The construction industry has been booming for several years, and most economic experts say it should have another two years of growth.

As the market settles, changes or consolidates, contractors should consider their options, including preparing their business for sale. Although most construction businesses do not sell to third parties, if a company is positioned correctly, it will be able to respond or follow other strategies.

Selling a business is a process. It can be long and complicated, or it can be smooth and straightforward. To maximize the value of a business, owners must prepare before placing it on the market and negotiating.

To be successful, owners need to prepare and review the company’s legal, financial, operational and regulatory status with enough time to correct any issues or be able to explain them. These are some key considerations in preparing a construction company for sale:

Transaction team

A seller needs to assemble a team that has experience with the construction industry and related mergers and acquisitions. Selling a business is not the same as a construction project. The team members are the owner and family, inside management team, legal advisers, financial advisers/investment bankers and accountants. It takes time to get the team on the same page.

Seller due diligence

Before going to market or providing any buyer with information, the seller needs to perform its own due diligence review to ensure there are no problems that could delay or adversely affect the sale. This gives the owner time to cure the problem or develop a negotiation strategy to address it, and identify regulatory or third-party consents needed to finalize a transaction. In construction businesses, the following areas need attention:

• Financial statements and other financial information – Audited financial statements are preferred but not always needed. The more reliable the information, like audited generally accepted accounting principles financial statements, the more solid the valuation. Tax filings and payments must also be confirmed. Quality of earnings reports can be beneficial. Reliable and improving cash flow is vital to a third-party sale.
• Corporate records – These need to be up to date and in good form. Sloppy records usually signal a lack of best business practices and might engender deeper scrutiny.
• Material contracts – Whether these are written or oral, transferable or not, and long-term or terminable may impact the company’s value.
• Material relationships with third parties – Are relationships documented or handshake deals? Will they survive a transfer to a new owner?
• Assets – What assets are legally in the company or owned by the owner outside of the company? Has the intellectual property and know-how been verified and can it be transferred, or are there employee ownership issues? Should the real property be in the company? What assets (e.g., cars, life insurance, sports tickets, cellphones, company cards) should not be part of the sale? Also, unused or obsolete assets need to be managed.
• Employees and employee benefits – Is there a union involved and are there change in control provisions or notification requirements? Are there written employment agreements and do they deal with a change in control? Does the owner expect employee flight from news of a sale? Should retention programs be established?
• Governmental permits and licenses – In construction, permits and licenses are often tied to individuals, not businesses. Often, the owner is the key person, and time and training are needed for transfer. Also, governmental licenses usually have change in control requirements.
• Legal claims – Can they be settled or insured around?
• Warranties – Most construction projects have trailing warranty claim exposure. Some historical exposure may be addressed with insurance, annuities or other techniques.
• Insurance coverage and bonding – Insurance coverage may be obtained for some historical issues or a negotiating strategy can be developed. Bonding and surety issues may be addressed with some work-arounds.
• Personal guaranties, debt, and long term obligations – These need to be identified and analyzed for alternatives.
• Real estate and environmental issues – Leases need to be reviewed for transferability. Is real estate part of the transaction? Are there environmental issues?
• Tax implications – Taxes need to be analyzed from the company’s and owner’s perspectives. The transaction’s structure will rely on the tax implications, including state tax items. Do not underestimate the benefit of good estate planning and gifting.

Valuation

Before a company goes to market, the owner needs to know the valuation range. A financial adviser/investment banker is needed for this. Good financial information is essential, and so is information about normalizing cash flow and possible synergies. Much depends on whether the company has been run as a stand-alone business or more like a family enterprise.

Personal impact on the owner

How will selling the business affect the owner personally, financially and emotionally? Most buyers will want a non-compete agreement from the owner. Can this owner stay away from an industry that he or she has spent a lifetime mastering? It takes time to process this impact. An important value add to the business is the reduction of dependency on the owner. With time and succession planning, this is doable. Family dynamics must also be considered, especially if there are family members who see themselves as successors to the business.

