Originally published in Financial Advisor

By Mark Hurley

If you go to an upscale grocery store these days, you will find that they no longer sell cold cuts but instead offer “artisanal cured meats,” including “mortadella.” As elegant as all of that may sound, what we are really talking about here is “baloney”; yes, a slurry of undesirable beef parts pureed with lard.

Similarly, if you are thinking about selling your wealth manager, you are probably besieged by a multitude of prospective buyers, many of whom proclaim to have a magical and elegant stock for which you should swap at least a portion of the ownership in your business.
Certainly, in a handful of cases, the stock they are offering may actually be a quite attractive asset that you should consider taking. Unfortunately, however, more often than not what they are selling ain’t quite what they say it is.

The challenge for any prospective seller is to figure out how to separate the true “artisanal cured meats” from the baloney. Please allow me to propose four questions that you might use in doing so.

1. What cash flow am I going to get on an ongoing basis from these shares?
Some buyers (most typically other wealth managers) offer equity that pays out an annual distribution. And if it is likely that you are going to hold the stock for a long time, the size of these distributions could make owning these shares very attractive.

Unfortunately, the wealth management landscape is littered with people who took stock and got a lot less ongoing cash flow than they expected. Most often this is because they did not insist that their distributions be contractually formulaic and tied to the buyer’s gross profitability—in other words, their distributions get paid before the people who control the company get paid anything. Absent this kind of protection, distributions are largely subjective and solely at the munificence of the buyer.

2. What kind of liquidity does the stock have?
Many (if not most) buyers offer stock that does not pay any cash flow. Thus, the only value you are ever going to get from owning it is entirely dependent on your ability to sell it in the future.

Unless the buyer is a public company with a very liquid stock, you should not bet heavily on any future sale. An obvious alternative is to require that the buyer provide contractual liquidity as part of the deal.

However, don’t be surprised if more than a few prospective buyers view you raising this topic as about as welcome as a discussion of botulism at a potluck dinner. Providing contractual liquidity requires that they set aside some capital and none of them like to do that.

More importantly, they would rather stick you with the risk that the stock ultimately is nothing more than worthless script.

However, if they really believe that the stock that they are offering is worth anything close to what they claim, they should have no trouble getting the capital necessary to provide you with contractual liquidity. Why? Because private equity firms are currently awash in money and are desperate to put it to work. It is like they are breast-stroking their way through an ocean of hundred-dollar bills.

For example, I spoke recently with the managing partner of a major financial services PE firm who indicated that its greatest challenge is finding investment opportunities. And while only a few years ago his firm would only consider those that would enable it to invest at least $125 million of capital, today it will consider opportunities that are half that size but it is having a hard time finding them.

Hence, the issue is not whether a buyer can provide contractual liquidity but whether it wants to.

3. What am I really getting—equity or out-of-the-money stock options?
One of the more clever tactics used by some buyers involves using valuation experts to say what their stock is worth. And the buyers use these analyses to persuade owners to trade their current equity—illiquid stock in a company that they control and which throws off a lot of cash flow—for illiquid stock that throws off no cash flow and is in a company that they do not control. (Of course, what the buyers don’t mention is that these experts wear a hat with moons and stars and talk about animal spirits and qualify the daylights out of their conclusions.)

We think that some buyers have adopted this tactic because they realize that the stock that they are offering is much closer to out-of-the-money stock options than real equity. More specifically, these acquirers’ capital structures typically have quite substantial (i.e., as much as $700 million to $800 million) of senior obligations such as preferred stock and debt that must first be fully paid before the common that they are offering ever receives a penny. And given the size of the claims that must be satisfied ahead of it, a lot of different things are going to have to line up perfectly if the common is ever to going to be worth anything.

In other words, what you are getting isn’t exactly equity as most people think of it. And it is certainly a lot less valuable than just holding on to your own stock.

4. What protections do I have from my economics being changed?
Most importantly, a less obvious but far more insidious risk involved in taking someone else’s equity is the potential for a “cram down,” i.e., the acquiring firm’s owners decide to unilaterally alter the company’s capital structure by placing new claims on its value that are ahead of yours. If this happens, the value of the shares that you received in exchange for your firm could be eviscerated in an instant.

Unfortunately, this is a fairly common outcome with many buyers because their operating agreements give the controlling shareholders extremely broad authority to do what they believe to be is “in the best interest of the company.” But what they decide is in the best interest of the company may be very different from your interests.

Similar to what I described earlier about distributions, any sane person thinking about taking stock from a buyer needs a series of detailed, contractual protections against the buyer unilaterally changing the value of what they are getting. Otherwise, there is a real possibility that all you will ultimately own is sand.

Avoid The Baloney And Maybe Keep Your Business
The bottom line is that, if you want to sell your business, in many if not most cases it makes the most sense to find an all-cash buyer who has the necessary capital to fund it. And while there are some rare instances where taking stock may make sense, ask the necessary questions so you can avoid the baloney. Otherwise, just keep your business.

Mark Hurley co-founded Fiduciary Network in 2006 and serves as its CEO.