Deborah Groban Olson Groban Olson Law Firm

Purchasing a company is a complex undertaking for any buyer. For employees buying on a leveraged basis, the complexity is increased both by the added debt and by changes in company leadership and investment structure that affect everyone who deals with the company. Anyone considering such a purchase must do a thorough investigation of the company as it exists and the expected effect of the changes such a proposed transaction are likely to create. This chapter will address the feasibility study conducted in association with a leveraged buyout (LBO) of a company or part of a company in which the employees, through an employee stock ownership plan (ESOP), constitute the buyer.

What Is a Feasibility Study? A feasibility study attempts to provide an accurate picture of the company as it currently exists and to project what it will look like over the next three to five years, based on proposed changes in ownership, financing, markets, product, costs of labor and raw materials, technology, the economy, and so on. A feasibility study attempts to assess the future viability of the target company and the ability of that company to support a proposed buyout transaction. In undertaking this effort, the feasibility study strives to predict the future, based on knowledge of the past and the application of assumptions about the future. The study usually includes a comparison of the target business with other competitors or similar businesses to see how it compares on a variety of business and financial criteria. The study is only as good as the past information, the validity of the future assumptions, and the care and detail with which the financial model(s) of the company are constructed. Anyone seeking to borrow money to buy a company will have to provide all the lenders with a feasibility study and a business plan. The study will have to show how the buyers plan to make enough money in the purchased business, over the term of the loan, to repay the loan out of cash flow and retain enough money to maintain and reinvest appropriately in the business so it will grow or at least retain its value.

The Time Frame Covered As a buyer or part of a buyer group, it is important to understand that the lenders are primarily interested in feasibility studies and business plans that study the term of their loan(s). A typical ESOP term loan financed with senior debt usually runs for five to seven years. A buyer, particularly a group of young employees, may have a much longer time frame of concern. If they are planning to own the company through an ESOP and obtain their ESOP benefit at retirement, the buyers may want a feasibility study to look at a longer term perspective than the one of most interest to the lenders. It is possible to have the same consultant provide a study covering the term of interest to the lenders, and also to create additional scenarios showing the buyers what the farther future is likely to look like. However, most consultants who provide feasibility studies are very wary of the veracity of any assumptions beyond three years.

Obtaining and Relying on Company Data One key indicator of the likelihood for a successful transaction is the willingness of the seller to provide the financial data needed to perform a feasibility study. Often a seller will want the prospective buyer or its consultants to sign a confidentiality agreement. If financial data are not forthcoming after the buyer has offered to sign a confidentiality agreement, it is likely that the seller is not seriously interested in selling to the buyer group. Unless the buyer has some other leverage over the seller, this may be the time to kill the deal. Large companies (and many smaller ones) are likely to have audited financial statements. In that case the financial information is usually provided in a standard format and may be reliable. However, it is crucial to read the cover letter accompanying any financial statements prepared by an outside accountant to determine what the financial statements actually are, and how much investigation the outside accountant did to verify the numbers. There are significant differences between audited financial statements, where the accountant actually tests the underlying data, and various compilations provided by accountants, which are simply standard arrangements of information as provided by management, without any testing. The cover letter may also show deviations from standard accounting procedures and may have an accountants opinion about the viability of the business. Many companies will not have audited financial statements. This does not mean they are financially weak. It may simply mean that they have never had a need to go to the expense and trouble to get audited financial statements. However, if you are going to borrow significant funds to purchase a company, the lender will require audited financial statements in the future. In either event, whether audited or unaudited, you cannot simply rely on the companys data when you buy the company. You must perform your own due diligence to determine whether the information given you is accurate. If it is not, you need to figure out a way to obtain accurate data. For the purposes of a pre-feasibility study, you may assume that the companys data are correct. Then you will study whether, assuming that information is correct, the company is worth buying. You will probably need a qualified professional, such as an investment banker, an appraiser, or an accountant, with experience in reviewing company financial data, to help you determine what the companys financial data really means.

Finding Resources and Hiring Consultants Pre-Feasibility Study Versus Full Feasibility Study Often, a buyer will do a preliminary feasibility study (a pre-feasibility study, often referred to as a quick and dirty study) to determine if it makes sense to invest the time, effort, and money needed to complete a full feasibility study, to weed out obvious deal killers. A pre-feasibility study uses readily available sources of information. There is not a bright line between pre- and full feasibility studies. The more information you can get in a pre-feasibility study the better, so long as you get the results in enough time to take action. The items listed below as belonging in a pre-feasibility study are basically those that the State of Michigan gets consultants to provide for $10,000 in 21 days using Economic Dislocation and Worker Adjustment Assistance Act (EDWAA). Most consultants believe they perform much more than $10,000 worth of work to provide such information. Many of the details included therein are normally thought to be part of a full feasibility study.

