When considering the transfer of stock to a key employee, or a group of key employees, (referred to Key group), you need to determine how much they want to be involved in the company, and the risk they are willing to take in the future of the company.
In Tier One of the purchase, the key group will purchase stock. They purchase stock from future salary, financing, or from future cash flow in the form of dividend payouts.
It wouldn’t be uncommon for the owner to want to see the purchasing employee put some skin in the game. Seeing the employee be committed allows the employer to consider future financial programs to help the employee purchase the balance of the stock under Tier 2 (the selling of the balance of the stock).
The owner in most cases will look at the bottom line what they want in the end and the financial capabilities of the key employee. Smaller employees will try to make it easier for the key person to purchase the stock. Using a bonus plan to help them buy the stock can be a very useful tool for both parties. The employer gets a tax deduction, while the employee has additional funds to purchase equity in the company.
Using lower valuation for a better cash flow when business is sold
A process an owner may go through when selling their business is to realize they may have higher net overall exit proceeds if a lower overall valuation can be supported for the company. There is an understanding that by using a lower valuation (defendable valuation), the owner will also be compensated with another benefit, such as deferred compensation payments. By doing this, the overall cash flow needed to make the sale is lower than selling at the value of the company, and paying the capital gains on the sale of the business. (see example below)
How This Is Done
The business is sold for the lowest defensible value the owner can sell it for. The owner will be taxed on the gain, as capital gain. The owner will also receive a tax-deductible payment (on the company level, taxable to the recipient of the income, called a deferred compensation. The combination of the sale price and the total deferred compensation payment equals the value of the company. Most owners know they have to pay a capital gain tax on the sale of the business but few know they have to pay a tax on the purchase of the business.
Purchaser buys the business for $1,000,000. The purchaser gets the money from the cash flow of the business. In a 40% tax bracket, the purchaser needs $1.7 million dollars of income to net $1 million dollars.
The seller would pay 20% of capital gain. Let’s say $200,000. The purchaser has to pay $700,000 to purchase the $1 million business. For a total of $900,000 of in taxes.
You value the business at $400,000, (lowest defensible value). You pay the capital gain on the $400,000. The cash flow for the business would be $500,000 vs. $1.7 million. However, the purchaser would engage with a deferred compensation plan to pay the difference of the sales price. The seller (former owner) would pay taxes on the deferred compensation payout, but pay less taxes on the capital gains. The purchaser would get a full tax deduction on the payments to the seller under the deferred compensation payout.
In this example, both parties would benefit with an overall cash flow savings of over $156,000.
There are a number of other considerations when selling your business, however, parties should be aware of creative ways of making the deal happen. No matter what you define the payment as, it is the amount of money you want for your business, only done in a more tax efficient manner.