Increase the value of the company

Through the process, areas for improvement can be identified. Some examples are increasing sales, profits and cash flow; restructuring the organization’s leadership and management; diversifying the customer base; building better operational systems; completing an audit of the company’s financials and improving weaknesses in financial controls; and creating a business strategy that doesn’t involve the owner.

These are just some considerations. Preparing a construction business for sale takes time and effort. The effort is essential to a successful transaction, and the process is invaluable to a good outcome.

Carmen Calzacorta is a shareholder with Schwabe, Williamson & Wyatt. She focuses her practice on business and corporate work for public, private, and family-owned businesses. Contact her at 503-796-2994 or at ccalzacorta@schwabe.com.

The post OP-ED: The process of preparing a construction business for sale appeared first on Daily Journal of Commerce.

The construction industry remains Oregon’s fastest-growing sector, expanding by nearly 10 percent this past year. That growth rate is more than double the rates of the next fastest categories: transportation, warehousing and utilities. Several surveys and reports forecast that growth is expected to continue.

So, why is this positive outlook a problem for the construction industry? Because a hot market is one of several triggers of ownership transition for construction, and many companies have not planned for it.

A robust market acts as a trigger as consolidations and valuation multiples become common talk in the marketplace. Owners perceive their company values going up. Acquirers assess where those companies are in the business cycle. Everyone in the cyclical construction industry understands the sector may soften ahead of the cycle. So the questions become:

• Is the timing right for this construction business to sell to a third party or to management?
• Will the owners get the most value?

Both of these questions depend on whether the company is “deal ready.” Timing is critical for most transactions because the window can be tight and readiness takes time. If the company has not planned for a business transition, it may miss the opportunity – especially if it has not planned because of the owner’s age and a lack of internal management succession status. Those are two other triggers for transition.

Most contracting companies’ value is in their hard assets, their ability to retain talented employees, their customer base and contracts, and their reputation. There is also added value if the contractor is in a specialty niche or has a strong geographic presence. However, the main value detractors are liabilities and debts, dependence on the owner and unpredictable future prospects.

Failure to plan ahead can leave a construction business in a bad situation if the owner wants to sell or is approached for a transaction and is not deal ready. Fewer than 20 percent of businesses for sale actually close. In the construction industry, the closing rate for outside sales is even less unless the selling company is in a unique niche or location, or the economy is just right.

Consider these tips for being deal ready:

Documentation and due diligence

The process of due diligence will reveal whether a company has planned to get the most value or whether there will be a corresponding impact on price or a failed transaction. For example, the failure to properly document the customer and employment relationships can haunt a seller in due diligence. Another common issue is when construction permits or licenses are held by the wrong individuals; then permitting becomes an issue. An additional issue is when the owner has personally guaranteed agreements or surety funding that could have been limited by time or amount if a transaction was expected. These items, and the lack of other housekeeping or preparation, can lead to the loss of real value as a potential buyer negotiates to lower the price or, alternatively, tries to circumvent the owners and go directly to the customers and employees without dealing with the owner. Remember, handshakes may be good for introductions, but they are not enough to document and protect value. This item becomes one of the detractors for unpredictable future prospects.

Knowing the goal

Planning allows the owner freedom to negotiate and set the terms of the transaction because the owner is prepared, knows the goal and has a backup plan. For example, if the owner has a succession plan and knows how much cash is needed both for personal and business needs, the owner can negotiate an earn-out or other deferred purchase price option without taking on risk due to time delays or the possibility of never getting that consideration. Alternatively, the business can walk from a transaction without investing expensive time and resources as it knows what it wants and needs and can continue with its ongoing plans.

Understanding historical liabilities

Historical liabilities can be a major negotiation point in construction industry transactions. Some of these concerns can be addressed up front with ongoing planning and proper contract documentation. These tools allow for limits on liability that are well defined and insurable and provide the owner and the acquirer with certainty about possible trailing liabilities from prior projects. This item can be a detractor as it affects liabilities.

