THE ULTIMATE GUIDE

HOW TO TO TRANSITION YOUR BUSINESS TO INSIDERS

THE ULTIMATE GUIDE ON HOW TO TO TRANSITION YOUR BUSINESS TO INSIDERS

Many owners assume selling a business is like selling a car. They don’t know who’s going to show up for a test drive, but hope to get a good price. These owners find a business broker to post an offering online, promising to expose it to thousands of interested buyers. Or perhaps they hire an M&A adviser to write up a detailed offering “book” and shop it to his or her network.

Ask a randomly selected group of business owners who they will eventually sell their businesses to, and you’ll repeatedly hear a similar set of ideas… can you relate?!?!

✔ They are at least 5 years out from planning an exit.

✔ They are making good money and having fun so there is no need to think about the exit.

✔ If they work hard and get revenue, clients and profit someone else will hopefully want to buy their company.

✔ Worst case scenario, if someone doesn’t knock on the door one of their kids or employees will want to buy the company.

Many owners don’t actually discuss their ideas or thought processes with anyone. They may just have an idea in their head of who represents the most likely buyers, or which options are best for their particular situation and long term desires.

This guide discusses the different ways to sell your business to someone internally. It will help you weigh the options of achieving a successful internal transition, ensuring that you have thought through all the variables before you choose a successor.

Because different internal business buyers will:

  • Be able to pay different amounts for the business
  • Be more risky to sell the business too
  • Require different levels of ongoing involvement once the transition starts
  • Come with different tax benefits 
  • Take longer to get your money and transition than others

It’s also important to know what type of internal buyer is best for you – the buyer that purchases your company will impact the following factors:

  • The price the buyer pays, and why
  • How long the sale process takes
  • How much control you have over the sale process (before and after the sale)
  • Deal structure and taxes you will have to pay

And after closing:

  • What happens to your employees
  • How your customers are treated
  • How long you will need to stick around
  • The longevity of your legacy and culture

The Best Way To Transition Your Business

The goal is to control the process, which means that, within your timeline and on your terms, you select the best internal buyer and price (and the net proceeds you ultimately get) for your business. If you have time, financial stability, and energy, then you can benefit from greater control and flexibility in making your choice… but you have to be ready to work hard for it.

In order to get the best internal transition and exit from your business you need 3 things:

  1. If you’ve got time, financial stability, and energy, you are most likely to secure an optimal exit as well as the legacy you want to leave behind with your company.
  2. If you are lacking energy but have time, and the company has financial stability, you can still sell your business (of course), but you may not have the drive to secure the optimal deal structure. You may be willing to settle for less than the best exit.
  3. If you have time and energy, but the company is lacking the necessary financial stability, now is the time to develop a strategy to improve the company’s cash flow and open up better exit options down the road. If you need to sell now, you will have much less bargaining power, and that will be reflected in the lowball offer or offers that you get for your business.

What will this guide teach me?

You’ll learn that selling a business is not a binary transaction. It’s not like selling a car for cash. There are many factors that will impact your ultimate return, including who you sell to, when you sell, and how you manage the tax structure and tax reduction strategies. We’ll take a close look at those factors in this guide. .

The guide will give you an understanding of the benefits of different internal ways to exit your business. You’ll come away with a plan to both maximize your net proceeds after selling your business, and ensure that you’re satisfied with the other intangibles, like the legacy you want to leave with your business after you’ve moved on.

The Goals of this Guide

Our objective is to make sure you understand ALL the ways you can transition your business to insiders, and how each exit option impacts your goals and financial outcome, BEFORE you sell your company.

This guide will also help you think about potential deal structures for selling to internal buyers – your family, management team, or an Employee Stock Ownership Plan (“ESOP”) and consider which is optimal for your situation.

We dive into selling to strategics or financial buyers, and IPO’s and liquidations in The Ultimate Guide to Your Best Exit Options – Part 2.

Structuring the Deal

There are numerous ways you can get paid by your buyer, whether they are internal or external.

