- How wealth in private businesses should be managed with the same degree of intensity and respect that is accorded to retirement funds;
- Challenges that entrepreneurs face when thinking about ways to manage their wealth and their business;
- The importance of diversify wealth outside of the business;
- The concept of a leverage recapitalization and creating financial independence for business owners.
About the GuestChristopher Mercer is the founder and chief executive officer of Mercer Capital. He has prepared, overseen, or contributed to more than a thousand valuations for purposes related to M&A, litigation, and tax, among others.
Chris is also the author of his most recent book, Unlocking Private Company Wealth: Proven Strategies and Tools for Managing Wealth in Your Private Business (Peabody Publishing, 2014).
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Read the Full Transcript Here:Noah Rosenfarb: Hello and welcome everyone. It’s your host, Noah Rosenfarb, the author of Exit: Healthy Wealthy and Wise and partner at Freedom Business Advisors.
Today’s guest is Chris Mercer. If you don’t know Chris, he is synonymous with valuation. Chris has been working with business owners and their advisors for over 30 years and is now focused on helping his fellow baby boomer business owners through his firm, Mercer Capital. Chris, thanks so much for coming on the show.
Chris Mercer: Thanks, Noah, glad to be here.
Noah Rosenfarb: So I’ve got a copy of your book in my hands, Unlocking Private Company Wealth. I love it. I love the concept of The 1% Solution you have in here and really, the core key of the switch is privately held businesses need to manage their business the same way that they look at their portfolio and the valuation of their company. Where did you come up with this idea and did I encapsulate it well enough for you?
Chris Mercer: Well, I came up with the idea a number of years ago. We value, in the normal course of business, a fairly large number of asset management firms and that’s a very nice business model because they charge fees for managing the fund, the retirement funds or other funds, based upon a percentage of the assets under management. One day, I was thinking about the fact that business owners begrudged spending almost anything, or in many cases, begrudged spending almost anything on managing the wealth in their business. I am not talking about managing the business because we all have to manage our business.
What dawned on me is that if we allocated a percentage of the value of our business to create the budget to manage the wealth in the business, and that is to do the estate planning and the vital life insurance and to get the appraisals and to do whatever else needs to be done. I make a long list of those kinds of activities in the books but if we allocate that budget, then we create the opportunity for some real planning. I think that the wealth in private businesses should be managed with the same degree of intensity and respect that is accorded to retirement funds and other liquid assets by the money management industry. So I said 1%, 1% of assets under management is fairly typical for an equity manager so I called it The 1% Solution. That’s where the concept came from.
In 2007, I was asked, I talked about that in a speech, The 1% Solution, just in passing and a gentleman asked me if I could give a speech on that topic alone, The 1% Solution, and I said, "Well, yes I will and I will write a little booklet that we can hand out to everybody who is there," and I called it The 1% Solution. We have distributed several thousands of those and it has been an interesting little piece to have. I decided to write the second edition of The 1% Solution and when I sat down to begin to write it, I realized that I needed to write a little bit more than just a really about a 15-page overview of managing private company wealth. The end result is Unlocking Private Company Wealth, which incorporates The 1% Solution in the first section. So that’s kind of where the book came from and that’s what the general concept is all about - managing wealth in private businesses.
Noah Rosenfarb: What would you say are the challenges that entrepreneurs face when thinking about ways to manage their wealth and their business?
Chris Mercer: Well, one of the biggest challenges is overcoming inertia. It is very easy to stay busy in your business and not focus on the important things that need to happen. I talk about in the book, I talk about a concept of, think about where you are right now in your business if you’re a business owner. Just think about that, where you are right now, where your business is, and I call that now the current status quo. And then I introduce the idea of thinking about the end game, that is where you are trying to get with your business and what would be a desirable outcome in terms of a third party sale, internal management transition, gifting, or sale to children, whatever the case might be, but to think about the end game.
Now, the time in between, I call that the interim time. The interim time is the time when we’re all busy running our businesses and it’s really easy day by day, week by week, month by month, not to do some of the kinds of things that are important to do if we want to manage wealth. Some of those things are just looking at your wealth as an investment. Most business owners can’t tell you what kind of rate of return they get on their investment in their business and it’s the biggest asset in their portfolio. They know to the tenth of a percentage point what their profit sharing plan returned last year or what funds that they have with another asset manager have returned because they think about those things, but they don’t think about the return on the biggest asset and they don’t think about what they can do to liquefy some of that wealth before you end up selling it maybe and then diversifying and creating a much more diversified portfolio so that over time, in many businesses, if owners focus on it, they can become wealthy independently of the business. When they do that, then they have true independence and wealth.