Retaining the talented employees

Planning will give the business time to develop and document a culture of commitment to retain talented and skilled employees. One of the keys to a successful transaction is that internal management succession is in place. This item can be a detractor as it shows dependence on the owner and it may impact reputation.

Planning for taxes and estate planning

Lastly, planning will allow for efficient tax and estate planning. Not losing value to taxes is important for retirement and not outliving the money. Like many private companies, contractors hold more than 70 percent of their wealth in their businesses.

In summary, while the market may be hot, transition still requires special planning for a construction industry business.

Carmen Calzacorta is a Schwabe, Williamson & Wyatt shareholder. She is co-chairwoman of the firm’s business transitions practice group. Contact her at 503-796-2994 or ccalzacorta@schwabe.com.

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Contractors likely have been forced to think about and probably document an “exit plan” at the request of their surety or banker or maybe family. One of these parties may have insisted on seeing paperwork that shows a plan is in place. For these groups, business continuity and succession planning are important to ensure completion of bonded or current projects, to make sure there is adequate funding to do so and to show that transition has been considered.

Perhaps a contractor put together some paperwork, checked the box and then put the bundle in a drawer or left it on a computer until the next renewal date. However, it really wasn’t the exit plan then or isn’t the exit plan now.

Like many private companies, contractors hold more than 70 percent of their hard-earned wealth in their businesses. People work hard to build their businesses, yet unlocking that value without losing much of it to taxes will be the key to their retirement and not outliving their money.

Common misconceptions exist in owners’ understanding of a successful business exit. If people do not understand the facts and the lore, their business wealth is likely at risk. Compounding this risk is the reality that 70 percent of transfers of private businesses to a second generation or to an outside buyer fail, and the statistics are worse for a further generational transfer.

Some of the misconceptions are:

“It can’t happen to me.”

This is where that document prepared for the surety or banker will come into play. Typically, that document does not align with the owner’s goals or the best interests of his estate when there is a premature death or disability. Even worse, it was likely prepared at the inception of the business, and many things have changed, including value. Unfortunately, poor planning has resulted in multiple horror stories of expensive litigation, bad tax consequences, disruption in management because a family member now wants to be the “boss” and other unintended consequences. If you do nothing else, reread those documents and update them.

“I will sell my business and then retire.”

This generally sounds like a good plan. Unfortunately, fewer than 20 percent of businesses for sale actually close. In the construction industry, the closing rate for outside sales is even less unless the selling company is in a unique niche or location, or the economy is just right. Most transactions in the construction industry are internal transitions, mainly to management or family by using gifting, stock sales, employee stock ownership plans (ESOPs), profits interests and other transfer mechanisms. These internal transfers require long-term planning and succession training to be successful.

“I will deal with an exit plan in __ years.”

Unfortunately, this becomes the mantra and the __ years never start, with the years rolling forward. In addition, most owners can’t wait. Even if the transition will occur in five, 10 or 15 years, it takes time and effort to replace an owner and to save. Most business owners have not provided for retirement, so they need to start to save early or save aggressively while they are in control of the company. Many strategies and plans are tax-efficient and can be used by business owners for this goal. Planning is key.

“If I get the ‘magic number,’ I will retire tomorrow.”

First, is the “magic number” realistic, both in terms of “value” and provision of dollars needed for retirement? “Value” means several things, depending on its context – i.e., is that after taxes and fees? Furthermore, most owners overvalue their business. Second, would that number together with all other savings and investments provide the income needed for retirement, given circumstances and desires? The exit process requires an analysis of personal and business needs. Third, would you be ready to accept the offer? Transitioning takes time, planning and a mindset open to change to be successful. This is especially true in the construction industry, where licensing, permitting and surety funding generally are tied to individuals and not companies.

