Selling Your Business to Employees or Family Members [Transcript]

 

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[Plan Your Future Today]

 

[Jay Simicek, Consultant, CEPA]
[FSBDC at UNF]

 

Jay Simicek:

The topic today is Exit Planning Options. If you own or co-own a small business, I’m sure you’ve spent a lot of time and effort building that business. That business now has value. If you’re watching this session, I’m sure that you’ve started the thought process toward the end of transitioning out of that business, selling your business in retirement. That’s called an exit process.

 

Of key importance in that whole exit process is understanding the options ahead of you. What this session is going to show you are some exit options organized in a way that we think will make sense to you. And it will be an overview. Obviously, there’ll be more research necessary by you and your staff to complete the information on the exit options. You’re looking to realize the most equity that you can possibly get and realize the value that you’ve built in your business.

 

Okay. Three major categories of options, with options within each of those categories. First, to sale to the insiders, second to sale to outsiders, and the third is liquidation.

 

First, sale to transfer to insiders. Four sub-options to this type of transaction. Number one, keeping the business in the family. Two, sale to various selected employees or employee group. Third, transfer to all your employees. And the fourth, sale to your co-owners and partners, if you have co-owners.

 

Let’s first talk about keeping the business in the family. All right. The format for this presentation will be as you see it in front of you. I’m going to give you some positives and negatives, advantages, disadvantages, pros and cons. And by leading you through some of those, we think you’ll have a better understanding of what that option is all about, and you’ll have the ability to make the decision on which option is best for you.

 

So in terms of keeping the business in the family, one of the positives is the legacy. We find that most small business owners would prefer that that legacy of that business that they’ve worked so hard in over the years stay after they leave. In this type of transaction, you would know the successor. If you’re keeping the business in the family, obviously you would know that family member and that successor. That’s a distinct advantage. Third is, the level of secrecy. Often, a small business owner is interested in privacy during the transition period. And in this case, you’d be more likely to maintain a level of secrecy.

 

Next, you’ll have the ability to do some advanced planning. Again, you’re working with that family member, and hopefully you’re working over a long period of time, you’ll have the time to work with them, so that you can do this together as a team. Next, there should be minimal disruption in this process because, again, you you’re working with a familiar figure, this family member. There should be motivation as well. The motivation of this family member to finally take over the business and assume the ownership.

 

On the negative side, we have found over the years that perhaps at least half or more half of family-owned businesses at one point or another intend to transfer the ownership of that business to a family member. But in reality, less than 30% of those transitions are successful, and even less than 10% are successful to the third generation. So it’s not an easy matter, and it takes some work to do.

 

The desire and qualification issue is critical. The most important bullet point in this slide is that you as an owner must know that that successor, that family member, number one has a desire… you may assume that they do, but often they don’t… and the qualifications and skillset to best lead this company. If you make false assumptions in this case, it could be devastating to that transition.

 

Next, conflicts and family favorites. Let’s be honest. Often in family-run businesses, especially where there are multiple family members, conflicts arise, family issues arise outside the business that can enter into the business negotiation. And then this issue of fairness. What’s the definition of fair? It’s all in the eyes of beholder. So most business owners would like to be fair. They may have family members inside the business, they certainly have family members outside the business, and they would like to be fair to all parties.

 

Some of the techniques that are often used in this type of transaction are gifting, annuities, and trusts. I might mention on trust. Trusts is a vehicle for you to shift assets from you, from the owner’s estate into other hands according to contractual arrangements for that shift.

 

Some of the trusts that you might want to explore are called the AB trust, the QTIP trust, the GRAT trust, life insurance mechanisms have trust associated with them, and a charitable remainder trust is often used. Also, there’s something called a family limited partnership, that could be used in an extended transition period. And then, obviously, just an outright sale to a family member could occur.

 

A lot of preparation, as you would imagine, needs to happen as these techniques are used. You need to research these and sit with your advisor to make sure that you understand each of these tools and techniques.

 

You need to groom a successor. This is very important. Again, back to the previous slide, you need to know whether there is the desire and the qualifications for this successor, even though it’s a family member. That family member that takes over the business needs to have stakeholder support. What do I mean by stakeholders? Obviously, the employees are a large stakeholder. Customers and vendors probably know you as the owner. They need to know the successor and trust that successor.

 

You need to have an estate plan well in hand and up to date. You need a board of directors. You certainly need a board of advisors. If you don’t have them in place, that’s prudent to do that at this time. And you need a management succession plan. Once that family member assumes the role of owner. It may create vacuums in your management team. You need to plan for the succession of those managers.

 

Now you’re selecting an employee that is not a family member. The positives in this case are that, again, you can select that owner that… Next, let’s talk about the sale to a selected employee or employee group. Some of the positive aspects of this type of transition are that you, as the owner, can make the selection yourself. And it will probably come from key management or your key leadership group, but you can make that selection.

 

Normally, this will maintain the continuity of the business while the transition period is taking place. You certainly should have a motivated buyer in this case. If you have an employee or a small group of key employees who are interested in taking over the business, they should be highly motivated to gain equity in the business. Also, there’s a chance for a lot of advanced planning in collaborating with this selected new owner or ownership group, you can actually take advantage of that planning cycle.