  1. Bank financing – buyers take out either a SBA or conventional loan so they can pay part or all of the price at closing.
  2. Installment sale – you accept a series of payments over time, often for 3-5 years after closing.
  3. Third-party financing – buyers tap some other form of credit like a mezzanine or subordinated loan from a private lender. While they’ll pay a higher interest rate, this can work if conventional financing won’t do the deal.
  4. Earn out / earned compensation via growth projections – buyers pay you based on the business hitting pre-agreed performance hurdles over time. This limits how much you have to argue over the sale price – let the business’s future sales or profits do the talking.
  5. Insiders buy-in over time by achieving performance metrics and growth — this is like the inverse of an earn out. They have the opportunity to buy your shares over time if the business grows according to pre-determined conditions.
  6. Employment contract — you remain an employee or consultant of the company, perhaps as CEO or president, and then the company pays you pre-established amounts in the form of salary and bonuses if you achieve certain milestones.
  7. Gifting / estate planning – if you want to move most of the proceeds into some type of trust for your children, grandchildren, spouse and other family members, now is the time to plan it out.
  8. Stock from the buyer’s corporation – this works if your buyer is a public corporation with shares traded on the open market. It’s much riskier with a private company buyer because you may not be able to liquidate the shares when you need cash.
  9. Royalties – similar to an earn-out, but based on the sales revenue of the company, not on the bottom line. In a royalty deal the recipient gets some percentage of the revenue, usually paid on a quarterly basis. It could be x percent of every dollar, or x cents for every unit sold. The upside, compared to an earn-out: if the new owners mismanage the bottom line, it won’t impact the amount you are paid (unless the company slips into default).
  10. ESOP you sell your shares to a trust for the Employee Stock Ownership Plan (“ESOP”), and you retain control as the trustee of the ESOP. The company takes on bank financing to pay you part of your proceeds now, and the rest later. This has some terrific tax implications we’ll get into below.

How your company is valued and the proceeds you ultimately receive are both impacted by the type of buyer. You can learn more about valuations and net proceeds with our Ultimate Guide to Knowing Your Business’s Value.

When considering a possible deal, important points to consider include:

  • How much you get paid (after all is said and done, including after taxes)
  • How you get paid
  • When you get paid
  • What’s the risk you won’t get paid

The Guide: Part 1 vs. Part 2

In Part 1 of our guide, we cover the internal buyers. In Part 2 you will learn about external buyers. As you begin exit planning, it’s important to consider both sets of potential buyers, and think about which buyer is the best fit for you and your business.

INTERNAL BUYERS

Partners
Management
Family
Liquidation

EXTERNAL BUYERS

Strategic Buyer
Financial Buyer
Initial Public Offering (“IPO”)
Employee Trust(ESOP)

Chapter #1. SELLING YOUR BUSINESS TO PARTNERS OR MANAGEMENT

Key Takeaways for this Chapter

  • ✔ Understand your likely benefits when selling to partners or management.
  • ✔ How to protect yourself after you sell your business to your partners or management.

There different challenges if you are thinking of selling your business to management or your partners than selling to a 3rd party. If you sell your business to a third party, typically, a stranger will hand you a big check, take the keys, and wish you well in retirement… that’s the idea anyway. If you want to know more about selling to a 3rd party, check out this Ultimate Guide to Selling Your Business to a 3rd Party.

You can preserve your legacy by selling to management.

After all, your business is like your baby, and perhaps you’d prefer to sell to someone you know and trust.

You might not want to risk a new owner firing your loyal employees, and/or packing up and moving the whole operation to another town, state or country.

So what’s the solution?

The reality is that there are options to exit your business by selling, transferring, or putting in place a succession plan to your partners or management team.

  • They may be people you started the company with, shoulder to shoulder.
  • Or they may have joined the company later, and played a key role in taking the business to the next level.

If you’ve been an effective steward of your business then you should have a team of managers that runs the day-to-day operations. Here’s an acid test: if you can take a week or two of uninterrupted vacation, then return to the company and find everything ran smoothly without your involvement, then you probably have a solid management team. Who better to sell the company to than teammates you know and trust?