Resources Under the EDWAA, most states have funds available (usually up to $10,000) to pay for a pre-feasibility study for a potential employee buyout in circumstances where a plant closing is likely. Often that means that a Workers Adjustment and Retraining Notification (WARN) notice has been given. Different states have different requirements for buyer groups to receive such funds. Some states have pre-approved consultants whom the state hires to do the study after the prospective buyer group has approached the state for assistance. Other organizations, such as labor unions, often require a pre-feasibility study to determine whether more resources should be expended on the project. It may also be possible to have a non-profit organization or a university business school provide a pre-feasibility study on a pro bono basis if other sources of funding are not available. Funding for feasibility studies in non-shutdown situations is very rarely available. In the case of owners of closely held companies selling to an ESOP, however, a feasibility study may not really be as complex as in a buyout of a failing company, a corporate division, or a large company. This chapter focuses on the more complex transactions. A feasibility assessment in a business continuity situation would essentially be a comparable to the preparation of a business plan for a loan.

The Focus of a Pre-Feasibility Study: A Quick Go or No Go A pre-feasibility study looks at the major factors that may cause the prospective buyer to stop the process, such as :

· Is there a willing seller who will cooperate with the buyer by providing information? · Has some major business change occurred, such as: the loss of a major customer or account; the loss of an important lease, copyright, patent, technology, piece of expensive or unique equipment, etc.; a change in product or technology by a competitor that has massively realigned the market; or any other event that substantially ends the previous market as it existed? · Has some physical or legal disaster incapacitated the business? · Can the buyer obtain reliable financial data (income statements, cash flow and balance sheet information) from the last three to five years available on the operation to be purchased? · Are there management, labor, or other personnel issues that will inhibit a smooth transition to employee ownership? · Does the employee buyout group have the necessary leadership to carry out an employee buyout?

The Buyout Association Creation of an employee buyout association provides hourly and management employees a structure for running the buyout process, including making decisions about hiring consultants; directing the buyout; forming a vision of employee ownership and priorities for the group as they negotiate with consultants, lenders and the seller; and a vehicle to receive funds from other sources, such as government agencies or foundations. When a group of employees begins the buyout process, it needs a pre-feasibility study and some consultants. Initially, it may obtain the pre-feasibility study through a non-profit or state agency. However, if the pre-feasibility study is positive for pursuing a buyout, the group will need a variety of consultants, including: · An attorney to help the group create a temporary structure for the buyout group, the permanent corporate and ESOP structures, and negotiate the legal aspects of the purchase. · An investment banker or financial advisor to analyze the companys competitive position in the market and its operation, develop a business plan, structure the financing for the buyout, negotiate the financial aspects of the purchase, and find additional resources, such as new managers. · An independent valuation consultant to value the ESOP stock and perhaps to provide a physical appraisal. · A participation consultant if there is a desire to create a participative employee-owned company.

It is important for the group to focus on its vision of employee ownership and participation early on in the consultant hiring phase. The views, experiences, and contractual relationships with the consultants will affect the outcome of the employee-owned company. Generally, a pre-feasibility study is undertaken on an hourly or fixed fee basis and not on a contingency basis. You do not want your consultant to give you a positive answer in order to get paid. You do want the consultant to give you the truth. Some investment bankers will do a free pre-feasibility study in projects that interest them, if you agree to hire them to handle the buyout transaction if there is a feasible project. This presents risks of conflict of interest, which are sometimes warranted if a quick study is needed and if the buyout group has sufficient faith that the consultant will say no if the deal is bad, and that the consultant will spend enough time on the study if the deal is marginal. If a pre-feasibility study shows that there is no reason to assume a purchase is not warranted, then a full study may be undertaken. It is also true that in many cases, after a pre-feasibility study, a full study is not pursued; rather, the parties begin negotiations for a sale and save the further investigation for the due diligence period after a letter of intent offer has been signed. The full feasibility study phase can also be referred to as the deal-structuring phase. Once a pre-feasibility study has been done that shows that there is no obvious reason why an employee buyout should not work, the next stage is to structure the outline and parameters of the proposed transaction, create a business plan, and seek financing. Sometimes this takes the form of a feasibility study. Sometimes an investment banker is hired to attempt to put together a deal for the buyer. Much of the work is the same. The differences lie in the basis and nature of payment for the financial consultants work and the definition of the final product. If a feasibility study is sought and paid for, the lead consultant is still seeking an answer to the question: Should the client want to buy the company? The final work product is likely to be a study report. Once the report is delivered, the buyout group still has to develop a business plan, arrange financing for the transaction, and take care of the other matters upon which financing is contingent, such as a new CEO, and so on. If a financed deal is the agreed-upon final work product, the study is often simply the preliminary act in financing and concluding a transaction. Usually, the lead consultant is an investment banker. Most often, the lead consultant is paid a retainer and a contingent success fee based on the amount and type of financing arranged. As part of the work, the lead consultant will find the additional elements needed to make financing feasible. If a buyout group chooses to hire an investment banker on a success-fee basis to conclude a transaction, the buyout group must be very careful about the contract it structures with the investment banker. Once a success-fee arrangement has been signed, the investment banker performs a huge amount of work to conclude a transaction. If the deal does not close, the investment banker may make little or nothing for its time. There is a heavy incentive for the investment banker to close the deal. If the buyout group has minimum requirements for its definition of an acceptable transaction, it must set them out in its initial contract with the lead consultant and investment banker so that any contingent compensation is based not only on closing a deal but also on ensuring that the deal has the features agreed upon by the buyout group and its consultants in the consultants contract. A valuation consultant is usually paid on an hourly basis or on a per project basis. The valuation consultant should have both ESOP valuation experience and knowledge of the companys industry. Generally the attorney is paid on an hourly basis, although some of the attorneys fees may be paid out of the closing fees. An experienced employee ownership attorney can help structure the buyout group to operate as a decision-making and fund-raising body during the buyout process, help the buyout group negotiate contracts with other consultants that meet the buyout groups objectives, and develop the necessary corporate, ESOP, and transaction documents.