“I will do it myself.”

Why can’t successful businesspeople do it themselves? Maybe they can, but the odds are against them. Furthermore, all the information can be overwhelming or lead people down a rabbit hole. Even with advisers, there are plenty of stories of expensive planning and processes leading to bad results. However, more successful transitions are accomplished with good teams than without. So assemble a good team of advisers whom you trust, and start or update that plan and process.

In summary, while exit planning for construction industry businesses is somewhat unique, there are certain realities and misconceptions that are common to all businesses. A good plan that is updated is critical. Then, there is the hard work of implementing it.

Carmen Calzacorta is a Schwabe, Williamson & Wyatt shareholder who handles issues involving business transactions, mergers and acquisitions, corporate finance, securities and capital markets, and business transitions. Contact her at 503-796-2994 or ccalzacorta@schwabe.com.

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There is a lot of speculation about how the Trump era will impact the construction industry – from the border wall, to pipeline projects, to fast-track future projects, to a focus on infrastructure needs, to proposed tax and regulatory changes. Is your business positioned to take advantages of these possible changes? In particular, do you have a business succession plan that can adapt to change?

The number one root cause of “contractor failure” is poor strategic leadership, according to an FMI Quarterly article published in June 2016. As stated in the article: “… many companies get into financial difficulty when ownership changes from one generation to the next. To ensure successful ownership transfer and management succession, owners need to prove that the company can grow and succeed without them.” This is a root cause of contractor failure – regardless of whether the business is family-owned. The other root causes are:

• excessive ego;
• too much change;
• loss of discipline; and
• inadequate capitalization.

Does this sound right or familiar? Remember, construction is an inherently risky business and it is dynamic.

So let’s focus on successful transition planning and changes in the construction industry. In the construction industry, more than 50 percent of firm owners are older than age 55, and fewer than half have a formal succession plan. These business owners know that they need a plan and many think they have a plan in place. But do they truly have a clear plan set up? And have they considered that now is the time to revisit that plan, given the possibility of future change under the Trump era?

Here are some considerations:

• Update the existing plan. If you have an existing plan, pull it out and revisit it with your professionals (management, lawyers, accountants, bankers, financial planners, etc.) and family. You need to be in a thoughtful position to adapt in a timely manner if a change occurs.
  For example, if tax changes affect individual rates or estate or gift taxes, you may want to make some decisions and implement them this year. If infrastructure incentives or tax or regulatory changes enable your business to invest in more equipment or people, will your plan accommodate that change in resources and timing?
• Communicate goals and adapt for change. Many owners “plan” to transfer the business to family or employees. Yet 70 percent of family business transfers fail due to lack of trust and communication. Communication and alignment are critical, especially when changes are expected. If you do not have the skill or the desire to communicate effectively, find and delegate this important function to someone on your planning team.
• Build, train and incentivize successors. This is one of the major factors in business transition failures – the lack of adequate training with the right management skills. For a construction business, license/regulatory and surety requirements are critical and skilled craft labor shortages are real.

First, decide what skills are required for the near and long-term needs of the company.

Then decide who will be an owner and who will be a manager based on the company’s needs and individuals’ skills.

Finally, decide how to compensate them, whether with equity or other incentives, like profits interests, cash or an employee stock ownership plan (ESOP).

There are many tools and approaches to select from, so it takes thought, planning and communication – especially given the various impacted generations (the silent generation, baby boomers, gen X, millennials, gen Z) and their needs and desires.

• Know the company’s worth now and in the future. This requires a current analysis of the company’s growth potential, asset assessment (real estate, equipment, etc.), management assessment and financial assessment (earnings and bank and surety credit). For many construction businesses, these items are dependent on the owner/founder, so a candid evaluation of the company’s worth without the owner/founder is important. You have to be realistic and flexible.
• Document the transition plan and the emergency plan. Many of the tools and approaches for a successful exit plan require legal documentation that should be negotiated and in place long before any transfer is to take place. A lack of planning and documenting can lead to unintended consequences and delays. With that said, interim plans and execution of a plan over time is prudent – so long as it is periodically revisited. However, in any event, an emergency succession plan should be documented and access provided to those who need to know about it.

