Page 21
this arrangement, the newly issued shares can be “put” back to the issuer.29 The new
investors buy “units” composed of a share of common stock and a “right” provided by the
issuing corporation. The right entitles the unit-holder to claim more stock if the market
price of the stock falls below a stated level. For instance, at a predetermined time, say at
the end of two years, the issuer guarantees to support a floor value for each unit-holder’s
position. In the event that the market value of the stock has risen above the stated floor
value, nothing happens. If the market value has fallen below the floor, however, the issuer
is obligated to make up the difference by giving unit holders additional common shares.30
Exhibit 6 provides a summary of how a money-back guarantee was used to facilitate equity
financing needed by a family business in order to fund raw materials and working capital
for a major new contract.
A potential difficulty arises when the new issue of puttable stock is not backed by a
strong, well-known entity. One solution is to arrange for a major bank to back the
guarantee by issuing an irrevocable letter of credit (for a fee, of course). Such an approach
takes advantage of the bank’s economies of scale in information processing, which can
reduce the cost of becoming informed.
Concluding Remarks
In order to achieve its full potential, a company should be able to continue through
its business lifecycle, whether or not that matches the human lifecycle of its founder. In
today’s financial arena there are a variety of ways in which a private business can harvest
liquidity to meet its own needs for growth, the consumption requirements of its founder, or
the challenges of tax and estate planning. So long as leadership succession can be arranged,
the business’ lifecycle can determine the course of the company.
29
For a discussion of the origins and use of puttable common stock, see Chen and Kensinger (1988).
For example, if the market value were $10 per share of common stock upon maturity and the guaranteed
floor were $15, the rights would entitle their holders to claim 50 new shares of common stock for every
100 rights they held.
30
Page 22
Exhibits
Exhibit 1: Available Methods of Harvest:
Orderly Liquidation:
Generating cash becomes the primary goal of the business:
• Sell assets; replace via lease arrangements if necessary
• Spin off project financing arrangements
• Withdraw free cash flows gradually
Debt Issue
Bond the business’ cash flows
• Borrow against future cash flows from the business
• Use Mezzanine financing (debt with warrants included)
Private sale:
Sell for cash, debt, or equity to:
• Another company or group of investors
• Management, frequently through a leveraged management
buyout
• Employees, usually in the form of an Employee Stock
Option Plan
• Family members (such as an inter-generational transfer
from the owner to his or her children)
Acquisition: Be acquired by or merged into another, usually larger, company
• Strategic acquisition, involving perceived synergies and
premium price
• Non-strategic acquisition, price based upon value of assets
or expected cash flows
IPO: Take the company public through a public stock offering
Page 23
Exhibit 2: Entrepreneurs’ Assessments of the Harvest Experience
•
•
•
•
•
•
•
To gain some insight into this process, Petty, Bygrave, and Shulman (1994)
collected a sample of acquisition transactions of privately-held companies reported in
Mergerstat Review between 1984 and 1990.31 The sample was limited to acquisitions
valued between $5 million and $100 million. Also, 278 venture-backed companies that
were acquired between the years of 1987 and 1990 were identified through the Venture
Economics database. This database includes the names of venture capitalists who
participated in the financing of the ventures. For all firms background information about
the buyer, seller, and the acquisition was collected from the Dow Jones News Retrieval
Service.
The issues addressed in the study fell into one of three areas: (1) the decision to
sell, (2) the selling process, and (3) the post sale. Using these issues as guidelines, phone
interviews were conducted for a limited sample of entrepreneurs. Some of the conclusions
reached from the interviews were as follows:
For some of the entrepreneurs, there was significant disappointment with the acquisition
process and the final outcome. They came to realize that the firm served as the base for
much of what they did, both in and out of the business arena. This sentiment existed more
with owners of the low-tech firms, especially service firms, than with the high-tech
companies.
The most prevalent reason for selling the company related to estate planning and the
opportunity to diversify the owner’s investments. A second reason for the sale related to
the need to finance future growth.
The harvest did provide the long-sought-after liquidity, but some entrepreneurs found
managing money more difficult, and less enjoyable, than they had expected, and less
rewarding than operating their own company.
The disillusionment of selling the firm was particularly evident when the entrepreneur
continued in the management of the company, but under the supervision of the acquiring
owners. The differences in corporate culture became a significant problem for both
companies involved in the transaction, but more so for the selling entrepreneur.
A number of the selling owners were disappointed in the advice they received from
“experts.” After the fact, they wished they had talked to other entrepreneurs who had
experienced the sale of a company.
Most entrepreneurs relied on their staff and advisors to determine a fair price for their
company. Thus, they would talk in terms of cash flows and earnings, most often the
capitalization or multiple of the earnings or cash flows, and seldom the present value of
future cash flows. However, most of the entrepreneurs felt they had a sense of what they
would accept for the firm, and that instinct had a greater influence than did the supporting
computations. Most often, price was not a serious issue.
There is considerable down-side risk if the acquisition is not consummated. During the
negotiations, management’s focus shifts from company operations to consummating the
sale. Members of the existing management team may be promised promotions after the
acquisition, which do not occur should the negotiations fail. Hence, there is a real risk of
loosing part of the management team and certainly taking several months to regain the
firm’s focus.
31
See Petty, Bygrave, and Shulman (1994).
Page 24
Exhibit 3: Harvesting Via The Leveraged ESOP
1. Employer company
guarantees payment of
loan.