Costs of a Feasibility Study or Deal Structuring Costs vary considerably depending on the size and complexity of the transaction. A pre-feasibility study should generally be completed in less than one month and cost no more than $10,000 to $15,000. The entire full feasibility study package outlined below could range in price from $40,000 to $200,000. Average costs for a full feasibility study of a closely held company sold for $35 million may have the following consultants, with the following estimated price ranges:

A) Business Plan $60,000 to 100,000 B) Asset appraisal (if no recent one exists) $15,000 C) Initial ESOP Stock Valuation $15,000 D) ESOP Attorney $40,000 to 75,000 E) Corporate Attorney $50,000 to $100,000 _______________ TOTAL $190,000 to $305,000

However, if an investment banker handles items A, B, and C above on a contingent fee basis, those items may be rolled into a financing fee that is based on a percentage (or sliding scale of percentages) of the amount of financing obtained. Similarly, lenders will charge origination fees based on a percentage of the amount lent. The total fees on a $35 million transaction might be $1,000,000 or more. These are generally rolled into the financed purchase price. There are a number of sources of financing for the feasibility study. The main ones are:

· Existing owners. · Employees. It is often helpful in finding matching funds to request at least a small contribution as a sign of commitment from employees. Often this is in the form of dues for membership in an employee buyout association. An employee buyout association also gives hourly and management employees a structure for making decisions about the direction of the buyout, and provides a vehicle to receive funds from other sources, such as government agencies. · Technical assistance grants from state agencies or the Federal Mediation and Conciliation Service or the Economic Development Administration, etc. · Local city or county economic development agencies. · Local benefactors, perhaps located through the union or mayors office. · Foundations, churches, community fundraising efforts, and unions. · Pro bono work by local business schools, firms and universities. · Contingent fee arrangements with consultants if you move directly to the deal-structuring mode that includes a feasibility study.

Finding and Choosing Consultants Finding appropriate people can be difficult, but there are several good starting points. You can ask:

· Nonprofit groups specializing in worker ownership, university business schools, union research and legal departments, and other employee ownership companies. · State economic research offices that have contact with economists and business analysts or state departments that serve your industry (departments of Commerce, Transportation, Forestry, Energy Commission, etc.). · Unions, chambers of commerce or industry trade associations, whose members may have used business consultants · University MBA programs at which you can ask the dean whether students undertake business consulting projects. · Department heads of university marketing, finance, and business departments who may know the faculty who do this kind of work. The National Center for Employee Ownership (NCEO) maintains a referral service of professional consultant members for member companies and employees. The NCEO can also provide initial non-technical advice to members, including a discussion of available options. You should interview at least three different consultants. Once you have found one or more likely individuals or groups, there are several questions that you must ask.

What to Look for in Potential Financial Consultants · Have they done feasibility studies for employee buyouts or subsidiary divestitures? · Have they done any market studies? · Have they done financial modeling or prepared business plans? · Have they had other business clients? · Do they have extensive business/finance experience? · Will they give you a list of clients for references? · Can they get the study done within six to eight weeks (depending on your time pressures)? · Are they willing to give opinions (with caveats)about issues for which all the data they would like are not available?

What to Look for in Valuation Consultants · They must be independent of the seller and the company, meaning they have not done other work for either of those parties. · They should work for the buyout association or the to-be-formed ESOP committee or its trustees. · Are they familiar with the law, Department of Labor regulations, and cases defining adequate consideration and fair market value? · Have they valued stock in other companies in your industry? Other ESOPs? Can they provide you with references?

What to Look for in ESOP Attorneys · How many ESOPs have they worked on? · Can they give you ESOP client references? · Do you and the attorney have compatible views on employee ownership and participation? · Do they have experience in structuring employee buyout associations and contracts between such associations and other consultants?

The Questions to Be Answered in a Pre-Feasibility Study Your pre-feasibility study should address the following issues:

Organizational Answers to the following questions will help you determine whether you have a group of employees who can carry out a buyout. · Do you have leadership from the management side that can lead the management group during the buyout process and either is a potential CEO or can help you locate one? · Have you created an employee buyout organization to assist with the pre-feasibility study, to make decisions about the steps to be taken in the buyout effort, and to raise money to take action? · Have you located resources to help you understand and carry out the employee buyout process? These may include a state or non-profit agency, and/or legal or financial professionals experienced with employee buyouts. · Do you have cooperation and leadership from the union, if there is one? · Can your labor and management leaders cooperate on a major project? Market and Comparison Data Answers to these questions will help you determine whether the company is in a viable market.

