Don’t let the concept of treasury stock cloud your transition strategy.
I always enjoy working alongside our clients as we go through the ownership transition planning process. Our clients are high performing professionals who have achieved great success and want to pass that success on to the next generation. Each project and ownership team are different in many regards, yet often times we are asked: What is normal? The truth is there is some level of normalcy in the calculation of value, terms of agreements between parties, and the overall structure of what needs to be done. But in the minutia of developing plans, there are lots of conditions and situations that can complicate the discussion. One of the main pain points for firms contemplating an internal transition is making it affordable for the next generation. This can lead to a lack of willing buyers and stunt the overall transition program.
In a scenario where there are no buyers and an outgoing shareholder has to sell stock or liquidate for a number of reasons (including death, disability, etc.), this transfer can be accomplished through a redemption by the firm. In a redemption, the firm acts as the buyer of the equity. This is a common attribute of many buy-sell agreements. In fact, there are really three ways in which this can be written in a buy-sell agreement. There can be a strict redemption by the firm, where the firm is the only avenue for transfers of equity, there can be a cross purchase agreement between the shareholders, and then there are hybrid agreements that provide a mix of the above options. In any instance there should be a clear order of operations indicating who and how they can purchase the outstanding equity being offered up for sale. One caveat here is that a life insurance policy should be put in place to mitigate the business risks associated with an owner passing away. In a recent study, Zweig Group found that 37 percent of owners in AEC firms do not have a life insurance policy securing their equity.
When developing a transition plan, you have to determine if you are planning to elevate high performing staff into an ownership role or spread the available stock across existing owners. If you are starting from scratch with all new owners, you probably have more work to do! Either way, if you can’t find willing buyers and have to look at the redemption of equity, this results in something called treasury stock in a corporation. A redemption in a corporation and an LLC or partnership looks a bit different and can have different tax implications based on the situation. But the concept is the same and impacts the balance sheet with a reduction in overall owner equity or book value. It also creates reverse dilution and increases the pro-rata percentage of ownership for existing owners. This is an important component to consider for transition planning, especially in a small, privately held AEC firm.
On Wall Street, stock buybacks are usually met with open arms and signal a positive forward-looking trajectory. It rewards shareholders and gives the company the opportunity to raise capital sometime in the future by reselling those shares. But in a privately held design firm, the buyers are finite. If you have a few owners who are looking to exit over a staggered 10-year period, a redemption of one or more owners’ stock may make it more difficult for other owners to exit in the future. The “stock market” in a privately held firm is not an expansive exchange where you can pick and choose your options from a long list. You have to be very focused on your goals and the initiatives that will get you to those goals. A large redemption by a firm can stunt growth efforts as capital that should be used to expand services, markets, and capabilities now has to be used to pay out exiting shareholders.
Zweig Group has found over the years that the most successful companies are ones where new owners have had to contribute some kind of capital of their own. Zweig Group’s 2020 Principals, Partners & Owners Survey Report found that in fast growth firms almost 70 percent of owners contributed their own capital or borrowed money to buy-in. In slow growth firms this number was 44 percent, stable firms 18 percent, and in declining firms just over 15 percent borrowed money to invest. Where outside capital was used to finance a portion or all of the investment, firms were able to grow and provide more opportunity for their staff. This seems to be a pretty clear distinction as it pertains to “what it means to be an owner” in these high growth firms.
If you are looking at your potential transition and are not sure how it will unfold, you need to first identify your pool of buyers and begin getting them involved in business planning and overall firm management. Develop trust and the proper skill sets in these individuals. This will help create a more viable transition plan by bringing other motivated professionals into the fold. In other instances, a redemption, with no intent to re-sell the shares, makes sense as an exit strategy. In others, it complicates the exit for other partners and can become an issue. Though there is a lot to think about and properly unpack in a transition planning effort, don’t let the concept of treasury stock cloud your strategy.
Will Swearingen is director of ownership transition advisory services at Zweig Group. He can be reached at firstname.lastname@example.org.Click here to read the full issue.