Enterprising families elect to “prune the family tree” for manifold reasons. For some, intra-family tensions have reached a breaking point, for others, there are different perspectives regarding the long-term prospects for the family businesses, and in yet others, different shareholder clienteles emerge with unreconcilable risk and return preferences.
Regardless of the reason, significant shareholder redemptions are among the least understood corporate transactions. In this week’s post, we consider the economics of family shareholder redemptions from three perspectives: the selling shareholder, the family business, and the remaining shareholders. Balancing these competing perspectives is one of the greatest challenges of executing a significant redemption.
The Selling Shareholder
When it is time for one or more shareholders to make a graceful exit, the economic interests of the selling shareholder diverge from those of the Company and the remaining shareholders.
- For the departing shareholder, sustainability of the family business ceases to be a guiding principle. The departing shareholder wants to maximize his or her proceeds from the sale of their stake, regardless of the burden such a purchase price could place on the business going forward.
- Most selling shareholders want cash when they sell their shares: trading one piece of paper (a stock certificate) for another (an interest-bearing note) is rarely perceived as a meaningful benefit. Selling shareholders presumably have some plan for deploying proceeds from a sale and receiving cash for their shares is likely an essential component of that plan.
Knowing what selling shareholders want is just one-third of the picture, however, we also need the perspective of the company itself and the remaining shareholders.
The Company
We use “the Company” to refer to the management team, employees, and other stakeholders who are not shareholders but do have a vested interest in seeing the family business grow and persist as an independent company.
- Cash used in a redemption is cash that is not available for investment in productive assets that can help the Company grow. If a redemption is going to occur, the Company is one of only two parties that can pay for it. Companies pay for shareholder redemptions by either (1) not making corporate investments in productive assets that would otherwise be made, (2) using existing liquidity, or (3) borrowing funds. Each of these options, in their own way, diminishes the Company’s ability to grow or flexibility to respond to emerging strategic opportunities or threats.
- From the perspective of the Company, these negative outcomes can be mitigated by paying the redemption price over time, using a note that is subordinated to all other corporate obligations, bears interest at a favorable (i.e., low) rate, and has flexible repayment terms.
- The redemption price matters to the Company because a price that is set too high may spark a “run on the bank” which leads to sale of the business. On the other hand, a price that is set too low may also prompt shareholders to explore selling the Company as the only way for those shareholders to “unlock” the value that has been created over the preceding years and decades. Regardless of the path taken, the Company would generally prefer to avoid a sale of the business.
- Above all, the Company craves certainty. If there are going to be claims on corporate cash flow for redemptions, the Company wants to be able to plan around the amount and timing of those obligations.
We were careful to distinguish between the Company and the remaining shareholders because – while there is significant overlap between the two – the interests of the two parties do not align perfectly. So we need to consider the perspective of the remaining shareholders separately.
Remaining Shareholders
If the Company doesn’t pay for the redemption, the remaining shareholders must. If there is no interest in bringing in a non-family source of equity capital, the remaining shareholders will pay for the redemption through diminished dividends or smaller ongoing redemption pools.
- There are only two potential sources of return for family shareholders: income return from dividends and capital appreciation from a growing value per share. From the perspective of family shareholders, funding a significant shareholder redemption reallocates at least a portion of their return from the income return bucket to the capital appreciation bucket. Since the benefit of capital appreciation is deferred to the future (perhaps even to one’s heirs), many family shareholders value current income more highly than capital appreciation. These shareholders find the prospect of trading away current income for greater capital appreciation distasteful.
- In view of this shift in return components, the remaining shareholders naturally want the increase in capital appreciation to exceed the decrease in current income associated with a significant redemption. How can this be accomplished? By paying a discounted price and/or financing the redemption with a shareholder note, which is what the selling shareholders naturally want to avoid…
The Great Balancing Act
As we said at the beginning of this post, enterprising families have a variety of reasons for pursuing a significant shareholder redemption. Regardless of the reason, executing a large redemption is a great balancing act. There are three parties to the transaction, each of which brings a unique perspective and set of needs and preferences to the deal. Structuring a redemption requires each of those parties to understand the perspectives of the others and acknowledge that tradeoffs will be inevitable. Careful modeling of the financial consequences of the redemption on each of the three constituencies is a necessary component of completing a redemption.
Necessary, but not sufficient. Financial modeling of the transaction should be situated in a broader context of what the real goals of the transaction are and what tradeoffs each of the parties to the redemption is willing to make. Only when the goals and tradeoffs are identified will the parties be able to identify a financial model that supports the great balancing act that is a family shareholder redemption.
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