· Obtain an overview of the industry and competition, including a forecast of demand and an assessment of market stability. Much of the information you need to compare your company to its competitors is available in published analyses (which you can find in a public or business school library) or from industry experts. Prime sources of data on your industry are available in libraries (such as public business libraries, university libraries, or major bank libraries), from your company, or from the following sources:

4 Standard & Poors Industry Surveys. 4 Value Line Investment Survey. 4 The Department of Commerces U.S. Industrial Outlook (annual). 4 Moodys Industrial Manual for your corporation or other companies in your industry (annual). 4 Walkers Manual of Western Corporations. 4 Dun & Bradstreet, Inc., Key Business Ratios. 4 10K report of your corporation (look at the presidents statement). 4 Market studies prepared for your corporation. 4 Trade journal articles on your industry located through the Business Periodical Guide and F&S Guide.

Industry experts whose opinions you should seek out include the following: 4 The analyst for the appropriate industry from the Bureau of Industrial Economics, Department of Commerce, Washington, D.C. 4 The trade association staff for your industrys trade association. 4 Market analysts for your industry (ask a reference librarian at a business library or get names from articles in trade journals). 4 If possible, sales and production managers at your company. 4 There are benchmarking criteria available for many industries through federally funded regional technology centers, such as the Industrial Technology Institute in Ann Arbor, MI. · Identify product lines currently and potentially available and ability to build market share as an independent company. Sources include local management, prospective management, industry publications and industry experts. · Review the capability of distribution channels as an independent company. · Explore possible marketing relationships with seller or others. · Evaluate the current customer base; include a review of customers lost and gained in recent years and any information available on future prospects for your business with them and, for customers who represent a high percentage of your business, their future market prospects. · Research industry trends, major technological changes and import threats, and the potential of the target company to compete with existing products or new products the company has the capacity to produce. · Research the companys competitive position with respect to product lines, quality, pricing structure and burden rate. · Assess the effect of increasing environmental regulation regarding production and use of products. · Where possible, compare product price, quality, delivery and market share with competition for major product lines. · Review market conclusions with industry experts and (where present) international union representatives for a reality check on your projections.

Management/Human Resources The following analysis should tell you whether you have the basic personnel necessary to run a stand-alone company, and whether they can work together in the complex process required to create and operate an employee-owned company.

· Evaluate management capability and continuity in key areas, including finance, operations and marketing. This assessment must be done by a competent and impartial outsider. The parties, labor and management alike, generally lack objectivity on this question. · Assess management and workforce capability and potential to reduce expenses, especially in recession or other negative circumstances. This generally requires a knowledgeable outsider who carefully listens to the parties and does independent research regarding the value of similar ideas tried at the target location and elsewhere. · Assess the potential to fill new and replacement positions of management and skilled workers. · Assess the potential to replace key management and support functions performed by parent company. · Assess management and labor support for employee ownership and the capacity to work together (particularly in cases where labor/management history has been difficult). · Assess the skills of middle management.

Operations/ Manufacturing The following items aim to answer the question of whether your company is an efficient producer in its market or the market you expect to enter.

· Assess the adequacy and condition of raw materials, the availability of standard parts, and the effectiveness of inventory controls and purchasing procedures. · Assess the effect of plant design and the level of technology on productivity (production bottlenecks), and evaluate the level and type of technology in use compared to the companys competition. · Evaluate the companys order turnaround and lead time and its competitive position regarding delivery. · Evaluate operating capability of the companys machinery and physical plant. · Evaluate productivity, efficiency and job costing information and compare potential production capacity, in units, with current performance. · Determine the companys burden rate and compare it with industry averages. Identify means to improve the burden rate in comparison with competition. · Assess the effectiveness of quality control systems. · Review cost estimating procedures and compare the cost of completed jobs to estimates. Assess the companys capability to assume estimating responsibility, particularly if estimating is currently done by its parent.

Financial The following items will help you determine a reasonable price for the company, whether its costs are competitive, and whether the new entity can afford the capital investment and working capital costs necessary to survive and compete.

· Review historical financial information and obtain background information for the companys current financial condition. · Compare the companys operating expenses, labor rate, financial performance, and cost structure with its competition and with industry norms. · Develop a preliminary financial model, including an integrated income statement, a balance sheet, cash flow projections, and a break-even analysis. · Determine the savings necessary to operate as a profitable employee-owned company. · Determine the new costs (or savings) of new services to be incurred as a stand-alone operation. · Estimate the value/purchase price, the cost of capital improvements, and working capital needs. · Assess potential collateral coverage for securing financing. · Assess the value of work in process. · Estimate equity and debt the employees might raise to finance the buyout, including seller financing. · Evaluate the strength of the investment for the employees compared with their alternatives. · Outline prospective alternative financing options.

