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Using Waterfalls in Exit Planning

  • July 01, 2019 11:21 AM
    Message # 7721576

    One of the most useful concepts in business planning is that of “waterfalls.” The analogy is apt, if perhaps less than perfect. Think of any outcome anticipated in a contract that is based on an “if…then” situation. It can likely be served by structuring waterfalls.

    I originally started using the term in buy/sell agreements. When a shareholder chooses to leave (or is forced out,) the options for purchasing his available stock are waterfalls. The first option may be for all the the shareholders to buy the stock in proportion to their existing ownership. If not all the shareholders wish to purchase, the “waterfall” or back-up option is for any subgroup of shareholders to buy the stock.

    The next waterfall is for a single shareholder to purchase all the surrendered shares. The final waterfall, if everyone declines the opportunity, is for the company to buy the shares as treasury stock. Each option level is defined in priority order and has its own time frame for exercise.

    Waterfall Distributions

    Recently I saw a business structure where the profits were distributed through waterfalls. (This is pretty much an advantage of using an LLC.) The investor partners received 100% of the profits until they reached a defined return on their investment. (This was a cumulative right, similar to cumulative preferred stock.) Once the target ROI was reached each year, there was a split of the profits between the investors and the managers, with the investors share being considered a return of their original capital. Finally, when all the capital had been repaid, there was another shift where the managers took the lion’s share of profits. The investors received some additional profit participation on a permanent, ongoing basis.

    How can this work in exit planning? Often a seller has a target number in mind for retirement funding to be generated by his or her company. That number can be come from operating income, or from the proceeds of a sale.

    Waterfalls in Leveraged Buyouts

    When the buyers are employees, they likely purchase some or all of their shares in installments. The pricing is at a fixed valuation, or may use a formula that rises and falls with the profitability of the company.

    It’s simple enough to develop waterfalls. Once the owner has received a target amount of operating income each year, the employee/buyers get a higher portion of any overage to apply to their stock purchases. Once the stock is paid for, the owner has an upside of more than the original planned price for the business.

    Structured correctly, waterfalls can be highly motivational (and lucrative) for all parties in a transition. As profitability rises, the buyers get paid-up equity more quickly. The seller has the ability to receive more than the originally anticipated price. Everyone shares in the rewards of their work.

    This article was originally published on my exit planning blog at Awake at 2 O'clock?

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