Several national manufacturing companies have gone public or obtained significant private equity investment this year — raising funds for expansion while giving owners an opportunity to cash out and exit. Based on these high-profile transactions, it is tempting for business owners in our community to think that when they are ready to retire, and that there will be buyers lining up to acquire them with premium offers.
Unfortunately, that is not the case for many businesses in our region. Most closely held, small-to-mid-sized local manufacturing companies do not go public or sell to a financial or strategic buyer. Rather, these companies more often develop successors from within — who are integrated and are transitioned into ownership over a period of years. Other companies experience unplanned transitions when events such as a death, disability or divorce occur. Businesses that are equipped with both a longer-term succession plan and a short-term contingency plan are most likely to have successful transitions. Those without plans tend to liquidate or have a forced sale, which yield low prices.
Transitions are imminent for many of our local manufacturing companies, but most owners are not planning for them. According to the 2018 State of Manufacturing in the Pacific Northwest survey conducted by Schwabe, Williamson & Wyatt and Aldrich CPAs + Advisors, 60% of respondents stated that they plan to transition out of their business within the next five years. However, only 41% of respondents reported having a plan to transition their business. It is best to start planning for a change in leadership and ownership at least three to five years before the expected transition. This allows time to identify criteria and steps toward developing new candidates either from within or outside of the company.
Many local manufacturing companies will transition by handing over the reins to a key employee or member of the management team, or to a family member with a desire and qualifications to run the business. A challenge to these transitions can be the financing — often younger employees or family members do not have significant funds available to put towards an equity purchase, nor do they want to be saddled with long-term debt to the seller.
However, creative business structures can facilitate the granting of profits interests to key employees that provide an opportunity to share in future growth. These structures can allow employees to receive profits-only ownership interests for a much lower cost than would be charged if they were to purchase capital ownership of the business, providing a strong incentive for recipients to stay with the company and grow it. Advance planning is critical to implement these types of structures.
In Southwest Washington’s manufacturing sector, a shortage of skilled workers to fill positions translates to a smaller pool of employees who may eventually become owners. As a result, owners may have a difficult time identifying and developing suitable successors internally. In some cases, that may require looking outside the company to fill leadership positions and offering those external candidates an opportunity to acquire ownership. Granting ownership to an outsider can backfire quickly if not done properly. Care is needed to ensure that other owners are comfortable sharing ownership with someone outside the company.
In many cases, setting up equity grants that vest over time — based on financial or operational benchmarks — is appropriate when offering ownership to an outsider. Even synthetic equity such as phantom stock or stock appreciation rights — under which the recipient is granted contractual economic benefits similar to stock ownership — can be an effective way to incent new leadership with awards that do not actually give up voting control.
Understanding and maximizing a company’s value is important for most sale transactions. A factor that can affect the value of manufacturing companies is the strength of its supply chain. Written contracts with suppliers that clearly define the parties’ rights and obligations are critical. This has become even more important in recent years with the proliferation of data protection and privacy regulations and product disclosure requirements applicable to manufacturers. Some suppliers will provide form contracts with onerous provisions that shift risk to the purchaser for things like the supplier’s negligence and upstream product liabilities. Business owners need to understand what their agreements obligate them to do so that they can plan accordingly for the risk. The failure to do so can decrease the odds of a successful company sale.
Everyone likes to have options, particularly when it comes to selling their business — one of the most significant transactions of their life. Maximize your options by planning now so that you can be prepared to act quickly and confidently when a transition opportunity arises.
Matt Bisturis is an attorney in Schwabe, Williamson & Wyatt’s manufacturing, distribution and retail industry group. He helps companies and their owners navigate the legal challenges that come with establishing, growing, operating and eventually transitioning their businesses. He can be reached at 360-905-1113 or firstname.lastname@example.org.