Legal · Outline and evaluate legal structure options involving a possible joint venture with the parent company or other equity investors, if appropriate. · Outline options for the legal structure for the employee-owned entity, including ESOPs, industrial or worker cooperatives, broad stock options, etc., if a buyout seems feasible. · Identify potential legal obstacles to a buyout, paying particular attention to environmental, pension, and retiree health insurance issues. · Assess the owners willingness to sell to employees, including the price and terms. · Assess the effect of the competition (to the new employee-owned company) arising from the current owners continued participation in the market or through his or her other companies or divisions, and assess ameliorating such competition with non-competition agreements. · Assess the companys ability to develop an affordable transition structure resulting in a stable, surviving company. · Estimate the need for future operating or subcontracting agreements.

Conclusion A finished pre-feasibility study should conclude with a report to the buyout committee that includes an analysis of the company showing:

· Its management, manufacturing, market, financial, human resources and legal status. · Its competitive position and the market for its products. · Its chief strengths and weaknesses compared to its competitors. · The purchase price, working capital, and capital expenditures and personnel changes necessary to make it viable. · Its approximate fair market value as-is. · Forecasted financial statements under good, bad, and average scenarios for the next three to five years based on clearly defined sets of assumptions for each scenario. · Likely financing options. · A recommendation as to whether, given all the above data, there are one or more realistic employee ownership options it would be worthwhile to pursue.

The Full Feasibility Study: A Checklist A feasibility study will differ greatly depending on the type of company and its circumstances. The purpose of the following discussion is not to describe how to do a feasibility study. The specific steps vary significantly from case to case, and the employees certainly do not need to be able to perform the analyses. Nevertheless, they do need to be concerned about whether the final product they receive as a feasibility study deals with the relevant issues, and they need to know how to interpret the results. There are four basic parts to the feasibility study:

1) Market factorsthe demand for the product. 2) Plant factorsthe viability of the plant with a small investment. 3) Financial factors. 4) Financing and transaction structuring.

The following sections describe the relevant points the consultant should investigate and the results that employees should seek. It may be desirable to have a contract with a consultant that requires the following analyses:

1. Market Factors

a. Future Market for Each Product __ Short-term and long-term demand outlook __ New uses for your products __ New substitutes for your products __ New, potentially profitable, product lines __ New competition from abroad __ If your product is an input for another product, short-term and long-term outlook for industry using your product __ Your market share by product line __ Shifts in your market share __ If the market is changing, niches for your product RESULTS SOUGHT: Whether you can expect continued demand for your products and, if so, approximately how many units can you expect to sell. b. Concentration/Competition in the Industry __ Type of market (local, regional, or national) __ Number or changes in number (new plants, plant closures) of companies in market __ Names of dominant producers and estimates of their market shares __ Changes in imports __ New production technologies; whether your plant has them and their importance __ Integration of your facility relative to competitors __ Distance from markets relative to competitors

RESULTS SOUGHT: Whether your company has any unique advantages or disadvantages relative to competitors.

c. Feasibility of Competition by a New Entity

1. Basis of competition for customers in your industry __ Importance of brand name __ Number of brands __ Homogeneity of product __ Effectiveness of price cutting __ Whether existing company is major brand __ How existing company has competed

RESULTS SOUGHT: Whether the employee-owned company will be able to compete for customers.

2. Normal Industry Distribution Channels __ Do most companies in industry use factory direct sales, distributors, or manufacturers representatives? __ What channels has existing management used? __ What distribution facilities (ex.: warehouses) will the employee-owned company need, and are they available? __ Can the company keep its existing distribution channels and contacts? If not, are there channels it could easily adopt? __ Will the company need to obtain a large new sales force? __ Are customers willing to purchase goods from the new employee-owned company? __ Are any large customers willing to provide letters of intent to purchase from the new company?

RESULTS SOUGHT: Whether there is a means of distribution available to the employee-owned company that will not require a complex, new network.

3. Sources of Inputs at Competitive Prices

__ Current suppliers of inputs (raw materials, etc.) __ Potential new sources of inputs __ Do current suppliers serve other facilities owned by your corporation? __ Will the employee-owned company purchase a sufficient amount of inputs to command competitive prices? __ Are there any very large suppliers of inputs? __ Are any large suppliers willing to provide letters of intent to sell to the new facility?

RESULTS SOUGHT: Whether the employee-owned facility can expect to have reliable sources of supply at a competitive price.

2. Plant Factors

a. Physical Condition of Plant and Equipment __ Historic maintenance schedule and changes in maintenance __ Historic reinvestment plan and changes in plan __ Average age of major capital equipment and remaining useful life of equipment __ Age of facility relative to average age for other plants owned by parent company and by other companies __ Need for major capital expenditures for maintenance, modernization, and/or regulation compliance __ Estimated value of plant and equipment to be purchased

RESULTS SOUGHT: Whether the facility has been maintained enough to allow continued productive use. Whether large capital expenditures can be avoided, at least in the first three to five years, or if needed within that time can pay for themselves. Which of the facilities for sale are needed by the employee-owned company and their maximum value to the new company.

