While most of us do not like to admit it, at some point in time letting go of the company will inevitably be something that must seriously be considered. According to a recent industry survey, 67% of all contractors surveyed do not have an exit strategy in place. When considering technical alternatives for the succession plan, keep in mind that many alternatives can be combined to achieve the desired results.
Management buy-outs are an excellent way to keep the business independent and insure that it will continue operating. A management buy-out can take a variety of forms; the most common include buy-sell agreements and stock options.
Once it is clear who should own how much stock, a price needs to be determined. This could be based on a reasonable formula by considering company assets and performance or an outside estimate of the company value. Sometimes owners create continuing compensation agreements. These commit the company to pay the former owner for a specified number of years. This obligation reduces future earnings and can reduce the value of the company, making the sale easier. After a mutually agreeable price is arrived at, it is necessary to arrange financing.
A wide range of possibilities exist for financing management buy-outs. The first question is how much can the managers purchase immediately. They can use cash, savings or take out loans. It is up to the managers to determine how they will purchase the stock. After the managers have planned to buy stock personally, they must figure out how the company can buy the rest. A number of alternatives exist to do this.
Loans or notes from banks are often used to purchase stock from an owner. This type of leveraged buy-out is attractive for its simplicity, but it has a few drawbacks:
- It requires the commitment of future profits to pay for the purchase of stock.
- It will probably force the company to pledge assets as collateral for the loan.
- It will require that payments on the stock be made in post-tax dollars.
Notes or loans from the seller extend payments over a number of years. This “seller financing” may reduce costs and make the transaction easier. But the payments are still in post-tax dollars and reasonable interest must be paid. Further, extending payment terms has a number of negative implications for the selling owner.
- The selling shareholder must pay the capital gains tax for the full purchase amount, while receiving only some of the cash to pay the taxes.
- The business owner will not be able to diversify his or her investment to reduce risk, often the primary goal of “cashing out” the business.
- If the owner wants security, the assets used as collateral cannot be leveraged for other business purposes.
While seller financing looks a lot like bank financing, the terms can be better because the owner has more confidence in the management team.
An installment purchase of stock is similar to seller financing and is attractive, as the management team and company can purchase the stock over a number of years. However, IRS rules make it difficult to implement. If the owner has not sold majority control, or substantially all of his or her stock the IRS may determine that the sale of stock did not substantially reduce the owner’s effective ownership, so they will tax the income as dividends, rather than capital gain. Fortunately, other tools, including trusts can be used to hold the stock until the company and/or management team can buy it.
Employee Stock Ownership Plans (ESOPs) can be used to finance part of the stock purchase on more favorable terms, while retaining control among the chosen management team. (See next section.)
Selling to the employees
A partial sale to an ESOP can make management buy-outs easier. The ESOP can purchase any amount of company stock on highly preferential terms. The effect is to reduce the total cost of the stock purchase, while retaining closely-held control among the primary shareholders.
Essentially, the ESOP is a retirement plan for the employees. It is similar to a 401(k) plan which invests substantially all of its assets in company stock. The stock is held in a trust under the control of a trustee appointed by the board of directors. Administration of the ESOP requires annual valuations by an outside party. The first valuation is more expensive, but the annual cost is often around a few thousand dollars.
Since the loan to purchase stock is made through the ESOP, a qualified retirement plan, the principal payments are a pre-tax expense. Thus, the company can purchase stock from the retiring owner dollar for dollar.
Buying stock through an ESOP has substantial advantages for the company. In addition, the selling shareholder can receive a major tax break as well. The owner can defer payment of capital gains taxes if all three of the following conditions are met:
- He or she has owned the stock for more than three years,
- He or she chooses to reinvest in a portfolio of domestic operating companies, and
- The ESOP owns at least 30% of the outstanding shares
The capital gains tax will come due when the replacement investments are sold, but can be avoided completely if the replacement investments pass into the estate of the selling shareholder.
The tax break for the selling shareholder means that on a $1 million sale of stock, the selling shareholder can reinvest the full $1 million, receiving income on that capital. If the stock is sold to anyone else, capital gains taxes must be paid.
ESOPs can make a management buy-out easier for the company and beneficial to the selling shareholder. Further, it will continue the business as an operating entity, controlled by chosen management and may have a positive impact on employee motivation.
Selling to an outsider
Selling to someone outside the business or family means the new owner may change or close it, but sometimes a “strategic buyer,” a competitor or related business, can offer the highest price. The business could be of greater value to the new owner if he or she takes the customer list, product name and sells the other assets. For some owners, this prospect is undesirable, but the benefits to the selling owner may outweigh that drawback.
Liquidation of the company is not usually considered an alternative in succession planning because the business ceases operation. Thus, no one succeeds the owner in running the business. Sometimes, though, liquidation of the assets is the best way for the owner to get the highest price for his or her business. The assets are valued, put on the market and sold. Proceeds from the sales are then used to pay off liabilities along the way.
All of the foregoing options are the basic options that could be considered as well as others – of course our business group can assist in planning for the future.