If you are considering this business succession plan, it’s important to think about the following:
Pros
  • You have more control over the process. Since all the parties are known to each other, you can set the pace
  • Buyers, their motives, and history are known.
  • You trust each other. If you don’t trust them…no deal!
  • Open communication can lead to the best outcome for all parties.
Cons
  • Perhaps you have a “complicated” history with your partners – that baggage may make it tougher to close a deal.
  • There will be a longer term horizon for you to be paid out. Partners are less likely to buy you out all at once, and more likely to want some seller financing.
  • By definition, having a longer payout period creates more risk for you compared to being paid out at closing.
Typical valuation process and deal structure
  • Multiple of EBITDA is the most common valuation method (although you may also run into Discounted Cash Flow Value). Multiples vary by industry, so know what multiple is standard for yours. Since you’re selling to insiders, you’re less likely to encounter disagreement here.
  • Consider the highest dollar amount versus the lowest defensible value. There’s always room to negotiate, but as everyone at the table know the business, they shouldn’t start off too far apart.
  • Get two third party valuations, then negotiate a current dollar value, and agree on what methodology you will use for future valuations. Best if the methodology for now and the future match.
  • Communicate openly and get everyone’s goals and objections aligned with the financials and deal structure and then NAIL it in a contract so there is no ambiguity down the road.
Questions to consider before structuring the deal
  • Do you need the money now, over time, or at all (maybe you want it all to go to your kids)?
  • How emotionally attached to the business will you be until you get all your money? Some people need a hard break and to move on right away. Others are comfortable “compartmentalizing” their life, creating emotional distance between themselves and the partners/ management they’ll be relying on for their money down the road.
  • Do you believe in your industry and the viability / growth of your company AT LEAST until you get paid?
Involvement after closing
  • Control – Determine the voting rights you, the partners and management will have. Is there a board of directors? If so, nail down details for decision making, term lengths, assignments, etc.
  • Roles / responsibilities – Determine who sets strategy, hires/fires management, and influences day-to-day decisions.
  • Financial:
    1. Keep a lid on major capital expenditures that could risk the cash flow the company needs for its future payments to you.
    2. Decide beforehand whether the partners or managers can add new debt to the company. Would that shift the company’s debt to you into a subordinated position? Make sure they need your written consent.
    3. Determine who sets salaries, distributions, and perks. In many cases, business owners take a lower salary than they would ordinarily earn if they performed the same role as an employee not an owner. If you’re staying on in a senior role, will you be compensated according to market rates?
Ongoing risk
  • Ordinary industry risks that could hurt the business. Since you’re not getting a big check up front, you face the same risks as you did before the sale.
  • What if management does not perform well? In most cases you won’t be in the day-to-day driver’s seat any longer. You face risk if the new leadership drives the company off the rails.
  • Risk of having personal guarantees still in the business. Many business owners have pledged personal guarantees for lines of credit or real estate transactions. If the business goes south, you could still be on the hook for these.
  • Risk of partners’ personal guarantees to you not holding up if called upon. In many cases your partners may have a lot of their own wealth invested in the company. If they provide personal guarantees to induce you to accept payment over time and the business subsequently goes south, they may not have the assets to cover their personal guarantee to you.
What can happen if things go south
  • Back-up Plan – Now, while the business is healthy, spend time to identify what extraordinary conditions would trigger your resumption of day-to-day control.
  • Control – Flesh out what taking back control would look like. For example, if you’re CEO prior to the sale, but hand over the reins to someone who runs the business into the ground, can you take over as CEO again? What happens to that other person?
  • Buy-back – Consider a mechanism allowing you buy back shares at a discount if the business is struggling. Say you sell shares at $10 each while the business is doing $4 million EBITDA. Later, under the new CEO, the business starts to lose money. Under these circumstances, a buy-back could facilitate a re-purchase of your shares at a lower price than you sold them for.

#2 SELLING YOUR BUSINESS TO YOUR FAMILY

Key Takeaways for this Section

Handing a family business down to the next generation

  • ✔ Selling to family members can be tough, but with good communication and planning it can be quite successful.
  • ✔ It’s critical to take care of the needs of the company first and foremost.
  • ✔ You can get paid on closing through a bank loan.

Handing a family business down to the next generation is notoriously difficult. Experts have coined a term called the 30-13-3 rule, which describes how 30 percent of companies survive after being passed down to the kids, then only 13 percent survive the transfer to grandchildren, and finally a meagre 3 percent survive the leap to a third generation.

On the other hand, handing down the business to family members can be, simultaneously, a rewarding exit and a means of estate planning. It’s a way to create a legacy for your family and your community. But it takes patience, clear communication, and the intestinal fortitude to make sure you put the needs of the business, your own future and retirement, ahead of the emotional needs of your loved ones.

