RESOURCES
Employee Buyout Tour
   |
|
September 24, 1999 by Malon Wilkus December 16, 1990 - Revised September 24, 1999
A. Introduction
Employee buyouts have been successful at many hundreds of small and large companies over the past twenty five years. Such transactions represent a meaningful percentage of all leveraged buyouts that have occurred over that time. Increasingly employees have come to expect participation in the ownership of the companies in which they work. Often employees become owners in the context of a corporate transaction. These transactions compete with the more common leveraged buyout sponsored by a firm specializing in such transactions. Employee buyouts have many advantages over these standard leveraged buyouts. This article describes many aspects of an employee buyout and compares such transactions with standard leveraged buyouts and strategic acquisitions. B. The Rise of Employee Buyouts Every year hundreds of subsidiaries, divisions, product lines, and entire corporations are sold. These sales are typically arranged through privately negotiated transactions or private auctions conducted by investment banks. The entities being sold range from healthy to distressed. Buyers are typically companies in the same line of business, companies with complementary product lines, or leveraged buyout firms. Selling a company to all its employees through an employee stock ownership plan (ESOP) transaction has been a growing trend. The National Center for Employee Ownership (NCEO) estimates that from 1985 through 1993, over 750 companies were established through selling a company or through corporate divestitures to newly created companies that are at least 25% ESOP-owned. A few examples of these transactions follow:
Employee buyouts have become an attractive alternative to the standard leveraged buyout for several reasons. First, there are the hard-to-measure but very real motivational effects of ownership. For the same reasons that managers who become owners in a management buyout are motivated to improve their performance, the workers as a whole are motivated to strive for the success and growth of an enterprise when they are equitably included in a transaction and their ownership shares are accompanied by participation and communication. Second, ESOP transactions offer significant financial benefits unavailable under any other ownership structure. The substantial tax benefits of ESOP transactions, which are discussed more fully below, make an ESOP a strong bidder in a buyout by increasing cash flow available for debt service. Finally, where employee concessions are needed for survival, such as at Northwest Airlines and particularly in unionized settings, employee ownership may be the only effective way of giving workers something of value in return for their sacrifices. Without sharing the "upside," employees may not be willing to make the sacrifices necessary for success. This article describes how employee buyouts of corporations, subsidiaries, divisions, and product lines are typically structured. It demonstrates why employees may be the most viable buyers and why the resulting ESOP company may be the healthiest company relative to alternative transaction structures. It also demonstrates the impact an ESOP can have on the value of a company, and thus on the return, after dilution, to equity investors in employee buyouts. The author hopes that more employee buyouts will be implemented as investors, owners, managers, unions, and employees learn that ESOPs can be competitive bidders and that multi-investor employee buyouts can provide a market rate of return to all investors. Sellers have learned that they can often maximize their return if they sell to management in a leveraged buyout transaction. Management has learned that through leveraged buyouts they too can share in the ownership of their company. It is time for sellers to learn that the advantages of selling to management are compounded when they sell to all employees. And it is time for employees and unions alike to realize that the opportunity for ownership comes around only rarely, and that when it does, management alone should not reach for the brass ring; instead, every shop worker, clerk, engineer, secretary, supervisor, and manager should reach out and take a stake in his or her company. Only if this becomes the norm will we broaden the ownership of wealth in this country and maintain a vigorous and dynamic free-market economy. C. Leveraged Buyouts of Corporate Divestitures Why are buyouts of corporations, subsidiaries, and divisions common today? There have always been many corporate transactions as companies have been bought and sold and have divested operating units for strategic reasons. The number of these corporate transactions skyrocketed in the 1980s, declined in the early 1990s, and has now risen again. There are many reasons for the large number of these transactions:
Each of these trends has contributed to the growth in leveraged buyouts of public and private corporations and their subsidiaries, divisions, or product lines. Many transactions, of course, are still completed by strategic buyers or by senior management teamed up with leveraged buyout firms with their own equity to invest. However, an increasing number of buyouts involve all the employees through the use of ESOPs. To fully understand the value that an ESOP can bring to a leveraged buyout, one must first understand how a typical management buyout is structured. D. Standard Leveraged Buyouts During the 1980s, it became more common for members of management, assisted by an investment group, to purchase their company, subsidiary, division, or product line. These transactions are commonly known as "leveraged buyouts" (LBOs) because the buyout group finances the transaction with funds borrowed against