b) Organizational Structure: Leadership, Functions, and Facilities

__ Is the facility a profit center or a cost center? __ Functions that would be included in a purchase of the facility, including personnel, marketing, sales, finance, and general management __ Personnel needed to fill gaps in functions __ Are the facilities at the plant complete, or would additional facilities be required, such as warehouses? __ Ability to keep top and middle management on board, if capable, or attract new, experienced management __ Does the existing work force have the necessary skills to operate the employee-owned facility? Is it willing to do so? __ Products or services transferred from other plants __ Products transferred to other plants

RESULTS SOUGHT: Whether the employee-owned company can have a smooth transition. This is determined by whether it can function as an independent facility without needing to be reorganized, whether it can be separated from current ownership without losing key suppliers or markets, and whether it can depend on having a committed management to lead it.

c) Plant Strengths and Weaknesses (based on the previous market and cost analyses) __ Reputation of the facility, including whether it has long-term suppliers and customers and their satisfaction with the facility __ Willingness of suppliers and customers to deal with the new company __ Quality or efficiency as a producer relative to other producers __ Low or high cost producer in its industry for each product __ Unique product offerings __ Other strengths and weaknesses RESULTS SOUGHT: Whether the facility has the goodwill of its suppliers and customers, whether these suppliers and customers will deal with the new company, and whether its competitiveness with other facilities is enhanced or reduced due to specific strengths or weaknesses.

3. Financial Factors

a. Economics of the Plant/Company 1. Cost structure for last three to five years: for each product line, including costs of materials, labor, energy, maintenance, allocated overhead, and number of units of output. __ Whether any unit costs are assessed at transfer prices (if so, revalue them to market prices) __ Changes over time in the shares of costs and reasons __ Changes over time in the usage of any input and reasons __ Historical capacity use and efficient use levels 2. Operating margins, computed using historical prices and costs __ Trend in prices and reasons __ Product lines with largest margins __ Adjustments to mix that would increase plant margins

3. Break-Even Volume __ Minimum volume of output at which revenues equal costs __ Volume of output that maximized profit margin __ Implications of optimal output for necessary changes in current output and employment for employee-owned company __ Feasibility of being able to sell optimal output given market projections about size of total market

4. Profitability, computed based upon earning data for facility for last five years or by subtracting from operating margins, unallocated fixed costs, estimated corporate charges, current interest costs, and depreciation expenses __ Trends in profitability __ How changes in mix identified above would change profits

5. Cash flow for the last five years, using the data above on profits (after tax computations), adding back depreciation expenses and subtracting out changes in working capital, department repayment, and capital expenditures.

__ Whether cash flow provided by operations has been sufficient to support necessary expenditures (compare profit plus depreciation to capital expenditures and debt repayment) __ If there are costs hanging over the plant for deferred maintenance, deferred replacement, pension or retiree health insurance or regulatory compliance, has plant cash flow been sufficient to finance them? If not, how much outside capital would be needed to finance them? __ If the prospective buyout has been an independent business, additions to debt or equity capital in the last five years __ Whether any of the facilitys assets are secured by debt

RESULTS SOUGHT: Whether the facility has historically shown economic viability, including whether it has been able to control its costs and maintain profit margins, whether it has operated at optimal levels of output and with an optimal mix of its products, whether the new worker-owned company could expect a market for the volume of output at which it breaks even and for the volume of output at which it maximizes profit, whether it has been able to finance through internal cash flow its own working capital and at least some of its other capital needs, and whether it has been able to raise any outside capital in the past. For all of the above, the reasons why the company did or did not achieve these profit, output, and financing aims.

b. Feasibility of Improving Operating Margins, Profitability, and Cash Flow

1. Ability to Control Costs __ Cost reductions that could be made and their effect on profit margins; in particular, feasibility of reducing overhead, improving inventory control, reducing spoilage and waste, reducing absenteeism, finding cheaper suppliers, and willingness of employees to trade off ownership for wage reductions (level of deferrals they are willing to consider); generally it is not advisable to trade the pension plan for ownership of the company.

2. Ability to Change Mix and Level of Output __ Change in mix that would raise overall profits __ Changes in output that are within the limits of the market that would raise overall profits

3. Ability to Raise Prices __ Based upon market study, is it possible to raise prices and roughly by how much?

4. Ability to Introduce New Products __ What are compatible new products (see market study) __ Operating margins on these products versus existing products

RESULTS SOUGHT: Whether profits can be increased by moderate cost reductions, changes in mix, changes in level of output, the introduction of new products, or price increases.

c. How Economics Would Change for the Employee-Owned Facility 1. Analyze the effect on profitability and cash flow of: __ The feasible changes in costs, prices, product mix, and products investigated above __ Different levels of capacity usage __ Required replacement of management staff and/or corporate functions __ Training costs for new employees __ Lower wages __ Initiating new sources of supply and/or customers __ Making deferred replacement, maintenance, and modernization expenditures 2. Estimate future operating margins, profits, and streams of cash flows for three years, taking into account the effects of the changes in (1) immediately above. 3. Compute working capital needs. If there is no good basis to estimate working capital needs, an approximation would be total operating expenses for four months (including rent, inventory, wages, leasehold improvements, and known interest costs) plus reserve to carry accounts receivable plus petty cash.

