Structuring Internal Buyouts
Buyout transactions are structured in many ways to maximize a buyer's return and a seller's proceeds. Central to the successful buyout is balance. Balance, so the post-buyout company prospers for the investors and sellers, as well as other stakeholders including employees, suppliers and customers.
One hundred percent ESOP buyouts no different, yet they are unique since equity is not typically part of the financing package. 'Equity' in these deals is comprised of 1) the elimination of federal and state income taxes that this structure creates, and 2) seller financing.
A trend has developed in structuring these ESOP seller notes where the total return is divided between current and deferred payments. The current return is paid in cash and the deferred return is paid out using warrants issued by the company. Structuring the ESOP seller notes starts with determining the fair market return and then splitting up the return to suit the note holder's needs. If the note holder needs cash flow, the cash interest is increased and the warrant part decreased. If the note holder doesn't have an immediate cash need, they reduce the cash interest income and increase the deferred payout by taking more warrants.
Splitting the total return this way is good for the company and the note holder. The company's cash interest expense is reduced by that portion attributed to the warrants and therefore reduces the annual interest expense. The warrant's actual return is driven by company performance relative to projections and therefore moves in synch with actual results.
An ESOP buyout using this structure has other constraints that impact the structuring of the notes. Since the warrant will be cashed out in the future point - optimally, as soon as less expensive debt can replace it - the ESOP company typically borrows to settle this IOU. The ESOP trustee will consider the expected 'cash out' cost of the warrant in relation to the total company value as 'dilution' and make certain it is reasonable, from a financial point of view. The traditional return measures such as an IRR, do not adequately account for this and need to be used in conjunction with other financial metrics.
The mathematics of pricing warrants by looking solely at an IRR usually works fine for companies growing rapidly, as the overall dilution from the warrant settlement becomes a smaller as the company value grows. Caution must be used, however, for companies growing more slowly, since a reasonable IRR for a fast growing company applied to a company growing more slowly may create excessive dilution. In the extreme case, even a reasonable IRR can leave the ESOP-owned company with less of the economic value of the business than it might have otherwise owned in a lower priced, more traditionally financed transaction.
Pilot Hill Advisors structures internal buyouts using ESOPs and MBOs. Do call if you'd like to discuss how we assist our clients with such transactions.
AUTHOR: Robert E. Massengill
POSTED IN: Finance