the assets and projected cash flows of the entity being acquired. These transactions usually rely heavily on senior debt and subordinated debt. The subordinated debt is provided by insurance companies, pension funds, subordinated debt funds, other institutional investors and often the seller of the company. Equity is provided by management and an investor group that specializes in leveraged buyouts. Leveraged buyouts are financed chiefly with borrowed capital, not only because such funds are readily available, but also because equity reaps higher returns (subject to greater risk) when transactions are financed predominately with debt. Senior lenders are not prepared to lend 100% against the collateral value of assets. Subordinated lenders, however, are prepared to take second liens on assets and be paid from the cash flows of the company left over after servicing senior debt in exchange for a premium rate of return. Subordinated debt allows a company to be more highly leveraged and reduces the need for equity, thereby replacing equity with less costly debt. Debt is less costly than equity financing for two reasons. First, equity is at greater risk. It is subordinated to debt, trade creditors, and others as to rights to cash flow, including cash flow generated in liquidation. Equity investors can therefore expect substantially higher returns on their investment than do lenders. Second, interest on debt is a deductible expense whereas dividends on equity are paid with after-tax dollars. Consequently it is more costly for a corporation to provide a certain return to equity than it is to provide the same level of return to debt. How do these varying costs of capital impact the seller? A seller can frequently receive the highest price from a buyer who relies heavily on debt financing. Today, a corporate as well as an LBO buyer typically values a company based on the cash flowing to a capital structure composed predominately of debt. This kind of capital structure maximizes the potential return to equity, although it reduces the flexibility and increases the operating risks of the company. The now-popular belief that companies are more competitive and profitable as independent units rather than as parts of conglomerates precipitated a wave of corporate divestitures in the 1980s. The 1960s and 1970s were periods of conglomeration, which by many accounts was a failed experiment. The 1980s was a time of "breaking up," "spinning off," and divesting corporate assets. The result is the de-conglomeration of corporate America. A standard leveraged buyout usually makes the new company an independent entity. This is frequently viewed as the most advantageous way to operate the company. Corporations are still the most frequent buyers of other corporations, however. A corporate bidder with easy access to credit may have a powerful advantage over a standard leveraged buyout. To enhance the value of the entire corporation and therefore the value of the company being purchased, a prospective corporate buyer may want to integrate the new company into the rest of its operations. A corporation that believes it can attain economies of scale, greater market share, expanded product lines, additional operating capacity, or any other enhancements to its existing business because of the acquisition may bid far above the levels associated with the potential cash flows and earnings of the new company on a stand-alone basis. If the corporation has sufficient access to capital and believes it can achieve important synergies between its current business and that of the new company, then it will normally be able to outbid a standard leveraged buyout. When competing for the purchase of a company, a standard leveraged buyout where an LBO firm has teamed up with existing senior management has a number of advantages over other bidders, including corporate bidders. At times, these advantages give management the edge in the bidding process. The existing management of the company usually understands the company better than any other prospective bidder. Management may know of hidden values in the company that will be hard for others to discover or realize. Management also requires less time to evaluate the company and generally knows in advance that the company will soon be for sale. Management often has well-thought-out plans for operating the company independently, including strategies to spur growth or reduce costs. An independent company requires less corporate reporting and can eliminate overhead costs associated with its parent. Management usually has close, personal ties with the company’s financing sources. And a management-supported bid is often viewed sympathetically by the board of directors, which must ultimately decide to whom to sell. E. Employee Buyouts An employee buyout is virtually identical in structure to an LBO, except that the ESOP becomes an additional investor that shares in the equity of the new company. An employee buyout generally is led by or has the support of senior management, and so all the advantages described above for standard leveraged buyouts apply for employee buyouts. Compared to the standard LBO, an employee buyout produces improvements in operations, reduces tax payments, and lowers the cost of capital. These advantages give the employees a better chance to win a bid, and, if they win, will result in a healthier company. As explained below, an employee buyout can be initiated by the owner, by management, by a union or unions, or by a third part. A corporation’s owners or board of directors may realize that selling the company or divesting a division may be most effectively accomplished through an employee buyout. The board of directors may assist an employee buyout effort in either a privately negotiated sale or a private auction of the company.