4. Estimate costs of purchasing necessary facilities from existing owners or others (see Plant Factors). Also estimate financing costs based upon your expectations as to sources of financing and potential cost (see Financing section). 5. Compare the estimated cash flows to the sum of the costs estimated in (3) and (4) using net present value analysis. This will need to be repeated once financing costs are more exactly estimated.

RESULTS SOUGHT: Whether the employee-owned company can achieve a rate of return high enough to maintain an efficient facility, pay back its lenders, and repay the employees for their investment.

4. Financing/ Transaction Structuring Factors Before financing can be sought, some assumptions must be made about security design, equity allocation, and corporate and ESOP governance. The consultant should discuss with the buyout group their desires and the importance of each to them. The buyout group may have little leverage over these matters. Investors and lenders often dictate these terms. However, a discussion with the consultant about the various options in these areas before his/her seeking investors gives the buyout group its best opportunity to affect the outcome. Securities design refers to the types of stock, bonds, warrants, and so on that each party would get in the transaction. Equity allocation between investors is the allocation of common and preferred stock between all the parties, particularly the ESOP, management, and outside investors. Corporate and ESOP governance covers all the questions about who votes on what matters within the corporation, how the stock in the ESOP is to be voted, how the ESOP trustee is selected and the ESOP trustees powers.

Evaluating the Feasibility Study Once the results of the feasibility study are obtained, the employees must decide whether to proceed with the proposed employee buyout. Where the results concerning market factors, plant factors, and potential improvement in these factors are overwhelmingly negative or positive, the decision may be easy. Because this will generally not be the case, it will probably be necessary to weigh the results carefully, considering the difficulties posed by each problem. The questions in the next section will be of some help in this task (other sources of advice include the consultant who prepared the feasibility study and potential investors in the company). These questions should be answered in the course of the feasibility study. For an employee buyout to be advisable, either (1) the answers to all of the market and plant questions below should be affirmative, or (2) the answers to all of the market questions should be affirmative, and any answers to plant questions that are negative should be canceled by positive options under potential improvements. The financial factors help determine if the target company can withstand the debt load that the transaction would place upon it. The financing/transaction structuring issues must be addressed to determine whether the buyout group is willing to go forward with a transaction structured in the fashion the investment banker believes is most likely to be required by the equity sources. Of course, there will be situations in which a decision is made to proceed when these preconditions are not met. The employees in these cases must present to investors and themselves convincing reasons why the new company will succeed. The document used to convince investors to participate in the buyout is the business plan.

1. Market Factors Can you expect continued demand for your products and, if so, approximately how many units can you expect to sell?

Yes___ No___ Number____

Is it likely that your company will be able to compete for customers? Yes___ No___ Is there a means of distribution available to your company that can be put into place in time to ensure uninterrupted distribution?

Yes___ No___

Can your company expect to have reliable sources of supplies at a competitive price?

Yes___ No___


2. Plant Factors Has the facility been maintained enough to allow continued productive use? Can large capital expenditures be avoided in the next few years? Yes___ No___

Does your company have, or can it obtain, necessary staff and facilities to function independently as soon as a transition is made to a worker-owned company?

Yes___ No___

Can your company retain current key suppliers and markets? Yes___ No___

Does your company have, and can it continue to keep, the goodwill of its suppliers and customers? Yes___ No___

Does your company have a committed management to lead it? Yes___ No___

Has your company historically earned a profit? If not, was it due to causes that can be reversed? Yes___ No___

Would your company break even given expected sales volume from the Market Factors section (question 1 above)? Yes___ No___

Can your company expect to be able to finance its own working capital and some part of its other capital needs after one year of operation? Yes___ No___


3. Potential Improvements If your company historically has not earned a profit, can profits be improved through moderate cost reductions or price increases? Yes___ No___

Can profits be improved through changing levels of the output or the mix of products, or introducing new products?

Yes___ No___

Can profits be improved through taking better advantage of unique characteristics of your companies? Yes___ No___

Can your company achieve a rate of return sufficient to maintain an efficient facility, repay its lenders, and repay employees and investors for their investment?

Yes___ No___

4. Financial Factors

Can the new company survive with the new debt a leveraged buyout would place on it? Yes___ No___

Can the new company get sufficient working capital to see it through a series of rough times? Yes___ No___


5. Financing/Transaction Structuring

Can the buyout committee live with the proposed equity design?

Yes___ No___

Can the buyout committee live with the proposed equity allocation?

Yes___ No___

Does the buyout committee agree with the consultant on a corporate and ESOP governance structure that the investment banker is willing to try to finance?