Firm
Lender
2. ESOP
borrows
money
from
lender.
5. Firm
makes annual
contribution
for employee
stock purchase
6. ESOP
makes
payment
on loan.
ESOP
4. Stock sent to ESOP
for benefit of employees.
3. Cash from loan used
to buy owner's stock.
Current
Owner
Adapted from Daniel R. Garner, Robert R. Owen, and Robert P. Conway, The Ernst &
Young Guide to Raising Capital, New York: John Wiley & Sons, 1991, p. 282. The
Initial Public Offering (IPO)
Page 25
Exhibit 4: Understanding the IPO Market
When contemplating a public offering, the entrepreneur needs to understand the basic
nature of the new-issues market. There is a large volume of research whose principal findings are
summarized below:
• New issues on average are significantly underpriced at the offering. The first-day rate of return
for investors purchasing a new issue averages 10 to 15 percent.32 These results are even more
pronounced for smaller companies (underpricing for IPOs totaling 10 million or less averages
30%). Price per share also matters—the average initial stock price run up for IPOs with an
offering price of less than $3.00 per share is 42.8 percent, whereas the average initial return on
IPOs with an offering price of $3.00 or more averages 8.6 percent.33 Moreover, underpricing
persists in every country with a stock market, although the amount of underpricing differs
among countries.34
• There are periods of higher average initial returns known as “hot issue” markets.35 There are
cycles in both volume of new issues and magnitude of first-day returns.36 The cycles in
underpricing make next month’s average initial return predictable based upon the current
month’s average with reasonable accuracy.37 Likewise, a high-volume month is more likely to
be followed by another high-volume month.38
• New issues tend to underperform for up to five years after the offering.39 . For IPOs during
the period 1975 to 1984, the total return from the end of the first day of trading to three years
later was 34.5 percent, compared to the return on the NYSE of 61.9 percent .40 Yet, firms that
issue during low-volume periods typically experience neither high initial price run-ups nor
subsequent long-run underperformance.41 Again these findings were more pronounced for
younger firms.42 Also, the earnings per share of companies going public typically grow
rapidly in the years before going public, but then decline after the IPO.43
32
See Ibbotson (1975).
See Chalk and Peavy (1987).
34
See Loughran, Ritter, and Rydqvist, (1994).
35
Hot issue markets were first identified by Ibbotson and Jaffe (1975).
36
See Ibbotson, Sindelar, and Ritter (1994).
37
The first-order autocorrelation of monthly average initial returns is 0.66.
38
The autocorrelation here is 0.89.
39
See Loughran (1993).
40
See Ritter (1991).
41
See Ibbotson, Sindelar, and Ritter (1994).
42
See Hanley and Ritter (1993).
43
See Jain and Kini (1994).
33
Page 26
Exhibit 5: The chronology of a public offering
Steps in the process:
•
The management decides to go public.
•
An investment banker is selected to serve as the underwriter, who in turn
brings together a group of investment houses called a syndicate to help sell
the shares.
•
A prospectus is prepared.
•
The managers, along with the investment banker, go on the road to tell the
firm's story to the brokers who will be selling the stock.
•
On the day before the offering is released to the public, the decision is made
as to the actual offering price.
•
All the work, which by now has taken months, comes to fruition in a single
event—offering the stock to the public and seeing how it is received.
During this process, the firm's owners and managers will be answering such questions as:
•
What do we need to do in advance of going public?
•
What are the legal requirements?
•
Who should be responsible for the different activities and how should we
structure our "team" to make it all happen?
•
How do we choose an investment banker?
•
How do we determine an appropriate price for the offering?
•
How is life different after we are a public company?
Page 27
Exhibit 6: The Arly Merchandise Company Example of Puttable Stock
The simple expedient of equity with a money-back guarantee was pioneered in 1984
by Arley Merchandise Company, a small New England maker of custom draperies and
upholstery. Having just won a large contract to supply a major hotel chain, it needed to
boost its equity capital and sought to accomplish an initial placement of $6 million worth of
stock. Because the company was still an unknown, however, Arley’s owners could not
persuade an investment banker to underwrite the stock at a price that was acceptable to
them. They wanted at least $8 per share, but the investment banker believed $6 was as
high as the public market would go.
A solution was found by offering the new equity in “units” consisting of a share of
stock plus a money-back guarantee (or put option) that would allow the investor to sell the
stock back to the company on the second anniversary of the initial offering, for the original
price. Each unit consisted of a share of common stock with a “right” providing the option
to sell the stock back to the company for cash or notes. The Arley units were offered at $8
each, with accompanying rights for investors to “put” their stock back to the company for
$8 per share two years later. Cash settlements were promised to small shareholders, but
holders of large blocks could be paid off in senior subordinated notes paying 128 percent
of the 10-year Treasury bond rate.
The units were offered in November 1984, and the stock began trading on the
American Stock Exchange, as puts, in December. Thereupon, just as the investment
bankers had predicted, the price quickly stabilized at $6 per share. The Boston Stock
Exchange, meanwhile, made a market in the separated puts and the whole units.
Through their willingness to lay themselves on the line in order to protect the initial
buyers of the stock, Arley’s original owners translated their confidence in the company’s
prospects into a higher stock price, overcoming the underpricing problem for their IPO.
Their story ended happily, too, for the stock was trading at $10 by the time the second
anniversary arrived; so no one asked for their money back.
Page 28
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Page 31