By Cory Howes
Some business owners have spent years grooming a child or other family member to take over, wanting the business to stay in the family. Others look to sell to a third party for a quick way out that will also give them a nest egg for their next phase of life. However, there is a third option–transferring the business to your employees. If you like the idea of transferring ownership your business to long-time faithful employees who have contributed greatly to the company’s success over the years, here are a couple of options for you to consider.
This type of transfer is a process, not an event. The management team comes together with the financing and arranges a deal with you to buy the assets and operations of the business. A management buyout has the benefit of being quicker and more confidential than a third-party transaction, and the structure of the deal can be more flexible. There’s also the added benefit that the legacy of the company will continue in the hands of those in management who have earned the opportunity to buy the business with their loyalty and hard work.
With this option, you may also be able to provide some continued service to the company as an officer and/or director. In addition, you may even be able to continue to play a smaller role in the business that you enjoy. Finally, you may be able to keep some control over the company.
When considering this option, it’s important that you consider the following factors:
- How much cash, debt, and earn-out will be involved?
- When will the transfer of control occur?
- If management has little or no capital, where will they get the money for the buyout?
Employee Stock Ownership Plans (ESOPs)
An ESOP is a qualified plan under the Employee Retirement Income Security Act of 1974 (ERISA). Instead of selling directly to management, you are making the sale to the ESOP, which has been set up by the company. The ESOP can either attempt to get bank financing to purchase the stock from you, or you can take a note for the value of your shares and have the repayment taken care of internally. The employees become plan participants, similar to other employee incentive programs and are entitled to benefits at certain points as determined by the terms of the ESOP.
This option is similar to a management buyout, but with potentially valuable tax benefits. With an ESOP, you are selling stock in the company, not the assets, so the taxes are capital gains, not ordinary income taxes. Because of this distinction, there are planning techniques available that may help save on taxes with this transaction.
When reviewing this option, there are a few things to consider:
- In order to repay the note, most (if not all) of the excess cash flow from the business may be needed, instead of using it to grow the company;
- The company must set aside money to meet repurchase obligations on the ESOP when an employee retires, dies, becomes incapacitated or terminates his or her employment after vesting;
- Stock in an ESOP is allocated based on payroll, so there are no extra management incentives.
Both management buyouts and ESOPs are options that should be considered if you are looking to transfer your business to your employees. We are here to help you as you weigh the pros and cons of all of your succession planning options. Give us a call, we would be happy to discuss these options more and find a solution that best protects you and your legacy.