The SC Johnson Company is a great example of a legacy. It started in 1882 in a hardware store in Racine, Wisconsin. After two prior business failures, 49-year-old Samuel C. Johnson started mixing up floor wax in a bathtub. He exited by selling the business to his son. Today SC Johnson is a $12 billion household goods company and its brands, like Windex, Ziploc, Drano, and Off, can be found in virtually every house. SC Johnson is still based in Racine, employs 12,000+ people, and in the last decade donated over $200 million to charitable causes. The founder’s fifth generation descendent, Fisk Johnson, serves as the company’s CEO.

If you’re considering following SC Johnson’s lead, with an exit by selling to family members, it’s important to first define exactly what you want to get out of the transition. Do you want to retain a stake in the business? Are you after some relinquishment of day-to-day work, or a complete exit? Do you need a large payout now to see you through retirement, or would a smaller payout (from the right buyer) or a payout over time work for you?

Next, make an honest assessment of who in the family can fill your shoes. You may be thinking of transferring the business to the kids, but you’re unsure how to divide the earnings and responsibility, and whether they’re ready to step up. Or you might be considering handing it over to siblings who don’t work in the business as much as you do.

Most owners don’t spend much time working on succession planning, and when they do, they are overwhelmed by the sheer number of options, even when the only broad option being considered is a transfer to family members. It’s important not to worry about all the potential pathways. Rather, take time to meet with the family group to find common ground, then identify the right frameworks and conventions that fit.

