Business owners who have the ability to hire, train and retain excellent employees do themselves a great favor when it comes time to sell their business. Recruited employees who sign on to the company culture, are potential purchases of the company. They get involved in all aspects of the business when given the chance. The ability to nurture these employees not only creates a great long-term employee, but possibly future owners of the company. The investment in good employees has the by-product of creating a potential market for the business owner’s business.
Over time, these owners can create employees who become extremely loyal, and feel part of a group and the business itself. They observe how the current owners treat the business, the employees, and learn the long-term elements needed for a successful growing business. They become clones of the current ownership, and start to think like owners, while taking on more responsibilities.
While the owners at some point need to make the commitment to the potential employee(s) purchaser to sell the business to them, it also means the employee or employee group needs to be able to commitment to the purchase of the business. To the purchasing party, this means committing to taking on risk and financing for the purchase of the business. In most cases this is something they never have done before.
The commitment to sell the business to key people, or key person is a long-term process. The owners have to make sure the key person (s), have the ability to think like employees, and the abilities to run the business with expectations of the company being profitable. The owners will spend time training and assessing the abilities of the key group to prepare them for the business takeover There is a commitment on both sides as to arranging this type of sale.
Financing the Sale:
A sale of the business to an outside group usually is a cash sale. Or, a combination of cash and stock of the new owner. (Usually when a larger company buys a smaller company).
It is here that the advisors need to make sure the selling owner maximizes his sales with tax efficient transactions. Many business owners sell their firms only to be surprised at the after-tax results of the sale. Keep in mind that when you sell the business, usually there is a low-cost basis, the consequence paying higher taxes on the gain, means less net profit!
If it is an asset sale, there may be a low-cost basis of the assets being sold, consequently creating more tax exposure, and more taxes.
Take for example, an asset being sold after it has been depreciated, it may be taxed as ordinary income. Usually the asset is owned by the corporation. If the company is a C corporation, the sale is taxed at the corporate level, then taxed at the personal level. The combination of a low-cost basis, C corporation tax, ordinary tax rates, and double taxation can erode gross profits to a point where the owner wonders why they sold the company for the next.
If the owner sells their company to a publicly traded company, and takes back some of the purchaser’s stock, there should be pause as the consequences should the stock value fall because of the transaction, and the uncertainly of the value when the selling owners wish to cash out.
It has happened more than once when selling owners, ended up with much less in their pockets after the taxes and expense of the sale were taken out!
Selling to a key group or a key person is usually a different arrangement. Usually the employee does not have the financial ability to purchase the company, thus a loan from the small business association or bank is needed. Sometimes, the employee comes up with money by refinancing their home or borrowing from the family. In many cases, the selling owner usually takes back a note expecting payment from the cash flow of the business. It’s common to have a combination of refinancing, a promissory note, and possible deferred compensation payment to the selling owner. In any event the selling owner usually has some skin in the game as to the financing of the sale. Because of owner financing, the ultimate payoff might be extended over a longer period of time. Not necessarily a bad thing, as the owner can spread the tax liability over a period of time. The owner will also have a security interest in the stock, assets, and receivables of the company, until the loan is paid off.
An executive benefit plan for the key people/group, is a well-advised strategy. Keeping the group tied to the business while the owner grooms them is very much a benefit for all parties. This keeps them involved and incentivized as to the ownership. By putting a vesting schedule into the benefit plan, you entice the employee to be involved with the company culture, as they have an incentive to stay. That increases the chances of their interest in purchasing the business in the future. This also gives the owner time to train the potential buyer employee and show them the ropes, and to see if they have the ability to run the company.
Along with a vesting schedule in the benefit plan, a non-compete agreement, and, a non-disclosure agreement should be executed. This protects the owner from competition from the key person or group, should they leave, and also, sharing of company secrets to a competitor.
These agreements prevent the key person from holding the owner hostage when a purchaser has an interest to buy the business but wants the key group to stay on. . Many times, the sale is predicated on the key people coming with the new owner. Wouldn’t it be easy for a key person to tell the current owner they will not go unless the current owner includes some of the profit of the sale as a bonus for the key person, or else they will not sign off on going with the new owner?
The agreements are usually enough to avoid this type of “hold up”.
Another option is selling your business to your key group is by using an ESOP. This allows the owners to contribute their shares of stock to the ESOP and then cash out. The ESOP is a qualified plan and can be tax efficient for the parties.
Professional Management;
Situations often occur when the owners want to sell but there is no buyer. Or, the company hasn’t developed value drivers and systems to increase the business value to justify a good market price or optimum market price. If that is the case, there is the option of hiring a professional manager to run the business while the owner becomes a passive owner, or until someone can be found to purchase the business. In many ways, having a professional manager will help the owner “tidy up his business” for a future sale, and focusing on getting the “house ready to sell”.
The Scenario That Is A Must!
All the scenarios discuss so far were based on a future timeline, and a long-term nurturing. However, not so when there is a death of the owner, co-owner, or key person.
When this trigger happens, chaos is created. For example; if a co-owner died, who is the owner’s new partner? Is it the deceased partner wife, kids, lawyer, trust or other family members? It may also trigger a pay out of a large sum of money, or a long-term payout, squeezing cash flow. Another issue would be the status of their credit line, the life blood of most companies. Will the bank call the loan?
A buy and sell agreement should be in place to address the triggers which can cause a transfer of ownership. The Buy and Sell agreement spell out what happens when there is a trigger. It should spell out the terms of the purchase, the funding along with a copious of other items.
- Death
- Divorce
- Bankruptcy
- Disability
- Disgruntled relationship of partner
- Involuntary or Voluntary leaving
- Retirement
To avoid the chaos, and the potential of having someone owning the majority of stock unintentionally, the stockholder agreement, or buy and sell should be in place. It also should be funded with life insurance to provide the necessary capital to transfer the business for value.
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