Yes___ No___


Special Issues in the Transition to Employee Ownership Labor and Employee Benefit Issues, Including Concessions Often, employee ownership is proposed to save a troubled company. Performing a pre-feasibility study will generally determine whether the company is too troubled for further consideration. Once past that hurdle, the question often arises whether employees will give up some portion of fixed wages and/or benefits and instead receive stock ownership and profit or gain sharing. Careful cost benefit analysis of the options is required. Key question for employees to answer before agreeing on any particular concession level are:

1) What is the economic present value of the concessions and how does it compare with the investments being made by other parties to the transaction? What is the value of the stock being offered to the employees? Do the employees have any more favorable alternative? 2) Does the financial analysis used in the feasibility study or business plan cover a long enough time frame to show how employees are likely to fare upon retirement? 3) Has the company planned to have the cash available for repurchasing the stock from employees upon their retirement? 4) Pension, environmental matters, and retiree health insurance liability are all factors that bear close attention from anyone performing a feasibility study. Employees reviewing such a study should pay close attention to proposed solutions to company financial problems that may affect their retirement benefits. 5) Unionized employees: contact your international union research department or the Worker Ownership Institute in Pittsburgh for more information on negotiating employee ownership. Continuity and Transition Issues: Management, Customers, Markets Any company going through an ownership change has a series of transition issues to handle. It is most important to have a positive public relations strategy explaining the buyout effort. Many people mistakenly think that an employee buyout is a last-ditch effort to save a failing company. However, employee ownership is often born of employee interest in getting a piece of the action in a good company or because the owners wish to retire. It is important to have a presentation on this subject ready for customers and suppliers, particularly if they may be contacted as part of a feasibility study. Management and all employees may well be nervous about job security during a feasibility study. If a company is overstaffed or poorly managed, there may be a need to change some of the personnel in an employee buyout. These decisions should be made with care, caution, and objectivity. Every effort should be made to keep personal allegiances and politics out of such decisions, by using assistance from outside consultants. The buyout committee should work to instill such values in its membership. Transition from Subsidiary to Stand-Alone Company It is not extremely difficult to replace many central corporate functions such as accounting, information systems, personnel, employee benefits administration, or the legal departmentservices which can be readily purchased from outside vendors. Often these can be handled at a savings over the corporate charge. The most difficult change is usually in marketing and distribution, and in some cases in engineering or product development. Where these are critical issues for the business, take special care that your feasibility study includes industry expertise in evaluating these problems and proposing solutions.


Conclusion A feasibility study attempts to provide an accurate picture of the company as it currently exists and to project what it will look like over the next three to five years (and occasionally longer if so required), based on a set of assumptions concerning ownership, markets, financing, products, costs of production, etc. As the buyer group, you must clearly think through everything you know about the company and what you desire from the buyout before you commission a feasibility study. You must make clear to the consultant you hire what you want to find out, and what your desires are. You should provide your consultant with all the information on the Company that you can obtain. You should hire someone who has experience not only in doing such studies but in getting the resulting transactions implemented and financed. You should ask your consultant whether he or she thinks you are asking all the necessary questions and or whether he or she sees other important questions that need answering. To get the most benefit from your study, you must be an active participant in determining the questions asked and in analyzing the answers provided. Your contract with the consultant should lay out in writing the questions you wish to have answered. If, upon receiving the feasibility study report, you feel questions you sought answers to were not answered, raise those questions with your consultant. You are not an expert in financial analysis, but you do know quite a lot about the company for which you work. Use your common sense and collective knowledge as a guide throughout the process. The more you take charge of the process, the more likely you are to be satisfied with the result.




1 Part of this chapter is based on the State of Michigan pre-feasibility study guidelines designed by James Houck of the Michigan Jobs Commission. The author would also like to specially thank Andrew Torgove for his assistance in reviewing and suggesting revisions to this chapter based on his experience in performing feasibility studies both in the private and public sectors. Andrew Torgove is a Senior Associate with the investment banking firm of Houlihan Lokey Howard & Zukin, which specializes in ESOP transactions.

2 A leveraged buyout is a purchase of a company in which most or all of the purchase price and working capital is borrowed.

3 A confidentiality agreement is a contract between the seller and the buyer and/or any of the buyers consultants, business partners or lenders, promising not to use the information provided for any purpose other than to evaluate the potential purchase of the business. It is not to be used for any competitive or collective bargaining purposes, etc.

4 Due diligence is intensive legal, accounting, real estate and environmental research performed by buyers and lenders before closing a transaction to make certain they know what they are buying and the liabilities included in it. This investigation tests many of the assumptions of the initial information that was used for the letter of intent.

5 A letter of intent is a letter from the prospective buyer to the prospective seller outlining a transaction generally, and offering to purchase at a given price, assuming certain facts prove to be true. It is usually only a few pages long, and is based on whatever information the seller has provided. That information is assumed to be correct for the purpose of the letter of intent offer. It is later tested in the due diligence phase of the transaction.

6 A well-qualified appraiser of assets may be needed for this analysis. The appraisal will cover land, buildings, inventory, and equipment that will be useful for the new company. The business is worth the market value of its assets that are necessary to conduct business plus a premium if the business is especially profitable or minus a discount if it is unprofitable.

7 A net present value analysis is a technique that allows you to compare income you receive in the future to cash you pay out now to buy the plant. It takes into account the fact that both inflation and the ability to invest money now and earn a return rather than spending it reduce the value of income received in the future.