Let’s look at a transfer to family members in more detail:
Pros
  • More control over the process – Unlike selling to a strategic, with a transfer to a family member you are in the driver’s seat.
  • Defined buyer, motives, and history – You know exactly who you’re working with. (You may have changed their diapers in years gone by.)
  • Trust – While there may be some jockeying between family members, it’s very likely you have a good idea of their values.
  • Benefit to family – With clear communication you can strike a deal that benefits all family members, including those who don’t want an operating role.
  • Creation of legacy – You’d be creating this for youself, your family and even your community, perhaps even on the scale that SC Johnson is to Racine.
  • Reduction of tax burden – A family transfer presents opportunities for your tax professional to reduce the tax burden that would otherwise land on the inheriting generation.
Cons
  • Complicated history – Many family businesses suffered internecine struggles, twists and turns along the way. This can be a minefield.
  • Emotional drama – Leo Tolstoy wrote, “All happy families are alike; each unhappy family is unhappy in its own way.” It’s not uncommon for drama, for example, if one of the grown children works hard in the business while siblings pursue other passions. Don’t tiptoe around sibling rivalries and emotional drama.
  • Longer payout – Family members usually rely on some owner financing to purchase the business. This can be more challenging if you, as the seller, expect to retire or need the money for something else.
  • More risk – By definition, a longer payout period creates more risk for you, in comparison to being paid out at closing. Consider what happens to your retirement if your family member runs the company into the ground.
Typical valuation process and deal structure
  • Even though owner financing will probably be used for the transaction, you will employ traditional valuation methods to establish company value. Again, using your industry’s multiple of EBITDA is the most common method.
  • Consider the highest dollar amount versus the lowest defensible value. Negotiate openly and fairly. Everyone at the table knows the business, yet there is room for respectful disagreement on future potential.
  • Work with your tax planner to determine your best structure for the amount of the business you want to gift to your children (or grandchildren), and whether it’s in the form of cash or stock.
Things to determine before structuring the deal
Money
  • When do you need the money? How much over the near and long term? Do you need a liquidity event so that you receive cash at the closing, or is that just a “nice to have” thing? Assume he meant “liquidity” not “liquidation” – wanted to make sure.
  • Forecast your ongoing cash flow needs after you transfer the business. To what extent and for how long will you rely on the company making future payments to you?
Control
  • Shareholder voting rights – Determine who gets to vote including: family members who will be operating the business, family members who will have an interest in the company but will not be involved in operations, and non-family shareholders. For example, if one of your children has been working in the company and would be a great president, while her brother pursues his passion to breed show dogs, should her brother have an equal vote?
  • Shareholder agreement – Work with your attorney to draft and execute an agreement tailored to your situation. This is your roadmap to clarity and family harmony.
  • Board of Directors or Advisors – It’s important to have a board to guide the next generation. Who’s on it? What length of term?
  • Determine how decision-making is structured – Identify which decisions require board approval, and which can be made by management. Can junior buy a gulfstream jet for the company?
  • Evaluate your emotional attachment to the business – Will you stand aside if the new president wants to change things that you care about? For example, if he or she wants to replace your best friend head of sales and bring in fresh talent, is that okay?
  • Future involvement – Decide how much do you want to stay involved with the business. Sure, you can continue hosting the annual Christmas party. But when your biggest customer comes to town, will you still expect to be the one taking him or her to dinner? How will your successor feel about that?
Financial
  • Salaries – Determine whether everyone is compensated according to the fair market value of their positions / experience. Perhaps you worked for decades at a lower than market rate. Are you expecting the family member who replaces you to follow suit? Is that fair, based on your respective ownership?
  • Distributions – Consider the conditions under which annual distributions will be authorized. If the company has a bad year, is it required to make distributions? It’s best to “crown the company as king,” so prepare a personal contingency plan in case of years when a distribution would harm the company.
  • Salaries vs. stock for family members – Separate your decision about dividing your estate from the salaries the company will pay your kids. You may want to divide your shares evenly among your estate’s heirs. Meanwhile the company can pay family members different wages, depending on their disparate skill sets and responsibilities.
  • Perks – Let’s assume you always drove a beat up truck; can your new president use company money for a BMW? Will you be able to keep your company truck? How about an assistant, expense account, or corner office?
Roles
  • Skill sets – Analyze and identify the gaps between different skill sets of the kids. Just because junior is smart as a whip, it doesn’t mean he’s ready to be the company CFO today.
  • Hire to fill the gaps – Find ways to work around the gaps in family member experience and capabilities. Don’t force a round peg into a square hole; identify their strengths and weaknesses, and set them up for success by leveraging their strengths.
External management
  • Bring in top talent – If family members are not ready for a leadership role, it’s important to serve the best interests of the company, and bring in talented outside leadership. Everyone benefits in the long run.
  • Transition – As you bring in external management, will YOU stay involved in operations. Even if the answer is “no” for the long term, it’s best, for stability, to maintain an operating role for an agreed transition period. Most businesses find a 6-12 month transition makes sense.
  • Responsibilities – In some cases the owner may continue working for the company even after transitioning leadership. You’ll need to jointly determine your new responsibilities. For example, if you started an apparel company because you loved designing clothes, and later grew into a general management role, now may be the time to return to your passion for design while external management takes the reins.
  • Salary – If you continue working for the company in some capacity, get agreement as to the salary. It may have to go up or down depending on the fair market value of your new role.
Involvement after closing
  • Ongoing role – Your involvement after the transfer depends on what ongoing role/responsibilities you want, and what level of oversight you’ll need to ensure the company will be able to pay you what it owes.
  • Develop a framework for decision-making – Clarify and write down how decisionmaking control will be allocated. Think through the hierarchy of interests/authority – owner/sellers, family member shareholders active in the business, family member shareholders not active in the business, and external managers. The distribution of responsibilities and authority is far more complicated than distribution of money.
Ongoing risk to consider / what happens when things go south.
  • Industry risks – Analyze the risks in your sector and market that could hurt the business. Since you’re not getting a big check up front, you face the same risks as you did before the sale.
  • The “Peter Principle ” – Determine if your management team’s skill set is capable of growing the business. If not, hire for any major gaps. Since you won’t be in the driver’s seat any longer, you want to mitigate the risk of new leadership driving it off the rails.
  • Personal guarantees – Many business owners have pledged their personal guarantees for lines of credit or real estate transactions. If the business fails, you could still be accountable for these.
GEXP Tips
  • Be formal in your approach – Craft a thoughtful communication and governance model. Appoint a board of directors that includes seasoned, independent directors who will offer wise counsel to newer leaders.
  • Prepare executive compensation plans – Ensure that these, for family and non-family members, are aligned with the financial goals of the business.
  • Communicate openly – Have a clear, written understanding about how active family vs. non-active family resolve conflict. Don’t be vague or indirect to spare a loved one’s feelings – clarity and candor will pay off in the long term. If one sibling is paid more than another, be open about why. The other one will probably understand

#3 SELLING YOUR BUSINESS TO YOUR EMPLOYEES THROUGH AN ESOP

Key Takeaways for this Section

  • ✔ Your largest after-tax payout could come from selling to your ESOP.
  • ✔ There are tremendous tax benefits.
  • ✔ You can control the company after the sale.

