It’s often said that business owners are “asset rich but cash poor”. Surely this isn’t always the case, but the statement suggests that business owners generally have a significant chunk of their net worth tied up in their business. Arguably the most extreme example of this would be Elon Musk, the world’s richest man. According to Bloomberg, Musk has about $3 billion in cash or cash-like assets. On an absolute basis, I certainly doubt that many individuals would argue that having $3 billion in cash constitutes being “cash poor.” The point is, this amount is relatively immaterial compared to his overall net worth, making up only 1% of it. No matter the scale, illiquidity is a prevalent factor for business owners. Luckily, there are numerous options for owners to generate liquidity.
When considering the various strategies for liquidity, there are a few key factors to ask yourself, such as: How quickly do I need liquidity? Am I okay with triggering a taxable event? Am I ready to move on and give up control in my company? Of course there are many other considerations that need to be taken into account, but these three factors can help you determine an appropriate liquidity strategy.
Sale to a Third Party – Full or Partial
The most straightforward approach is a full sale of the business to a third-party. Larger companies may work with bankers and advisors to help facilitate a sale, while smaller companies may work directly with the buyer to come to an agreement. Acquirers may be financial or strategic in nature, with the latter usually paying a higher price. A full sale of the business is a sound option for owners who aren’t looking to retain ownership in the company and are okay with triggering a taxable event. Time to liquidity will depend on how quickly a deal can be consummated, but is generally expected to take between 6 – 12 months.
For business owners who would like to generate some liquidity, but are not ready to exit the business entirely, there may be opportunities to sell off a portion of the business. A leveraged buyout is an example of a partial sale. This strategy involves a private equity investor who takes control of the business by acquiring an equity stake in the company, typically financed heavily with debt. In many cases, the owner receives cash for a portion of their stock while staying on to help grow the business. Typically, the owner is taxed on the shares sold, but a tax deferral can be achieved by rolling over the stock into the newly capitalized company. Depending on how the deal is structured, owners may achieve partial liquidity between 6 -12 months and full liquidity after the private equity firm exits years down the road. A key advantage to this strategy is that the owner keeps some of the upside potential in the business by retaining equity in the company.
Sale to Insiders – MBO or ESOP
Another strategy involves selling the company to insiders via a management buyout (MBO) or an employee stock ownership plan (ESOP). As the name suggests, an MBO is a transaction where the existing management team purchases the business. Alternatively, an ESOP is an employee benefit plan that results in employees taking ownership of the company. ESOP’s fall under the Employee Retirement Income Security Act of 1974 (ERISA) and therefore require a number of federal compliance requirements. MBO’s and ESOP’s often allow for smooth transitions to individuals that already know the ins and outs of the business. MBO’s and ESOP’s generally take 6 – 12 months to close. These strategies are appropriate for owners looking to exit the business and can trigger taxable events depending on how the deal is structured. In some cases, the owner will continue working in the business for a few years to ensure a smooth transition.
Dividend recapitalizations are another liquidity strategy for businesses that are large enough. This strategy involves the issuance of new debt that is used to pay a special dividend to shareholders. Historically, this approach has primarily been used by private equity investors. However, this is becoming a more popular liquidity tool for business owners that have stable enough operations to secure debt financing from lenders. Dividend recapitalizations will create a tax liability, but the dividends are categorized as “qualified dividends” and are taxed at the more favorable capital gains rate, compared with ordinary dividends which are taxed as ordinary income. This strategy is favorable for owners who do not want to sell their stake in their business and need liquidity fairly quickly.
For owners who would like to retain control of their company but are in need of liquidity, they may consider arranging a personal loan secured by their shares in the company. This strategy generally involves a “put” arrangement where the borrower can put the loan to the company as a source of repayment. An advantage of this approach is that it avoids triggering a taxable event. However, by including a put arrangement this may be considered a constructive sale, which would trigger a tax liability. Getting a personal loan is the quickest approach to achieving liquidity and is an attractive alternative for owners who want to remain in control.
By no means does this article provide a comprehensive list of options f for owners to transition from “asset rich but cash poor” to “asset rich and cash rich”.