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Staying Private: Liquidity Options for Entrepreneurial Companies

(Print Version)

by Aziz El-Tahch, Ryan Gandre, Matthew J. Hricko, Corey Rosen, Ken Sawyer, and Ira Starr

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For many entrepreneurs, going public is part of the inevitable and desirable track of building a company. For others, it is seems a sad but unavoidable compromise of their dreams. However, while conventional wisdom has it that a sale or IPO is inevitable, this is very much not the case.

Company owners may want to stay private for a number of reasons. Not everyone, for instance, wants to be a serial entrepreneur. Selling out after a few years for a large return may seem attractive financially, but then what? The existing business may provide a kind of lifestyle and work satisfaction that would hard to match in an alternative scenario. For other owners, the issue is more about the social mission of the company. In still other situations, the company may fully intend to be sold one day, but "one day" might be far off. And a commitment to employee ownership may be a driving force as well.

This book has been written to help those entrepreneurs who want to stay private do so. It discusses four options for staying private: (1) internal redemptions and employee-to-employee sales; (2) internal stock markets; (3) secondary sales, including secondary markets, private equity investors, and other buyers; and (4) employee stock ownership plans (ESOPs). In addition, the book discusses how private companies should value their shares.

Publication Details

Format: Perfect-bound book, 106 pages
Dimensions: 6 x 9 inches
Edition: 1st (December 2014)
Status: In stock


1. Internal Redemptions of Employee Equity Awards
2. Internal Markets
3. Using Secondary Sales of Shares for Equity Liquidity
4. Private Equity and ESOPs: A Creative Combination
5. Valuation for Stock-Based Compensation Plans in Early-Stage Companies
About the Authors
About the NCEO


From Chapter 1, "Internal Redemptions of Employee Equity Awards"

The redemption of shares is not tax-deductible to the corporation. Some employee equity plans involve the direct ownership of shares by employees other than through stock options or restricted stock awards or units. The tax treatment of the redemption of these shares depends whether the redemption is treated as a capital gain or a dividend. A redemption can be treated as a transaction subject to capital gains tax. Section 302 of the Internal Revenue Code (the "Code") sets requirements for what must be done to qualify. To qualify as a redemption, the sale must be a "substantially disproportionate redemption" of stock. Immediately after the redemption, the shareholder must own less than 50% of the total combined voting power of all classes of stock entitled to vote and less than 80% of the stock the individual owned prior to the redemption. If a redemption is a complete termination of a shareholder's interest, that automatically qualifies. If the sale is treated as a capital gain, the seller pays capital gains taxes on the difference between the basis for the shares (the value when they were acquired) and the current value.
If the redemption is treated as a qualifying dividend (which, almost by definition, any redemption of shares pursuant to an employee equity plan would be), then the redemption is treated under dividend tax rules that have rates parallel to those for capital gains taxes. If it is not a qualifying dividend, then the tax rates follow ordinary income tax rules. Qualifying dividends are those based on shares held for at least 61 days during the 121-day period that begins 60 days before a company declares a dividend.

If the plan provide stock options, stock appreciation rights, phantom stock, or restricted stock, the tax treatment depends on the kind of award issued and, in the case of restricted stock, whether the employee makes an 83(b) election. Rules for each are explained below.

From Chapter 4, "Private Equity and ESOPs: A Creative Combination" (footnote omitted)

In a PE-backed ESOP recapitalization, the PE firm invests in a company by (1) lending the company subordinated debt with warrants, (2) the proceeds of which are lent by the company to the ESOP, which, in turn, (3) buys the selling shareholders' equity in the company. In most cases the selling shareholder does not cash out completely but rather co-invests part of his or her proceeds alongside the PE firm in the same security purchased by the PE firm. As a result of this transaction, the ESOP is left as the sole shareholder of the target company, which would elect to become an S corporation post-transaction if not one already. While a PE firm could realize enhanced cash flows in C corporations through tax deductible, non-cash contributions to the ESOP, the benefits that can be realized with S corporations are much more significant. Because federal income tax laws permit ESOPs—which are tax-exempt entities—to hold shares of an S corporation, S corporations whose common stock is solely held by an ESOP are exempt from federal income tax. This significantly increases the company's free cash flow, which can be used to repay debt more quickly, to make current interest payments on the subordinated debt, or as capital to grow the company.

If the company was a C corporation to begin with, this structure enables the selling shareholder to take advantage of Section 1042 of the Internal Revenue Code, which effectively allows a selling shareholder to indefinitely defer or eliminate capital gains taxes if he or she sells shares to an ESOP. To qualify for this tax deferral, the target company must be a C corporation at the closing of the transaction (in certain cases in which the company is an S corporation or an LLC, the company may convert to a C corporation to allow the selling shareholders to take advantage of this benefit); the selling shareholders must have held company stock for at least three years; the ESOP must own at least 30% of the stock of the company after the transaction; and the selling shareholder must rollover the proceeds into qualified replacement property, generally consisting of stocks or bonds of U.S. companies. The advantages of electing Section 1042 treatment in connection with a sale to an ESOP have recently increased given the increase in long-term capital gains tax rates and the inclusion of the 3.8% Medicare surtax, which began in 2013. For example, a selling shareholder in California could be faced with an effective combined capital gains charge of up to 33.9%, based on federal capital gains tax rates of 23.8% and state capital gains tax rate of above 10%. The tax-advantaged ESOP recapitalization structure, as illustrated in an example of an $80 million enterprise value transaction in figure 4-2, has the potential to generate 20% to 50% more after-tax initial cash proceeds than an LBO or a sale to a strategic buyer.

From Chapter 5, "Valuation for Stock-Based Compensation Plans in Early-Stage Companies"

In addition to early-stage companies (e.g., companies funded with complex capital structures comprising convertible securities), the value allocation techniques outlined in the Practice Aid can be applied to any situation where one part of the capital structure stands to achieve significant upside due to the effects of leverage if EV increases in the future.

For example, assume that Company B raised $180 million in debt a few years before the valuation date. The debt financing was completed at 4.6x earnings before interest, taxes, depreciation, and amortization ("EBITDA"). Since that time, Company B's EBITDA has decreased 31%, while EV pricing multiples in Company B's industry have declined from 9.0x EBITDA to 6.5x EBITDA. As a result, the implied residual value available to common shareholders is significantly depressed. In fact, application of the current value method would suggest a common equity value of $0 based on these assumptions, as illustrated in table 5-6 and figure 5-3.

Assuming that Company B expects to generate sufficient cash flow to service its debt obligations and there is no imminent expectation of a liquidity event (or bankruptcy), the current value method does not reflect the going-concern value of the enterprise from the standpoint of the common shareholders. Specifically, the current value method ignores the fact that Company B's shareholders have a claim on the company's future upside above a certain level of EV (i.e., in this case, an EV greater than the face amount of interest-bearing debt plus any accrued interest would result in a positive common equity value).