As a business owner, identifying a solid exit strategy that allows you to move to the next phase of your life comfortably and keeps the business running can be a challenge.
This challenge is compounded when a key employee, or group of key employees, expresses an interest in buying the business, but lacks the cash flow upfront needed to outright purchase the business at a purchase price that is based on the current business valuation.
Some of that success and value is a direct result of the efforts of these key employees. Oftentimes, owners who are looking to transition out and have the business success continue desire to reward those key people who have helped them along the way.
Fortunately, there are several deal structures you can consider to facilitate this transition and sale process without requiring immediate cash or the employee seeking traditional financing from a bank.
Our Business Succession Planning team frequently helps clients navigate the nuances of this specific situation and prepare for a smooth transition. In this article, you’ll learn four key strategies to consider as you begin to build your succession plan.
Owner / Seller Financing
Owner financing is a type of installment sale that involves the current business owner acting as a non-traditional lender. The owner extends a loan to the key employee(s), who then makes monthly installment payments for the full term of the loan to repay the debt.
The payments made by the employee will consist of the usual components of principal repayment and interest on the outstanding principal much like a mortgage repayment. There are several things to consider with these payments.
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The interest rate used for the loan should be a rate that is competitive with interest rates for a similar loan in the marketplace.
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To the owner who is extending the loan, the interest received is additional income and is taxed the same as W-2 income is taxed according to the taxpayer’s marginal tax bracket.
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There are tax implications to be aware of with the strategy. The principal repayments are subject to capital gains tax, which varies based on the owner’s tax basis in the business. In this regard, there are tax advantages to receiving these principal payments over the course of several years as opposed to taking one lump sum payment for the business and owing all the capital gains tax in one year.
Benefits to Owner Financing
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Quick Transition of Ownership: The business can be transferred more swiftly to new ownership and management teams compared to traditional sales on the open market because the lengthy processes of finding potential buyers and bank underwriting are avoided.
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Simplified Due Diligence: The due diligence process is streamlined as the buyer is already familiar with the business.
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Interest Income: The owner can earn an additional return from the interest on the loan.
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Capital Gains Tax Distributed: The capital gains tax that is owned from the sale of the business is spread out over several years (term of the loan) as opposed to receiving a lump sum payment and owing all the capital gains tax at once.
Downsides to Owner Financing
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Risk of Default: If the business does not perform well under new management, the owner may face the risk of default and potentially regain ownership of a struggling business.
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Continued Involvement: The owner cannot fully disengage from the business, as they will be concerned about its performance, which is tied to the success of their next chapter.
Employee Buyout Plan
An employee buyout plan is designed to reward team members with stock based on the business's performance.
In an employee buyout plan, employees may initially buy some shares or units with their own money to ensure they have "skin in the game" and are committed to the plan, though this does not have to be required.
Employees then receive bonuses as the business exceeds certain revenue or profit thresholds that they use to purchase additional shares or units in the business. It is common for many business owners to take distributions from their businesses to pay for taxes, and the minority owners will also receive these distributions on a pro rata basis for the same purpose.
If there is an excess amount distributed beyond the tax liability, that money can be used to purchase more shares or units, thus accelerating the transition process.
Benefits to an Employee Buyout Plan
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Motivated Employees: Employees have a vested interest in increasing the business's profitability.
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Ownership Experience: Employees gain firsthand experience of business ownership.
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Known Buyer: The buyer is already familiar with the business.
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Simplified Due Diligence: Less thorough due diligence is required.
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Mentorship Opportunity: The owner can mentor future owners, ensuring a smoother transition. This is often overlooked as a key element for a successful transition.
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Increased Business Value: The business's value can grow over time, potentially resulting in a higher final sale price.
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Business Owner is in Control. The owner of the company remains the majority shareholder and is in control of the decisions made within the business.
Downsides to an Employee Buyout Plan
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Extended Timeline: The transfer of ownership process can take a long time.
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Continued Owner Involvement: The owner cannot completely disengage from the business immediately which may not work if the current owner is burned out or lacks the enthusiasm or aptitude to mentor the new owner.
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Risk of Failure: Business does not grow in profitability as projected, and employees are unable to meet purchase requirements within an acceptable timeframe.
Gifting a Portion of Ownership
In this approach, the business owner gifts shares or units of the business to the key employee. Similar to the Employee Buyout Plan, the now minority owner will receive their proportionate share of distributions to pay taxes. With any excess cash, additional shares or units can be purchased.
Benefits and Downsides of Gifting a Portion of Ownership
The advantages and disadvantages of this method are like those of the Employee Buyout Plan. However, a big disadvantage is this strategy can take significantly more time, as there is not a profit share component to this approach that incentivizes the key employee to increase the profitability of the business, which provides them the funds to purchase more shares or units.
There are mixed emotions about gifting shares. Some owners feel the key employee starts off with no “skin in the game” and others see it as a reward for all that the key employee has done over the years to grow the business. Each circumstance is different.
Hybrid Versions
The good news about these plans is that they can be customized to what each owner wants to achieve and the timeline in which they want to achieve it.
Each of the strategies discussed can be combined to create a flexible program that focuses on the goal of transitioning the ownership to key employees who lack the money to immediately purchase the business.
Small Business Administration Lending
Though the timelines for these transition strategies may sound like they stretch far into the future, it may be shorter than one initially imagines.
The goal of these plans is to gradually increase the ownership of the future leaders of the business to 10-20%, at which point the Small Business Administration becomes a possible option for borrowing the funds necessary to purchase the remaining shares or units of the business.
Once this is achieved, the business owner can be bought out of their remaining shares and move onto the next chapter of their lives.
The Bottom Line
These strategies do take time, and because of that, identifying the future leaders of your business and preparing them to run the business is better addressed sooner rather than later.
Even if the lessons are small at first, they will grow in complexity over time thus creating a pathway to a successful transition, ensuring continuity, and preserving the legacy you’ve built.
We believe business owners shouldn't have to choose between a succession that benefits the business or their personal plan. They can and should be able to achieve both.
To explore these options and begin to structure a plan that works for you and your business, we recommend downloading our succession planning worksheet. This helpful guide will help you begin to craft a succession plan that is tailored toward your goals and the continued success of the business.