An Employee Stock Ownership Plan, or ESOP, is a qualified retirement plan allowed by federal law to borrow money to purchase the stock of a company, with a range of associated tax benefits. ESOPs are used for business succession and exit strategies in private companies. Your tax adviser will often recommend an ESOP when you’re interested in selling to your management team. But they’re equally effective if you plan to sell the business to your family members. It’s a good way to get liquidity on your exit.

The ESOP itself is the buyer, but you control the process. You sell all your stock to the plan for a combination of a promissory note from the ESOP and cash the ESOP borrows from a bank. You’ll seller-finance about half the purchase price. If your company is profitable and generates good cash flow, bank financing should be available for this transaction – usually at about 50 percent of the fair market value of your stock. Cash contributions from the business – from operating profits – are subsequently made to the plan in order to pay interest and principal to the bank and to you for your seller note.

Your employees are a part of this – they all get an interest in the ESOP, typically based pro rata on their respective salaries. This interest converts into qualified retirement income when an employee leaves the company.

Why Sell to Your Employees Via an ESOP?

Here’s a real life example:

Bob Riggs Salon used an ESOP as golden handcuffs for management as part of the owner’s succession plan. Bob owned and ran three salons bearing his name. He wanted to retire and have Heather, his young protégé and general manager, take over the business, but Heather didn’t have any assets to borrow against. So Bob set up an ESOP, appointed an independent trustee to the plan, and sold the ESOP his stock valued at $2 million. A bank lent the plan $1 million, using the salons’ assets as collateral and its operating income as the source of repayment. Bob seller-financed the other $1 million, receiving a promissory note from the ESOP.

Bob had the plan pay him $900,000 cash at closing from the bank loan proceeds, which he used to pay off his home mortgage and for some retirement travel. He left $100,000 in the ESOP and invested it in a diversified portfolio of bonds and stock index funds. Income from these investments and contributions from the business would go into the trust to pay off the bank loan and the seller note over a ten year period.

At the same time, Bob granted Heather a majority interest in the stock held by the ESOP (smaller interests went to all full time employees). Heather knew she couldn’t sell her stock until both the bank’s and Bob’s notes were repaid. But she understood that she was effectively the new owner, which motivated her to build up her company. Heather was a savvy operator. Over the next few years she focused on maximizing productivity at the existing locations. She subsequently used the additional cashflow to acquire three stores in different parts of the city, which she rebranded as Bob Rigg’s Salons. Then she began incrementally opening all-new locations. Revenue and profits soared.

By the time Bob’s note was paid off, Heather had tripled the number of Bob Rigg’s Salons in the city. They were a bit more upscale, and enjoyed a reputation for being a great place to work. Not only did Bob have a perfect exit financially, but under Heather’s leadership the salon chain became a wonderful legacy for his life’s work.

Let’s take a look at the transition to an ESOP in more detail:
Pros
Capital gains benefit for S-Corp sellers

You can defer or eliminate capital gains tax since you’re selling to a qualified retirement plan.

  • Similar to “like-kind” exchanges, found in Internal Revenue Code (“IRC”) sections 1031 and 1035, where you sell some property or annuity, respectively, and rollover the proceeds into new ones while deferring capital gains tax.
  • Compare it to selling your business to a strategic, for example, for $3 million when your basis in the company (your original investment) is $250,000:
    1. Typically, you pay 15-20 percent capital gains tax on some portion of this $2.75 million long-term gain.
    2. Taxes payable could be $400,000-$500,000 depending on your income level and allocation of the purchase price.
    3. If, instead, you sell your business to the ESOP for $3 million, generally zero capital gains taxes are due. BIG difference!
  • For 100% ESOP-owned S Corporations, you will have a completely tax free entity for pass through income.
    1. You may see this as too good to be true, but it is correct. Company profits are not taxed at the federal or state level.
    2. Depending on the state, you will be driving 30 to 50 percent of additional cash flow to the bottom line.
Tax deferral for C corporation sellers

If the ESOP owns 30 percent or more of the shares in a closely-held C corporation, the seller can rollover their proceeds into other stocks or bonds while deferring any tax on the gain.

  • Under the IRC section 1042, the owner must rollover the proceeds into “qualified replacement property” (QRP) – certain US stocks and bonds.
  • If the seller holds the QRP until they die, it’s treated on a stepped up cost basis for the heirs, providing them more favorable treatment under federal and many state capital gains taxation regimes.
Company benefits

ESOP plans can significantly boost net profits:

  • Tax deductions are allowed for both principal and interest paid by the ESOP on the bank loan and for the seller’s note. In fact, any cash the company puts into the ESOP is deductible.
  • Any new shares the company issues to the ESOP are also tax deductible.
  • For S Corporations that aren’t completely owned by the ESOP, ordinary income is converted to capital gains income, with the benefit of a lower tax rate.
Estate tax planning benefits

There are significant opportunities to reduce the amount of money you and your heirs pay in taxes.