Change for the construction industry is expected during the Trump era. Is your succession plan in shape to effectively benefit from the changes?

Carmen Calzacorta is a shareholder with Schwabe, Williamson & Wyatt and co-chairwoman of its business transitions practice group. Contact her at 503-796-2994 or ccalzacorta@schwabe.com.

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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.

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It is considered a “best practice” to have “independent” or “outside” directors on a corporate board. Companies listed on the NYSE and NASDAQ are required to have a majority of directors be independent. Also, public companies’ audit committees are required to be independent. Why? What value does “independence” provide to corporate boards and, in particular, to a closely held business or family business board?

First, there is independence. For publicly traded companies, that means that the director has “no material relationship with the company,” or “a relationship that … would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.” In other words, the director does not have a material or pecuniary relationship with the company, other than sitting on the board, holding some shares and collecting board fees. “Independence” means free of conflicts of interest, free from management influence, and free of incentives that influence decisions.

Second, an outside director can bring different expertise and a fresh viewpoint to the company. This diversity of perspective can enhance a company’s ability to make strategic and operational business decisions that maximize value. An independent director can share ideas, tools and experiences used in different businesses and industries that may result in a new outlook or a fresh way of looking at an old problem. This way, the board can take advantage of lessons learned at other companies and/or best practices that can add value.

Third, these directors usually act as directors on other boards and have extensive experience in corporate governance, risk management and other best practices. Since a board’s main obligation is oversight, independent directors can improve the board’s ability to provide proper accountability of management and enterprise risk. However, to attract outside directors, the board must function in a professional manner. These directors want to make a positive impact on the company, and if their time is not valued or the board meetings do not run efficiently and effectively, these directors will not continue to serve.

Fourth, an independent director can act as a mentor to management or to other board members and can spearhead an educational process on the proper functioning of a board and the best practices in board management.

Fifth, outside directors provide an element of discipline and the benefit of protection to all directors from claims that they violated fiduciary duties or had conflicts of interest. Most corporate state laws provide that if action is approved by a majority of the directors “who have no direct or indirect interest in the transaction,” then the transaction is not voidable. Independent directors often constructively challenge management in an effort to make better decisions for the company.

Sixth, as “outsiders,” these directors have a different network of industry and personal contacts, and they can make introductions and provide advice ranging from managerial talent to product development.

Seventh, effective outside directors are not insiders, so they take management out of operational aspects and instead direct managers to focus on key strategic direction and challenges.

And lastly, in a closely held or family business, independence helps when the family or management has lost objectivity. Outside directors can help clarify goals and roles. They can help take the emotion out of a decision and require that objective facts and perspectives be presented in order to come to a business decision. This is particularly important in a family business where hiring, firing, promoting and compensating family members and succession or transition planning are key decisions. It is also invaluable when a family manager is in need of disciplinary action.

In conclusion, independent directors can add great value to a business, but only if they are allowed to play the role of outside director and the right outside director is selected.

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.

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Family businesses account for approximately 80 percent of U.S. companies and 80 to 90 percent of businesses across the globe. Some of the world’s biggest companies are family-owned, including Samsung, Tata Group, Wal-Mart and Cargill, and about one-third of all companies in the Fortune 500 are family-controlled.

Yet family business models often are overlooked because only 30 percent make it past just one generation, only 12 percent remain viable into the third generation and only 3 percent operate into the fourth generation and beyond. Nevertheless, there are valuable lessons to be learned from successful family businesses and the characteristics they all share.