 

And then lastly, there’s a chance of a possible private equity infusion into the business at this point. This private equity could be used with a number of these options, and it certainly applies to this case. On the negative side, the buyer knows the business. And normally that’s a positive, but the buyer also knows the negatives. They know what’s known as skeletons in closet.

 

Next, we find typically in employee group or employee purchase that financing maybe a bit of a difficulty. That’s why a leveraged buyout or an LBO is often used so they can get some financing assistance. There’s, from time to time, operational distraction, especially if you have a group of employees that are spending more time on the purchase than on running the business.

 

Next, because you’ll probably want employment contracts going forward with these new owners and some of the employees that are involved in the new management succession, the sale terms of the price may be affected. So you need to watch out for that.

 

Possible seller financing or the owner taking back a loan. Again, that refers to the inherent financing difficulty in some of these transactions. It’s not that taking back a loan by the seller is a bad thing. It’s done all the time and it can be very successful, but you just have to make sure that you cover the risks in doing that.

 

The last bullet is what I call manager versus leader. You as the owner, really must make sure that you know that these succession individuals, these new owners and leaders of the company will be managerial material and leadership material. It’s my experience that manager leader doesn’t always come in the same package. So make sure you have both management and leadership talent.

 

Next, let’s talk about sale to employees. Again, we’re talking about sale inside the business. And in this case, you may explore the option of selling to all your employees. The common tool for this is called an employee stock ownership plan, better known as an ESOP. On the positive side, for those of you that don’t know what an ESOP is very quickly, an ESOP is a tool that was initiated back in the ‘70s as part of the initial ERISA legislation.

 

It is a trust and it is a benefit. It’s governed by a lot of the rules and regulations of ERISA law. It’s a trust. It allows your employees to gain stock ownership in your business without them contributing, without them taking money out of their pocket to do so, so to speak. So it makes some critical tax advantages that you need to know about: one is for the seller, one is for the company going forward.

 

The first tax advantage is for the seller. It has to do with the capital gains. As you know that during the sale transaction, you as a seller will be liable for capital gains tax. In any stop transaction, it’s possible for you to defer all capital gains taxes. That’s a big one for you, the seller.

 

Second, for the company going forward, there’s also a tax advantage. If that ESOP company going forward is a sub S corporation, under certain circumstances they can exempt federal income tax and some state taxes as well. So yes, those are very big factors in not only the selling transaction, but also the company going forward.

 

Next is company culture. This is a very important factor. ESOPs have been around since, as I said, the ‘70s and ‘80s, and there’s enough research done on ESOP companies to show that a well-run ESOP company with a really good culture, an ownership culture, beats its competition. There’s better bottom line performance. It’s shown through evidence. So keep that in mind.

 

An ESOP is almost an ideal solution if you want a gradual exit, because you can sell chunks of your stock, you can stay in the business as long as you want, selling pieces of the stock to the ESOP. So it can accommodate a gradually exit.

 

Another real positive advantage is that according to the laws, you as a seller are guaranteed fair market value for your business. Compare this to selling to an outside entity, where there would be a negotiation for that price. In this case, law says that you get fair market value. And of course, the positive benefit for all the employees after the transaction is the employees have a real wealth creation vehicle for themselves.

 

On the negative side, this is a specialized transaction, and you need experienced advisors to do it. So there could be some significant cost. That cost would be determined by the complexity of the deal, of course.

 

Advanced communication would probably be required. And those of you that are worried about the privacy issue throughout the entire process, we have found that advanced communication, especially with the employees, is actually a prudent thing to do. You must understand that there’s a repurchase obligation involved with the new ESOP company, which means that the company buys back the stock from employees that leave the company.

 

Certain qualifications more or less apply to companies that enter into this ESOP transaction. The preferences for obviously profitable companies, companies that have a positive cash flow, future debt capacity, and low turnover. For instance, a fast food restaurant that has a number of part-time employees and a lot of turnover is typically not a candidate for this type of transaction.

 

The next option for selling inside is what’s known as sale to co-owners or partners. Obviously, if you have a co-owner partner. But if you do, the positives would be a well-structured buy-sell agreement. Buy-sell agreement is absolutely critical. And if you have a good one, that’s a positive. In that buy-sell agreement will be the right of first refusal for the other partners, and the purchase options would be laid out. The method of valuation and the financing for that co-owner or partner buyout would be laid out in the buy/sell agreement.

 

Again, we’d have the chance for advanced planning because you know that entity that’s going to be buying. There’s probably less business disruption with this type of a sale because you’re not going outside. In this case, you would have well-informed buyers, especially if those buyers are working in the business and really familiar with the business. This whole transaction and the process could very well be done at a lower cost than some of the other options.

 

On the negative side if there’s no buy-sell, you’re looking for some possible disagreements and discord if the buy/sell agreement issues are held to the last moment. Even if there is a buy-sell, there may be fewer options. Even though they’re well laid out in the agreement, there may be fewer options for you than if you didn’t have one at all.

 

There’s also a chance of a lower price than some of the other options. If there’s a lack of involvement by that partner. In other words, it’s an outside partner rather than one that’s working in the business, there’s going to be a learning curve. And if they’re going to suddenly become the owner of the business and become more involved than they were in the past, you have to bring them up to speed, and that could lengthen the time that the exit is being done. And of course, the proceeds may come at a slower pace if this education process has to take place.

 

Okay. That wraps up the overview for selling your business inside, to insiders. Thank you for attending.

 

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