Noah Rosenfarb: When dealing with that specific issue of diversifying outside of the business and monitoring the wealth inside the business, the owners that I talk to, they seem so laissez-faire about what the business is worth because they say," Well, it’s not for sale and so I’m measuring how much money do I get out of the business. That’s my own barometer." What do you have to say to them?
Chris Mercer: Well, what I have to say is it matters what your business is worth. It matters that you take care to diversify while you can because think about this, you’ve been involved with many business owners. I’ve been involved with many. Most of the time when a company sells, most of the time when a company sells, the owner did not have a conscious plan to sell the company six months or a year before the sale occurred. An unexpected something came along. Something triggered and there was an adverse event at the company that forced the sale and a change of heart, all kinds of things happens to create something unexpected. Well, bad things happen even to good companies and it’s not my advice to any business owner to leave all of the eggs in that same basket until some indeterminate time in the future when you hope that you have a successful exit.
Noah Rosenfarb: Yeah. Have you seen that play out? Can you share a story where somebody came to you after an aftermath and said, "Chris, is there any way you could help me pick up the pieces?"
Chris Mercer: I have a better story than that. It happened before. A number of years ago, about 13 years ago, we were talking with a company in the aircraft interior business. They refitted aircraft interiors and they had a booming little business. They called us to talk about our representing them to sell the company and so we prepared an engagement letter. We talked to them. They said that it’s a go but they waited almost six months before they signed the engagement letter so that we could get started. We executed a process that was as rapid as possible. We had interested buyers in the company and we were down to one small due diligence question that was going to be fairly easy to resolve. The buyer came to the company. We came, we met, we pretty much resolved that issue, and then a few days later, two aircrafts slammed into the towers in New York City. Six months later, this company was bankrupt because its business was gone. So my point is, and this is just a dramatic example to emphasize the case, these guys waited until it was too late.
My advice to business owners is don’t wait until it’s too late to diversify and to work on the business. That doesn’t mean you’re selling the business necessarily. Maybe that means you’re focused on dividends or distribution policy, but do things that you can while you can because when it’s too late, Noah, it’s too late. Just like you want to get financing to do something, well, if financing is available, that’s good. If the company is doing well, that’s good, but if you wait until the day after the market shuts down, it’s too late. You won’t get the financing. If you wait until something bad happens to your company’s performance, it’s too late. You won’t get the financing so it’s my belief and the belief is based upon my personal experience at Mercer Capital and interviewing, talking with, and working with many, many business owners over the last 30+ years that it is better when business owners focus on the inevitable transitions that are going to occur in management and ownership, and plan, plan to diversify while they can. A good example of a potential for diversification would be a leveraged dividend.
Noah Rosenfarb: Why don’t you explain that concept? I find most owners have a very limited understanding of the capital structure in their company and they know they could go to the bank for debt if they are going to buy something or they need money, but they don’t really grasp the concept of going to the bank to get money that they are going to take out of the company.
Chris Mercer: The concept is really very simple. You have a company that’s profitable, that in many cases is underleveraged, maybe has no leverage at all. You have no desire to sell the business or the owner has no desire to sell the business, wants to run the business, wants to continue to grow the business. One of the things that you can do is go to the bank and borrow, let’s just say, just make the number real, borrow $5 million or $10 million depending upon what your EBITDA is, but maybe two or three times EBITDA. Borrow that money. Pay it out as a special dividend, as a leverage dividend, you recapitalizing the company with debt. You have money that you take outside of the company. You can diversify with that. You have liquidity outside of the company. You have a company that is not overleveraged and you have a bank that’s happy because they are lending to you instead of holding cash for you. So they make more money that way.