Adopt a long-term vision and investment strategy

Many non-family businesses manage investment for near-term growth, or measure short-term performance; however, family businesses tend to take a longer-term perspective, focusing on benefits for the next generation rather than immediate gains by taking on risks. Family businesses will accept a lower return in good times to ensure survival in bad times; they will invest in an upturn or a downturn because of their long-term outlook.

This vision may be documented in a Family Constitution or Value Statement, or it may be manifested in the election process for those who serve on the board. Documenting this longer-term thinking and a broader perspective often sets the stage for stewardship and lasting culture. Recently, much talk has taken place about non-family businesses being encouraged to manage for the long term, yet many fail to put processes in place to measure progress in this regard.

Inspire more trust and commitment from employees and communities

Many decisions in family-owned businesses are measured by looking at family, employees and the community, including customers and suppliers.

While non-family companies use stock grants and options and other short-term incentives to reward behavior, many family-owned businesses create a culture of commitment and retain talent by investing in people and rewarding performance over the long term. Other businesses support and invest in their communities either through loyalty programs, gift giving, job creation and other mechanisms, while family-owned businesses tend to be more committed and reliable to the “family” causes.

The family may act through a foundation or independently through individual trusts, scholarships and other charitable vehicles.

Cope with exploration, conflict or change

Exploration, conflict and change are inevitable when the ownership, the family and the business have different interests. The owners have a financial stake, but the family holds the emotional core, including family communication, trust and rivalries. The business may be the only asset or one in a number of businesses within a family enterprise.

Providing a process for exploring different approaches and/or for anticipating and predicting how the family, the owners and the business will confront these issues as they react and respond to change is critical. Family-based issues often are more critical than business-based ones. Choice of entity, shareholder agreements, liquidity programs, family councils, family constitutions and other mechanisms help deal with multi-generational dynamics and inevitable disputes. Non-family businesses often have the same issues but don’t plan for this type of conflict resolution.

Nurture and take care of the family

Successful family businesses actively build connection and shared purposes over generations. Careful estate planning will preserve family assets and assure family control. Communication vehicles, such as family meetings, single-family offices (whether physical or electronic) and other training provide for future continuity. Non-family businesses have similar constituents and stakeholders, and these tools could be beneficial.

Plan ahead for leadership transition

Orderly transition requires planning whether succession is to own, manage or sell. Transition can build or break the family firm. Successors have to be selected, trained, groomed and given the opportunity to lead – and more importantly, they should want the job.

But in a family-owned business there is also the exiting CEO and the task of defining that person’s role going forward. For a smooth, conflict-free transition, the former head of the company needs to have a clearly defined role after stepping down. Oftentimes, an outside board of advisers or independent directors can assist this essential function. Non-family businesses must also plan and cultivate human capital for the next generation or next owner.

Transition is going to happen, whether planned or not. Given that family-owned businesses play a key role in our economy, there are numerous lessons to be learned from their successes and their failures. Family-controlled businesses can serve as an example of how planning and using a variety of corporate tools and processes can lead to long-term success and stewardship.

Carmen Calzacorta is a shareholder with Schwabe, Williamson & Wyatt in its business transactions; mergers and acquisitions; corporate finance, securities and capital markets; and business transitions practice groups. Contact her at 503-796-2994 or ccalzacorta@schwabe.com.

The post OP-ED: Family-owned businesses are getting it right appeared first on Daily Journal of Commerce.

If a buyer wants to pay less than what the seller wants to pocket, a valuation gap exists. However, an earn-out solution can bridge that gap. It can be a win-win situation, but it can also be a mistake waiting to happen.

Earn-outs can be a valuable feature of merger and acquisition deals. According to the 2011 Private Target Mergers and Acquisitions Deal Points Study by the American Bar Association’s Business Law Section, 38 percent of private company deals (100 transactions closed in 2010) included earn-outs.

What is an earn-out?