  • Under ESOP plans, a future equity stake of 20-30 percent would be valued at $0 today because the company is leveraged, with debt owing for bank and seller financing.
  • There are many estate planning tools that your advisor can draw on to accomplish your inheritance goals:
    1. GRTs –Guaranteed Retained Trusts are irrevocable trusts that minimize tax liability when the assets of the estate transfer to the heirs. The seller of a business gifts company stock to the GRT and receives an annuity back over their lifetime.
      • There are two kinds of GRTs: (1) GRAT — Grantor Retained Annuity Trust, where the annuity amount varies based on the trust’s investment return; and (2) GRUT – Grantor Retained Unitrusts, where the annuity amount is fixed.
      • Because the stock was gifted the heirs receive a carryover tax basis in the inheritance, saving them lots of money.
    2. IDGT – An Intentionally Defective Grantor Trust is a tool used to freeze certain assets of an individual for estate tax purposes, but not for income tax purposes.
    3. CRT – A Charitable Remainder Trusts is used to convert the proceeds of the sale into lifetime income. It reduces your income taxes now, and estate taxes when you die.
    4. GRT – A Guaranteed Revocable Trust ensures the management and preservation of the seller’s assets if he or she is disabled, and establishes all the details for their estate plan. This trust may not shield heirs from estate taxes, but most GRT’s are treated as part of a decedent’s estate for federal income tax purposes.
    5. ILIT – An Irrevocable Life Insurance Trust pays for a life insurance policy on a tax-favorable basis. Ownership of an existing policy can be transferred to the ILIT after it’s been formed, or the trust can purchase the policy directly.
      • This has tax benefits if your heirs stand to inherit more than $10 million from you, since the new 2018 exemption was increased to $10 million.
      • For example, if, at the time of your death, your business was worth $6 million and you had a $5 million life insurance policy, the ILIT would shield the amount that exceeds the exemption.
Culture benefits
  • Selling to an ESOP can allow senior management to maintain control, rather than bringing in a strategic buyer’s management team.
  • An ESOP provides employees with an equity interest in the company without cost to them.
  • Employee ownership creates a “yes we can” attitude and helps get rid of negativity.
  • It aligns interests, so everyone understands and works for the same goal. Establishing an ESOP doesn’t mean that all employees have a right to see the books – they are not yet shareholders, and the ESOP doesn’t grant them shareholder rights. But the culture often transforms, as employees are mindful of where their interest in the stock is headed.
  • Productivity improves, as employees regard themselves as “Employee-Owners.”
Employees’ financial benefits
  • Employees maintain positions and remain employed, compared to a sale to a strategic where they could be laid off.
  • There is the potential for employees to make more money compared to non-ESOP companies where, at best, 401Ks are used to invest for retirement.
    1. When an employee retires, goes on disability, or otherwise leaves they will have a stock balance in the plan.
    2. The company is legally required to buy the stock balance with cash.
    3. The employee generally rolls the cash into an individual IRA because it’s qualified plan money, just like a 401K.
  • It’s easier to assign key employees a stake in the outcome that is equivalent to their work and worth, because shares are distributed as a percentage of payroll (within compliance), not based on “favoritism.”
Control

The seller controls the entire process:

  • Valuation – As the seller you decide what mechanism is used to value the company (i.e. multiple of earnings, discounted cash flow).
  • Advisor team – You can pull together your trusted advisors like tax planner, wealth/estate manager and lawyer for guidance.
  • Trustee – You appoint an independent trustee for the plan – someone that you know and trust with no personal stake in your business.
  • Timing – When you initiate this sale is entirely up to you. There is quite a bit of pre-work involved, but the only urgent trigger occurs if you’re anxious to retire.
  • Staying involved – After the sale, you can be as involved in the company as you want, whether that means CEO and chairman of the board, or retirement and travel.
Legacy

Selling to an ESOP keeps jobs in your community, versus the potential of losing jobs after you sell to a third party or strategic buyer. You’ll be glad you did when you see your former employees around town.