So the idea of a leveraged dividend recap is not something that I made up or something that’s new. If you read about private equity in America, you know that they’ve had a hard time selling some of their 5, 6, 7, 8-year-old investments where they typically like to diversify every 5-7 years. What have they done? When they couldn’t find an acceptable selling price, they have gone to a bank or gone to financing, obtained financing, paid out leveraged dividends, provided funds to return to their investors, and then they still have a good investment. The idea is I tell company management that it is a bad thing to keep cash in the company. You say, "Well, I want to keep cash for a rainy day." Well, you don’t keep cash in the company for a rainy day, at least, I don’t think you should. Take that money out. Take it out and diversify with it. If you have a great investment opportunity, you can always put it back in the company but it’s always a good idea to get assets out of the company.
The interesting thing about a leveraged dividend recapitalization for example is that the return on equity goes up. Your equity goes down, your earning goes down a little bit because you don’t have earnings on the cash. You’re paying on the debt but your return on equity goes up and as you pay down that debt, you return on the investment that remains on the business is accelerated significantly. So it’s all about managing wealth, get money outside so you can diversify your portfolio so that you can become independent of the business where one of your options then becomes, I will be an investor-owner. That is an option that most owners never thing about.
Noah Rosenfarb: I brought this idea to a variety of clients and I’ve had a difficult time getting buy-in because what I find is that there’s this emotional attachment to being debt free, at least to the companies that I’ve spoken to about this, they essentially had no debt on the books. Maybe they had a working line of credit for some seasonality but there’s no real debt on their company. It’s like a badge of honor and my attitude is I think it’s a badge of poor management and so there’s this conflict inherent between a financial mind like yours or mine that says, "Wait a minute. If we insert some leverage, we get the capital structure more efficient. We’re going to have a higher return on equity and then we could take the proceeds and investment outside this company and even if we don’t exceed the cost of capital, then we still have these benefits of diversification."
But owners, at least the owners I’m talking to and you know kind of in this lower end of the middle market people whose companies are worth $5-$100 million, it has been a struggle for me to get this education and get over this emotional hurdle the same way it is for people that like to pay down their house and have the house paid off.
Chris Mercer: Sure. Well, it’s all a matter of managing wealth to me and my question to the business owner who has no debt, who may be, in many cases, accumulating cash or other excess assets, securities and portfolio, the economic effect of that behavior is to continually drive them the return on equity or the return on the owner’s investment.
Now, if that’s what the owner wants and that’s what makes them comfortable, I guess that’s okay but management comfort is not a reason to keep cash. The owner in that situation needs to separate himself, separate his roles between that of a manager and that of an owner. As an owner, he would want some reasonable amount of leverage. As a manager, maybe he is comfortable with the cash on the balance sheet or the accumulation of cash.
I’ve been working with a client. I think maybe this year it will happen. I had been asking them to consider a significant leveraged dividend recapitalization for, I guess, three years now. Maybe this is the fourth year. It’s that ideal candidate. They have been paying down debt almost to the point where they are debt free and accumulating cash. Return on equity has been driven down. This is the case where a modest amount of debt with the payment of cash out could create independence for the owners, independent of the business forever and they still have the business. I think the owners are maybe finally coming around. So it’s not necessarily an easy talk but we as advisors, I think, have to have that kind of conversation. I explained to them that I feel the responsibility to them to make that opportunity available to them.
Noah Rosenfarb: The leveraged dividend recap is maybe, at least in my mind, a tougher discussion than implementing an dividend policy, and I think one of the things you do eloquently in the book is lay out all the positive attributes of companies implementing a dividend policy. Just anecdotally, I was in a CPA firm. I was a partner in a CPA firm which my father was the founder of and I never understood why he didn’t get a dividend. I used to beg him to start paying the dividends. It’s separate from compensation because then the ownership would have value.
He never listened to that advice but now in one of the privately held businesses that I own, we’re out of the gate and in a position where I want to pay the dividend and so I’ve told the CEO. He’s got the first dividend payment coming up on January 15th and he’s feeling the pressure. I said, "You know, it’s exactly what it’s there to do. I want you to have to make capital allocation decisions with pressure and not feel like there’s all this free cash flow that you could readily reinvest. Why don’t you just share a story with me of some companies that implemented a dividend policy and the impact it had on the family and the owners themselves?