An earn-out is a deal pricing mechanism where a portion of the purchase price is contingent upon certain post-closing events or targets being attained over a specified period of time, and paid at a later date. It is most commonly used in deals valued at less than $250 million. The earn-out amount generally represents 20 to 30 percent of the total deal consideration, but deals go as high as 40 to 60 percent. Earn-out periods are typically in the one- to three-year range.

When do earn-outs work best?

They are particularly useful:

• For a development or entrepreneurial stage business with limited operating history

• For new product lines or technologies

• For large projects or projects in the pipeline at the time of the acquisition

• For Markets or sectors where valuation multiples are reaching a peak

• To keep a seller with “skin in the game”

• If there is a private owner with “optimistic” projections

• For volatile industries and/or uncertain times

• For asset-light businesses

• For turnarounds

• When a buyer has limited access to funds

Earn-outs typically don’t work in the health care industry because of federal fraud and abuse laws. They also are not appropriate under certain circumstances – for example, if the buyer intends to integrate the target company into its business.

How should earn-outs be structured?

For an earn-out to be a good resolution and not become a problem or area of dispute, it must be well thought out and documented. Every deal is different.

• Set realistic expectations. An estimated 50 to 90 percent of mergers and acquisitions fail to meet financial expectations, according to Jim Price of Business Insider. Because the odds of any acquisition succeeding are unclear, adding an earn-out only adds to the uncertainty.

An earn-out works only if the seller understands that part of the purchase price is contingent and the seller may never get it. On the flipside, the buyer must understand that the former owner will run the business to maximize the earn-out. Earn-out terms need to reflect the proper motivations from each party’s perspective.

• Keep it simple. Given all the variables, it is tempting to make an earn-out complicated with multiple goals and measurements. Simple is better. An easy-to-quantify metric is what is needed to be successful, such as a top line metric (e.g., revenues), an earnings-related metric or a non-financial metric (e.g., regulatory milestones). Independent of settling on a benchmark, there are plenty of other structural items to resolve – such as payments (timing, type and the number), floors and caps, the duration, security for the earn-out payment, “all or nothing,” adjustments for integration, etc.

Even simple terms can become disputes. In July 2013, a unit of global construction conglomerate Foster Wheeler AG sued the former operator of a firm it acquired in 2009 over how the term “business” was defined in the earn-out. As described more below, keeping it simple doesn’t mean failing to be clear.

• Keep some control. Most earn-outs are premised on the successor entity continuing to do what it has always done with a similar structure, but with more funds for growth. To the extent that major changes or loss of autonomy are expected, these items need to be identified and addressed. Some operating controls to be discussed are: future funding, expansion or consolidation plans, hiring, firing or the moving around of key personnel, restricting dividends or payments, product launches, taking on debt, keeping separate books and records, and getting board or informational rights.

• Document the deal. Keeping it simple doesn’t mean keeping the paperwork to one page. Care must be taken to clearly and concisely set out the terms. Attaching detailed accounting principles and sample calculations to the contract are recommended. Attention to detail is very important and will likely help resolve issues efficiently and effectively. Leaving important words undefined usually results in disagreements. Not every aspect or word can be spelled out, but the exercise of discussing the terms and providing examples helps to flush out expectations and potential areas of dispute.

Dispute resolution is a vital element of earn-outs.

There are several tax and accounting aspects of any earn-out structure to be reviewed and factored in prior to any agreement on the earn-out terms. For example, inaccurate estimates of the fair value of the earn-out payments can lead to earning volatility under accounting rules (FAS 141R) or payments may be taxed as compensation income rather than capital gains. The tax and accounting treatment should not come as a surprise after the deal.

An earn-out can be a valuable solution in bridging the valuation gap. Competent legal, accounting and financial specialists can help structure an earn-out that will work. Failing to take the time and getting the advice to work through and document the earn-out will likely lead to a bad mistake.

Carmen Calzacorta is a shareholder at Schwabe, Williamson & Wyatt and chairwoman of its Business Transitions group. Contact her at 503-796-2994 or ccalzacorta@schwabe.com.

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