Cons
Industry risk

Since you are extending seller financing, you face the same industry and competitive risks that you faced as a business owner. Take time to consider how much external risk your business will face while it still owes you money.

Management and employee risks
  • Is your management team ready to drive the company’s continued growth?
  • Are your employees ready to participate in the financial discussions and education needed to get everyone on the same page?
Financial risks
  • Can your company’s cash flow service the debt and continue to support organic growth?
  • Can the company afford to pay out each employee the owed funds when they leave or retire?
Typical valuation process and deal structure
When selling to an ESOP that you control, you will still need to use standard methods of valuation.
  • The most common approach is to apply your industry sector’s traditional multiple against the trailing 12 month EBITDA.
  • Other valuation methods like discounted cash flow models, or detailed industry comparatives are fine too.
  • Valuation should be done by an ESOP specialist, based on what a financial / strategic buyer would pay for your business.
  • This isn’t a time to stretch the valuation to a higher number, because you could be setting up the company for failure if it can’t service the debt.
Deal structure

Typically, the ESOP pays you half the purchase price in cash from the proceeds of the bank loan, and half by issuing you a promissory note.

  • The ESOP can pay you a higher interest rate than it pays the bank, similar to a mezzanine loan at about 12 percent APR.
  • You pay ordinary income taxes on the interest earnings.
  • Instead of receiving cash interest earnings of 12 percent, you might accept a reduced interest rate – for example 4 percent – and get warrants in kind, thus reducing your income tax payable.
    1. Warrants are like stock options – a future equity stake.
    2. Reducing your cash interest rate to 4 percent over a ten year period could justify a warrant grant worth about 20 percent of the future equity of the company. And that’s after you’ve already sold 100 percent of your stock!
    3. You get this second bite of the apple after the bank and seller note are paid, taxed as capital gains not ordinary income.
Involvement after closing

You get to call the shots on what life will look like after the sale.

  • Management role – You can still receive salary and perks if you remain in an operating role, but you can’t simply take money out for personal use.
  • Board – You can still sit on the board and run the company after establishing the ESOP, including receiving board fees.
  • Trustee – You select the trustee – perhaps a trusted friend.
  • Open book management processes – You determine how much of the company financials should be shared with employees, now that they have a vested interest.
What happens the company fails after you do an ESOP?
  • An ESOP holds all the common stock in a company. If a company goes bankrupt the value of the ESOP, as the common stock holder, plummets.
  • If the company enters bankruptcy protection while the ESOP still owes you money on your seller note, some or all of the remaining payments you’re owed from the ESOP are at risk.
  • You may be able to set up a contingency in your ESOP plan allowing you to take control of the company if the ESOP defaults on your note, providing you with the opportunity to get the business back on track.
The process
  • Education – Work with experts to understand how an ESOP works in your situation.
  • Complimentary multipoint review – Rely on your experts to examine and review the details from all angles.
  • Preliminary valuation and analysis – It’s best to have an ESOP expert prepare the valuation.
  • Feasibility – Your company should have a value of at least $5 million, and 20 or more employees for an ESOP to be feasible. If you meet these thresholds, keep in mind that while you’ll pay significant upfront professional fees, a well-structured ESOP can yield considerable long term savings.
  • Implementation – Once you’ve got all the pieces together, it’s time to update management and employees, and roll out the program.

Conclusion:

Before you determine the type exit you want, it’s important to:

  • Think about the lifestyle you want after the sale and what that will entail, from an emotional and financial perspective.
  • Know the net dollar amount you need to realize in order to maintain your lifestyle and meet your financial goals.
  • Determine how much money you need at closing versus over time, and how much risk you’re willing to accept in relation to any later payments.
  • Decide what level of involvement you want to have with the company after your exit. This includes your role and responsibility, and ongoing emotional involvement – for example, if you extend seller financing, you will still have an attachment to the company for some time.
    • Identify what’s important to you besides price:
    • Your legacy
    • Employees
    • Benefiting the community
    • Family harmony
    • Maintaining culture
    • Charity involvement

If you find yourself prioritizing non-price factors, selling to internal buyers may be the best exit path for you, but it’s important to understand all of your options. In Part 2 of the Ultimate Guide to Your Best Exit Options, we dive into external exit options, including selling to strategics, investors, IPOs and liquidation. It’s critical to know what’s available to you before mapping out your own path…so keep reading!