Chris Mercer: One of my early clients, and going back to the late 1980s, was a company, it was an auto parts supplier. They had been growing fairly rapidly and the primary owner of the company had brought his sons into ownership of the business. He called me up one day. He was ahead of me in this regard and he said, "I’m thinking about implementing a dividend policy and I want your help in deciding what that dividend policy should be." Well, Noah, I didn’t know much about dividend policy at that time so I began to read everything that I could possibly could and looked at some public companies and they were paying a dividend that average yield about maybe 2.5%. He was growing a little more rapidly and so I came back with this miraculous recommendation for a policy. "Why don’t you pay a dividend of 1.5% of value?" We were valuing the company every year for the family for planning purposes and because this owner had wanted to measure his progress in his company.
So they implemented that policy of a 1.5% dividend. I think the dividend at that time was about $300,000. What that did was it created the opportunity for his sons to begin to diversify in their ownership and for him to begin to diversify in their ownership. They maintained a similar dividend policy until they sold the company in the 1990s. That experience made me realize that every company has a dividend policy. It may be that I’m going to ignore dividends and not pay them but that’s a policy. Not a very good one maybe but I make the point in the book that every company has a dividend policy. So why not have one that helps drive value? If you pay a dividend on a regular basis and do not accumulate excess assets, 1) your return on equity will be good, 2) if you get that cash out of the company and it’s not part of working capital on a regular basis, if and when you sell the company, you won’t be arguing over whether that cash is needed in working capital or not. So to the owner that wants comfort for cash on the balance sheet, I would just say that they are setting up a future discussion to discount that cash on the part of the buyers because the buyer will want that cash in working capital so that they can take it out and pay off debt dollar for dollar.
But I think that the dividend policy is critical for service companies. You said, "Dad, why don’t you pay a dividend?" because if there’s a dividend, then someone can buy that dividend stream and pay something for it. That’s what I call identifiable earnings. The earnings over and above compensation that is paid pro-rata to ownership, and when those earnings are clear, then you’ve created transferable value, which is another concept in the book. It’s value to an owner. This company may be priceless for emotional reasons, for ego reasons, or whatever but unless it has value that is transferable, unless it has value that somebody else will pay for, then it really doesn’t have the kind of value it’s going to create independence or a good end game.
Noah Rosenfarb: What do you think of transferable value? How would you define that different than a valuation, or is it one and the same?
Chris Mercer: In a typical company, value is fairly clear. We would normalize salaries. We would create a value and then the owner, if he sold the business, would be contractually bound to keep the salary that was normalized. Where this issue is really critical is in all kinds of service related companies where people did crazy things like payout all the earnings so as not to pay any taxes. Well, a better policy would be to be sure in service companies that we have a clear distinction between return on labor and return on capital because if you have clearly distributable earnings that are over and above all labor costs, then those earnings are identifiable and they can be capitalized. If you don’t have those numbers, then you’re arguing over what those numbers should be or if you want to make an internal transfer, then there are no earnings really for someone to buy. So you may have eliminated the possibility of an internal transfer by not separating return on labor from return on capital or ownership.
Noah Rosenfarb: Well, my advice to family businesses is to do the same thing. When they have family members that are shareholders and employees, and perhaps they have family members that are shareholders but not employees, and essentially, it’s creating the same distinction so that people understand what is the compensation for their effort and what is their reward for ownership because without that distinction, there is a high probability of family dispute.
Chris Mercer: Well, in many family businesses, the people who are in the company may have a tendency to think that because of their efforts, the company is so valuable as opposed to thinking that because of the investment of my other family members, I’m able to run this successful company.
So they want to take non pro-rata benefits out of the company. Well, those non pro-rata benefits, excess salary for example for an owner running a business over and above normalized compensation is really a non pro-rata return to one shareholder, and there’s no wonder when that happens that the shareholders who are not working in the company feel wronged. It’s just one of those things where in the family business, there is a clear distinction between the return on labor and market wages are paid to the people who have jobs in the business, and then return on capital which is a pro-rata distribution to all of the shareholders. When that occurs, generally speaking, you don’t have those issues.
Noah Rosenfarb: You shared a lot of stories in the book about companies that did different things to manage their private wealth. Why don’t you share one or two of those stories that you want to make sure all of our listeners here?
