Executive, Board Transitions Require Careful Liquidity Planning

By John Erwin  

The landscape of financial services has shifted radically over the previous 20 years. Not only do millennials and Generation Z make up an increasingly large portion of the workforce, bringing with them their own unique preferences and traits, technology has fundamentally changed how consumers look to engage with their financial institution.  

At the same time however, bank management and boards of directors have remained largely static, with the average age of a bank executive around 55 years old. This has benefited the industry with a wealth of institutional knowledge and experience that many banks would struggle without. While these boards and executives try to recruit fresh, talented members to bolster their own knowledge, there is a growing concern of “what’s next?”  

Strategies for director and executive transitions  

These accomplished directors and executives serve in many critical roles, but the frank truth is no one wants to work forever. Instead, they are planning their retirement and how to spend their golden years reaping the benefits of their dedicated work. Likewise, many of these individuals have a vested stake in the success of their bank, whether in the form of stock options or outright ownership. As a result, many of them are carefully evaluating and balancing their options when it comes to making their exit.  

Smaller financial institutions, however, typically have illiquid stock that can be difficult to valuate and sell. This can present challenges when directors and executives want to cash in on their ownership, but there is no clear market or price point for them to make their exit at. In such scenarios, executives and directors will want to take a calculated approach to making their exit in order to maximize value for all owners.  

The desired approach largely depends on the bank’s ownership structure and who the shareholders are. For instance, if there are only one or two shareholders looking to cash out, they will generally need to find other potential investors looking to buy in, or they’ll need to conduct a stock buyback. Thanks in part to the 2017 tax reform law, these buybacks have grown in popularity as companies use their additional aftertax earnings to create liquidity for shareholders.  

Another option in this situation could be the establishment of an employee stock ownership plan, which is an employee-owner program that provides a company’s workforce with ownership interest in the company. Shareholders looking to exit could then sell their shares to the ESOP to liquidate their investment, and in turn, provide a qualified retirement benefit for employees and invest them in the bank’s continued success.  

On the flip side, if the entire management or ownership group is ready to exit, they will generally seek out a cash or equity sell. A cash sell creates a taxable event for shareholders and essentially ends their investment at that point. The primary concern for shareholders in these situations is the price being paid and whether they are satisfied with it.  

Most deals however, involve some form of equity where the acquiring bank agrees to buy the shareholders institution with a mix of cash and equity. This can create a substantial amount of liquidity for the selling bank’s shareholders if it has very illiquid stock and the acquirer’s stock is much more liquid, such as being an actively traded public company.  

For deals that are funded largely through equity, an important element to keep in mind is proper due diligence conducted in both directions. With a cash deal, the seller is typically less interested in the acquiring bank’s long-term plan, but rather on the price they are being paid. After all, they are making their exit. Equity deals, in contrast, involve exchanging their ownership for a stake in another institution. This creates a marriage of sorts where the seller’s return depends significantly on the success of the acquiring institution.  

In such situations, it’s not only important for the selling institution to conduct proper financial due diligence to ensure the purchasing institution is healthy, but to also confirm that the buyer and seller both understand each other’s expectations for how the combined bank will operate. This means developing a clearly defined vision for future success, especially in an industry that is being fundamentally changed by the introduction of new technologies and market players. Sellers in particular will want to verify that buyers are technologically savvy and willing to adjust their approach to meet changing consumer needs.  

For shareholders looking to retain or continue their investment, but perhaps distance themselves from day-to-day operations, succession planning becomes the main priority. When bankers use a leveraged ESOP or share buy-back, their time horizon for a return is significantly longer. In these situations, shareholders will want to ensure they are training their team, but also looking for out for opportunities and talent outside their institution.  

The key question shareholders should ask themselves is: “Do I have the proper executive team to fit within my long-term plans, or will I need to go outside the company?” The answer to this question will typically define a banker’s next steps in terms of either recruiting new executive staff or seeking support outside their new organization. Either way, shareholders will want to ensure whoever is left in charge is excited and ready for the bank’s future growth.  

Generous lead times provide flexibility 

Typically, this will require some incentive to ensure executives stick around and are invested in the bank’s long-term success. Current shareholders will need to have some in-depth conversations on this point, as it could mean transferring some of their current ownership to the next team or potentially creating a stock or equity plan. This way, when the executives consider their own personal and professional success, they will include the bank’s as well.  

For many of the decisions discussed in here, even a year or two out is a short time horizon to be planning for such efforts. The sooner and more clearly defined a bank’s succession plan is developed, the easier and smoother the transition will be for customers, employees and shareholders alike.  

John Erwin is senior audit manager at PKM, an Atlanta-based accounting and advisory firm serving public and private organizations in the financial services, insurance and technology industries.