Private Sale
The board’s control of a private sale is, however, limited by its financing sources; by the requirement that an independent, qualified valuation firm be engaged by the ESOP trustee to pass on the fairness of the transaction to the ESOP; and by the requirement that the ESOP pay no more than fair market value and that the transaction be prudent from a financial point of view. To maintain its independence the valuation firm’s fee, though usually paid by the seller, cannot be contingent on the completion of the transaction.
Private Auction Management-Initiated A management-initiated employee buyout is typically initiated by senior management and can be supported by the board and owners of the corporation, even to the extent of providing corporate funds to conduct such an effort. Management can be a powerful bidder because it has all the advantages of an inside management group along with the attributes of ESOP financing. If management also includes union and non-union employees in structuring the transaction and gains employee sacrifices in exchange for ownership, it will be significantly more competitive in bidding for the company and, if successful, will produce in a healthier stand-alone enterprise. Union-Initiated Non-management employees can initiate an employee buyout. Typically, one or more unions representing the employees do this. The company can support such a buyout effort with corporate funds. The employees must team up with qualified management in implementing the buyout and then operating the company. Union-initiated employee buyout efforts often invite existing management to join the union in buying the company. A union can also seek other, more qualified, management with which to participate, or it can selectively invite members of the existing management to its side. Third Party Initiated Any prospective bidder for a company can integrate an ESOP into the overall ownership structure of the transaction. Such an effort can reap the various tax and other advantages associated with ESOP financing and therefore enhance its competitiveness. However, without the involvement and support of the overall workforce and without sharing all the rights of ownership, particularly voting rights, it is unlikely that employee sacrifices can be attained in exchange for ownership. F. Union Considerations It would be nice for sellers if employees were always motivated to trade off concessions for ownership. However, workers usually have little discretionary income and even less desire to see it taken away. Workers generally wish to protect their current income rather than gamble on their company’s future. When a company undergoes a standard leveraged buyout, no one is more at risk than the employees. The cash investment from an investor typically accounts for 10% to 20% of the total financing requirements of a standard leveraged buyout. Normally, such an investment represents only a fraction of the investor’s portfolio. If the company fails, the investors experience losses, not a catastrophe. Management personnel typically invest a portion of their net worth in LBOs in return for a sizable equity stake and the continuation of their relatively high salaries. If the company fails, management personnel fall back on their accumulated resources and take their college degrees elsewhere. In the standard LBO, the average employee invests nothing and receives nothing, but assumes enormous risks. For such employees, not only their ability to own their homes and provide their children with a good education but also their very livelihoods depend on their company’s success or failure. Stable income and accruing pension benefits form the bulk of their financial resources. If their company is leveraged, these resources are put at great risk. (However, there may be greater risk for employees if the company fails to undergo a buyout.) If the company falters, the employees are asked to sacrifice. If the company fails, the employees enter the job market with limited or non-transferable skills and meager resources to relocate and retrain. In return for their risks, the employees normally receive no stake in the success of the company. Security of wages and benefits should be the foremost consideration of unions. Therefore, if a corporate buyer comes along with deep pockets, the employees, whether organized or not, generally opt for the role of wage earner and pass on the opportunity and risks of being owners. To out-bid such corporate buyers is tough and requires substantial concessions. However, if a corporate buyer is a union buster or is someone who probably will move the facilities to Timbuktu, the employees will normally consider long and hard their willingness to take concessions rather than risk losing their jobs. If the employees on average are near retirement and if their retirement benefits are substantial, they may view any efforts to gain ownership as a waste of time. Where a distressed company is for sale and employees are entitled to substantial severance or shutdown payments, they may consider it more lucrative to take such payments instead of supporting an employee buyout. In such cases, the union’s interest may be aligned more with job preservation through employee ownership than with the interests of existing employees. If the alternative to an employee buyout is an LBO by a "financial buyer," then the employees should be concerned about the likelihood of workforce, wage, and benefit reductions being imposed on them so the corporation can survive its tremendous LBO-imposed debt load. If workers are operating under a collective bargaining agreement, they should expect demands for givebacks in the next round of negotiations. They may also