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Your Shareholders May Be the Greatest Risk to Your Stock Value

Managing risk is essential to maximizing the value of your firm.  As a result, business leaders are challenged to mitigate risk by staying on top of all aspects of company operations. However, firms are often overlooking the age demographics of their shareholders.  Far too many firms are not incorporating ownership planning into their strategic plans and this is increasing the risk of NOT achieving your strategic plan.

Appaisers assess business risk by relying on historical financial performance to derive their understanding of the operating risks.  If profits are too high they may question the sustainability of the current profit margins. If revenues (and hopefully) earnings are growing faster than the overall economy, they will assess the sustainability of the current growth rates.  As such, a business appraiser will assign a discount rate to reflect the risk the future cash flows based on current performance.

Liquidity risk of a stock in a closely-held company is more difficult to assess because the factors that impact the discount for lack of marketability are more intangible in nature.  When comparing the stock value of a closely-held company to a publicly traded company with similar services and risks, an investor can reasonably expect a discount for lack of marketability ranging from 20% to 45% on the value of the closely-held company.  An investor is able to dispose of his investment in a publicly traded company at any time so long as there is a market for that stock.  But closely-held firms do not have a public market for their shares and usually have restrictions on who can own the shares (usually employees of the company).  In fact, most shareholders typically hold onto their investment until they terminate their employment with the company.  That inability to dispose of their investment in a timely manner increases the investment risk.  Factors that impact the discount for lack of marketability include the attractiveness of the industry, volatility of cash flow, future prospects for the company within the industry it serves, and quality of the management team.

However, another factor that we are seeing more frequently as a risk to liquidity is the age demographic of shareholders.  We are currently seeing increasing repurchase obligation risks among our clients as more Baby Boomers begin to retire.  As a result, the supply of shares is exceeding the demand and this is having an impact on a firms’ future available cash flow.

There are five forces competing for that available cash flow that leaders must manage efficiently.

  1. Working Capital – Firms must “invest” cash until a client pays its invoice.  The longer it takes to collect on its accounts receivable, the more cash that is required to be invested in the company.  The most common working capital accounts demanding cash are accounts receivable and work in progress, or WIP.
  1. Debt Obligations – Many firms will finance some or all of their capital investments in order to limit current uses of cash.  Sometimes the demand for cash is so strong that companies are forced to borrow in order to meet those demands.  Most common sources of creditor financing are lines of credits, term loans for capital investments, and shareholder seller notes.  The latter usually occurs when companies redeem shares from a shareholder.
  1. Capital Expenditures – The most common types of capital investments made by an A/E firm is often represented by computers, office furniture, field equipment, vehicles, and software (Auto-Cad ® and ERP systems).  In high growth A/E firms, it is also not unusual to see significant investments in leasehold improvements as firms acquire more space for its employees.  Many firms will exercise greater discretion in deferring capital expenditure when cash flow is weak.  In professional services firms, the risk of deferring capital investment is much lower than a company that is asset intensive, such as a manufacturing firm or a real estate company because the key underlying assets of professional services are the people – labor.
  1. Incentive Compensation – Many firms, in order to attract, retain, and motivate their employees, offer benefits above and beyond their base salaries.  While most incentive compensation plans are often tied to company and individual performance, employees of many A/E firms have become accustomed to seeing incentive compensation as part of their overall compensation package that it has become, for better or for worse, a standard benefit plan.  
  1. Return on Investment – Critical to ensuring liquidity of common stock in a closely-held company is the ability to make available current returns on investment – dividend payments.  An A/E firm is likely to generate most of its return requirement on current returns rather than long term returns (stock appreciation).  As a result, many shareholders of closely-held companies have come to expect an annual distribution of profits based on their pro rata interest in the company.

In the event that the future repurchase obligations consume increasing portions of your firm’s future available cash flow, will your firm be able to adequately fund the five sources of demand for cash? We have seen an increasing number of firms trying to meet their repurchase obligations by deferring capital expenditures, reducing incentive compensation and reducing profit distributions. Deferring capital expenditures for an extended period of time can limit your firm’s ability to compete in an already tight competitive environment – especially if you haven’t been making significant investments in technology. Reducing incentive compensation so you can allocate your profits to former employees to satisfy the shareholder notes can leave your employees disillusioned – especially if the company is performing well.  Reducing profits allocated to shareholders, reduces the dividend pay-out which in turns reduces the liquidity of the shares.

I have been conducting business valuations for 25 years and never have I witnessed more A/E firms either implementing or considering ESOPs than today. As a result of firm leaders incorporating ownership planning into their strategic plans, more A/E firms are finding that ESOPs can be the vehicle that increases the available cash flow to meet the needs of the five sources of demand.  Plus there are great tax incentives that can increase the liquidity of your shares.and companies that sponsor an ESOP, for the most part, enjoy lower discounts for lack of marketability than non-sponsoring firms. It is important to note, however, that ESOPs should not be considered the solution to all of your shareholder liquidity issues

Ownership planning must be closely tied into your strategic plan. Understanding your repurchase obligation will allow you to see if your future growth objective is even feasible given the availability of cash for future growth.  If this is a concern of yours, you’re not alone, at Rusk O’Brien Gido + Partners, we find that the two biggest challenges facing companies today are sustaining growth and repurchasing shares of retiring employees. Give us a call if you think we can help your firm.