Chris Mercer: Okay. A number of years ago, one of our guys went to visit a regular client and this regular client was somewhat frustrated. His wife was on his case because they had very little liquid wealth outside of the business. His business ownership interest was probably worth $35 million at that time. He was a controlling shareholder but not the total shareholder of this business. So in his frustration, I had talked to him about this a few years before and he remembered that when my guy was down that year a few years ago and my guy got us together on the phone and we talked. So I called his name, Norm. Norm and I got together and basically, I said, "Norm, we’ll work together and we need to accomplish a few things."
Norm was in his late 70s. So his interim time was not that long. I said, 1) "We’ll hire a chief operating officer." He made a search and we got some help, and he hired his COO. That was good to help training his children to help manage the business who were in the business. 2) We converted him from a C Corporation to an S Corporation, which was wonderful because they had an ESOP that owned maybe 20% of the company so that was a brand new cash flow stream to the ESOP. The CFO still loves me. I said, "We need to do a leveraged share repurchase and buy some of your stock to get," $10 million was his number, "a $10 million net of taxes out of the business."
So we went to the bank, at the Cooperative Regional Bank, arranged a financing that was workable and did a leveraged recapitalization, bought back a portion of his stock, got his $10 million out of the business. Fast forward a few years, the debt has all paid down. They had repurchased some stocks so his ownership position came back close to where it was before. So when he died a couple of years ago, his wife was secure, the business was in good shape, and he had done a good job in that short interim period of working with us and with a number of advisors to make all of those things happen.
He could have just run the company and never had the money outside. He could have just done a lot of things but he did a small handful of things that made a huge difference in his end game, and that’s what I’m really suggesting to business owners to day and to advisors who talk to business owners. Have these kinds of conversations because it does make a difference. There is no question that it made a difference in this company’s value and in this family’s diversification. His wife is independent of the company. The company continues to do well fortunately and is being run by one of the children.
Noah Rosenfarb: That’s great.
Chris Mercer: None of those things would have happened if we hadn’t had that conversation.
Noah Rosenfarb: And it’s like you said, these may seem like big changes, taking on debt, but the reality is they are very, you know, small, slight changes in the way people do business and they open up worlds of opportunity.
Chris Mercer: Right and I will say this, I would never recommend that a private company take on four times, five times, six times EBITDA, debt to engage in these kinds of transactions. I would much rather take on 2-3 times reasonable amount of leverage, get that taken care of, and then do it again over time as opposed to putting the company at perhaps undue risk.
Noah Rosenfarb: Yeah, well what would you like to leave our listeners with before we end today’s podcast?
Chris Mercer: Well, I would leave with the idea that if you’re a business owner or if you’re an advisor to a business owner who is talking to business owners, think about where you are today, your current status quo, and then if you’re an advisor to a business owner, talk to the business owner about what his or her end gain really is and try to get that picture because reaching that successful result will occur in the interim between those times, in the future time that I call the interim time and literally, one or two or three decisions that are effectively implemented can make a huge difference, as in the example of Norm that I just talked about in the family’s wealth, in the position of the company, and in just terms of overall happiness because once that deal was done, his wife was secure, that she didn’t have to worry about a thing regardless of what happens to the company, and that’s what I call independence.
Noah Rosenfarb: Yeah, terrific.
Chris Mercer: So I would leave, think about now, think about then, and think about the two or three things that need to happen, and maybe it’s the implementation of the dividend policy that keeps on. It is not necessarily just one or two things, but it’s what am I going to do that make me able to, I guess, dance in the end game or dance in the end zone. There’s a book, Dance in the End Zone, by Patrick Ungashick. It’s a beautiful image, though. You want to be dancing at your end game.
Noah Rosenfarb: No doubt about it.
Chris Mercer: You’ve got to be dancing at your end game.
Noah Rosenfarb: So Chris, as people would like to seek your wise counsel or find out more information about the variety of books you’ve written and papers you’ve written, how should they get in touch with you?
Chris Mercer: Anyone can call me at 901-685-2120. A good place to go would be my blog at www.ChrisMercer.net, of course Mercer Capital’s website, and my email is MercerC@MercerCapital.com. I answer all calls and I answer all emails.
Noah Rosenfarb: Terrific. Well, thanks so much for joining us today. To all our listeners, please stay tuned for more great guests. Feel free to rate us on iTunes, share your feedback with us on Divestopedia or send me an email at email@example.com if you have a suggestion for a guest. Thanks again and hope to hear from you soon.