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Dealers at a Crossroads – Choosing the Right M&A Transaction

As we enter the later stages of the Coronavirus pandemic, equipment companies in material handling and related industries are seeing the light at the end of the tunnel. Some businesses have even flourished in the last few quarters. Buoyed by changing trends in consumer consumption, purchase behavior, and decentralized commerce – and further bolstered by the broader reopening of the country – the outlook for dealers is strong.

Typically, after an adverse economic event, there is significant pent-up demand for business liquidity events. Our current moment is no exception. M&A activity is once again on the rise, and established owner-operators are asking themselves tough questions.

  • “Do I have another market cycle in me?”
  • “Is now the time to sell?”
  • “What would life be like without my business?”

This uncertainly doesn’t end once an owner opts to pursue a liquidity event. Instead, a whole new set of questions may arise. That’s because a sale process isn’t binary. Sellers have transaction options. Partial sales are possible, and even complete sales have differing sets of pros and cons, depending on the buyer.

For the purposes of this article, we’ll explore four sale options: to a competitor, to a financial buyer such as private equity, to a manufacturer, and to an employee stock ownership plan (ESOP).

Option 1 – Sale to Manufacturer

The primary manufacturer will often have a right of first refusal or a contract with the dealer that complicates a sale to any other buyer. 

Pros Cons
  • A transaction “on rails”
  • Reduce due diligence and closing process
  • Sale proceeds are fully taxable
  • May trigger depreciation recapture
  • Often a lower valuation than other transaction options
  • Seller gives up all future participation in the growth of the business

Option 2 – Sale to a Competitor

When most owners think about a sale, this is the option that first comes to mind. A larger player or deep-pocketed upstart who wants to take over your customers and/or territory will offer to buy your dealership.

Pros Cons
  • Widely understood process
  • The buyer understands your market’s dynamics
  • That familiarity may facilitate a smooth transition for your customers and operations
  • Sale proceeds are fully taxable
  • May trigger depreciation recapture
  • Employees, including long-tenured staff and top talent, won’t be retained
  • For example, a buyer won’t need 2 CFOs
  • Those employees who are let go will generally be left with hard feelings and little to show for their efforts

Option 3 – Sale to Private Equity

Most PE deals are a type of leveraged buyout. To complete an acquisition, a private equity firm will lever-up a company’s balance sheet with private debt. Once in charge, the PE firm may seek to professionalize operations and drive future efficiencies. 

Pros Cons
  • Selling shareholders may receive a substantial portion of the purchase price upfront, potentially at a valuation premium
  • PE buyers are often focused on growing and scaling a business, rather than completely absorbing it
  • Structural and operational changes may support add-on acquisitions

 

  • Sale proceeds are fully taxable
  • May trigger depreciation recapture
  • PE firms often have the final say in operational and M&A decisions
  • Seller may be required to reinvest some of their sale proceeds in the new business structure
  • Risk of using excessive leverage, amortized with after-tax dollars​

Option 4 – Sale to an ESOP

Similar to a management buyout, a company finances the purchase of an owner’s stock.  But in this instance, the buyer is an employee trust, rather than a management team.  

Pros Cons
  • Sellers can defer or eliminate capital gains taxes on sale proceeds and maintain upside
  • The company receives tax deductions equivalent to the sale value and can become a tax-free entity as a 100% S Corp ESOP
  • Does not trigger a depreciation recapture event
  • The Board of directors continues to oversee operations
  • Employee trust cannot pay more than fair market value
  • A highly structured deal process
  • Regulatory oversight by the Department of Labor and Internal Revenue Service
  • Outside lenders can often provide non-resource financing, but this may only cover a portion of the transaction (seller notes fund the remainder)

There isn’t necessarily a right or wrong option for dealership owners who decide to move ahead with a sale. But there are “best fits” relative to a seller’s needs and goals. A well-reasoned decision can mean the difference between a positive transaction and a seller’s remorse.

So, let’s review these options based on an owner’s priorities.

Seeking a Complete Exit

Owners that want to cash out and not look back should give serious consideration to a manufacturer or competitor sale. Both options will likely represent the cleanest of breaks – free of continuing management duties and most other ongoing entanglements.

A sale to a manufacturer sometimes represents the express lane for some owners and the only option for other dealerships. If ease, time-to-close, and transactional simplicity are paramount – even at the potential expense of a decreased valuation – this may be a desirable option.

Of course, both transactions are subject to capital gains taxes, as well as depreciation recapture, so a premium valuation can take on outsized importance. With that in mind, a strategic sale to a competitor may yield greater returns.

Looking to Gradually Step Back

If you are interested in paring back your day-to-day involvement while diversifying your personal portfolio, a private equity or ESOP sale may be right for you. Both can provide a partial liquidity event with potential upside. Ongoing “skin in the game” takes the form of rolled equity in a PE sale and retained stock and/or stock warrants in an employee stock ownership plan transaction.

Dealerships seeking an infusion of outside talent could be well-served by a private equity buyer. These firms often specialize in industry-specific transactions and provide operational know-how and human capital to scale their portfolio companies. The common trade-off is a loss of independence. While selling shareholders may play a role in the restructured entity, day-to-day control is generally assumed by the PE firm.

If a dealership already has the bench strength to facilitate a gradual leadership transition, an ESOP may be an attractive PE alternative. Sellers and their companies can reap the associated tax benefits with only a 30% sale to an employee trust. Even in the event of a majority or 100% ESOP sale, the company’s board of directors will continue to operate the business, and sellers can continue to earn a salary and a maintain meaningful role, without being obligated to stay.

Interested in Diversification Only

While certain owners may be fully invested in their dealerships, it could be the right time to get chips off the table. The case for an ESOP is very compelling under these circumstances. Selling shareholders can complete a partial, fair market value sale to an employee trust and still maintain a majority interest.

Under a minority ESOP, operations and leadership remain virtually unchanged, while the company benefits from increased cash flow, thanks to the ESOP’s tax incentives. Employee-owned companies, on average, are also more stable and productive than their non-ESOP equivalents. The stock incentive can help foster increased employee engagement and provide a unique incentive for attracting and retaining top talent.

An employee-owned company also has significant flexibility to accommodate evolving stakeholder goals and future growth. Partial ESOP sales can be followed by a range of transactions including secondary ESOP sales, M&A or PE deals, and ESOP plan terminations. As a result, owners have the latitude to actively shape their business legacies even after a minority ESOP sale.

The sale of a company is one of the most significant transactions a business owner will face, and it can have a huge impact on their future and the legacy they leave behind. An educated seller will always end up with the best possible outcome given the available options.  Taking the time to explore the full impact of transaction alternatives on all your stakeholders will put you in a position to avoid surprises and ensure you’re on the best path.

To listen to Nathan and Kevin Lawton explain more, click here for the podcast.

 About the Author:

Nathan Perkins is recognized as an expert in the investment banking space and speaks regularly on the topic of ESOPs as a liquidity strategy for business owners. Throughout his 20-year career, he has advised on over 300 ESOP M&A transactions encompassing over $1 billion in value.  Prior to joining CSG in 2014, Nathan was a Vice President at Bank of America Merrill Lynch where he focused on ESOP strategies for ultra-high net worth families. He held a similar position at Morgan Stanley for over seven years.