fear that their highly leveraged company will be prone to failure in any future recession, or will fail simply due to lack of resources to invest adequately in capital equipment, research and development, and marketing. All of these fears are well founded. If the likely buyer is a financial buyer who intends to use leveraged buyout techniques, the employees may as well buy the company themselves using an ESOP. If the company can be purchased on the same terms as a competing LBO, an employee buyout’s tax and other advantages will enhance the company’s viability. In this way, if the company is successful due to the workers’ sacrifices or any other reason, the employees will automatically reap the benefits of success through owning the company. It is in the union’s interest to consider each bid before aligning itself with one particular bidder. Once aligned, however, it is not in the union’s interest to align itself with any other bidder. If the union did so, it would be bidding against itself. The union’s objective, if its members buy a company, is to pay the lowest possible price. A union supporting an employee buyout with concessions will generally demand pass-through voting and representation on the board of directors for its membership. Typically, one third of the directors of such a board represent the salaried employees, one third represent the bargaining unit, and one third are composed of independent directors or directors representing cash equity investors. In all of these cases, employees are faced with very personal and significant financial considerations and, like other buyers, will usually make their decision based on their assessment of the financial cost and benefits to them and their families. Employees virtually never invest their cash savings or pension assets in an employee buyout. Their "sweat equity investment" usually comes in the form of lower wages, salaries and benefits over a three to five year period. G. Leveraged Buyout Financing Structure Virtually all LBOs are financed with a combination of senior debt, subordinated debt, and equity. The amount of equity required in a transaction is determined in part by the amount of debt that can be borrowed. The following describes the various components of financing in a typical leveraged buyout. 1. Senior Debt
A. Revolving Line of Credit
B. Term Debt
These funds are loaned based on the amount and predictability of cash flow exceeding that required to service senior debt. Interest costs can be anywhere from two to eight percentage points more than senior debt. Because subordinated debt usually has little collateral protection, it may be granted an "equity kicker" with the intention of providing the lender with a 18% to 25% compound annual total return over five years resulting from both the interest charges and equity kicker. (Figure 3)
Those who invest in the equity of a company typically reap seven rights of ownership:
However, dividend and liquidation rights of equity investors are typically subordinated in an LBO to the interests of the secured lenders of the company. Liquidation rights are further subordinated to the unsecured creditors of the company. Management usually invests in the equity of an LBO company together with a leveraged buyout fund, a corporate investor, or a group composed of institutional equity investors. The seller and subordinated lenders sometimes receive equity in the new company. An institutional investor investing in the equity of an LBO typically seeks a 30% to 40% compounded annual total return over five years, depending on the perceived risk. Note that these returns are only projections; the investor has no contractual rights to such returns like a lender has concerning interest charges. In an employee buyout a similar proportion of equity capital in cash may be needed in the transaction. Such equity may come from management, from outside sources such as an LBO fund (ACS is a source for such capital) or other institutional investors, or from elections by employees to invest cash assets or to roll over a portion of their 401(k) or other pension fund assets into the new company’s ESOP (such direct investments by non-management employees is quite rare). Regardless of the source of the cash equity investment, cash equity investors must share ownership with the ESOP and the various rights of ownership must be carved up among all the equity investors. The dilution experienced by the non-ESOP equity investors is offset by the improved cash flows associated with ESOP financing and a favorable distribution of the various rights of ownership. If the seller is prepared to take a subordinated note as part of the payment of the purchase price, or if local, state, or federal financing is available, an employee buyout can occur with little or no cash equity investments. Or, if the collateral value of the assets exceeds the purchase price, an employee buyout may be achieved without a cash equity investor. This is rare, however, and typically occurs in distress situations where the seller has no alternative buyers yet has substantial shutdown liabilities, and the workers are prepared to enhance the company’s cash flow by trading concessions for ownership (sweat equity). H. Structure of a Typical LBO The financing for an Employee Buyout is very similar to a LBO. The advantages for an Employee Buyout come from various improvements that can be achieved in the company's cash flows. These improved cash flows can be used to afford the highest price for the company or, more ideally, can be retained by the buyer to imporve the company's equity. The outline below models a typical LBO; the next section details how an ESOP can enhance the transaction. A Typical LBO
|
