YOUR BUYER MIGHT BE SITTING IN THE OFFICE RIGHT NEXT TO YOU
In previous posts we have talked about partners and family members as prospective buyers of your business. However, you might not have either partners or family members involved. So that begs the question; “Isn’t that what business brokers are for?” In building your plan to retire and cash in, instead of counting on a business broker you might consider developing a key employee as a potential buyer. There are many facets to such a plan but making certain that there will be money available is paramount.
Employees typically do not have the cash needed for an immediate buyout, and owners know they cannot risk selling a business to employees who have no cash. Take Skip Joneson, the fictional owner of Joneson IT Solutions, Inc. Skip's management team is capable and interested in buying the company. The business has little debt and good cash flow. When Skip met with his advisors to discuss the topic, one of their first questions was, "When do you want to leave the business?" If Skip answers, "Now" a sale to employees who lack cash is fraught with risk. If Skip's answer is, "I'd like to be out and cashed-out of the business in five to eight years," a well-designed exit plan can make that happen, but Skip must start today.
ANY BUYOUT PLAN MUST ACCOMPLISH THE FOLLOWING GOALS:
1. Minimize risk for the owner, the company, and the employees by keeping the owner in control of the business and the sale process until the owner receives the entire purchase price.
2. Ensure that the owner receives full value for his or her ownership interest.
3. Minimize the income taxes of both the owner and the employees.
The key to selling to employees is not just time. There can be no certainty of success unless the employees are retained over the long haul and have enough money to guarantee success. Capable employees have options. I recently overheard a conversation at a family picnic. My cousin was telling one of my brothers that he had just switched jobs and had doubled his income. Needless to say, my brother started questioning his compensation and immediately determined that his skills were more valuable to a new employer. We had talked for years about his plan to buy out his employer, but he would never execute his plan. He was giving up too much salary to risk his future in a small business even if he could own it. Employee retention should be a high priority. Assuring that they have the money to close the deal is a close second.
If you plan well in advance of your departure, you can achieve these three goals. Special planning is required to meet the income tax minimization goal.
THREE STAGE PLAN DESIGN
A plan to execute a successful employee buyout has three stages.
- The purchase of key employee permanent life insurance payable on death to the company. This covers the risk of losing the employee because of premature death. The cash value is reserved for the employee and his family. It funds an additional fringe benefit designed to assure the employee is incentivized to stay with the company. It funds a supplementary retirement income or, in the event of an early death, capitalizes that income stream for the surviving family. It can be subject to a vesting schedule to create a golden handcuff that makes it unwise to leave. If the employee eventually buys the company the cash value of the policy will provide a significant down payment. Design of the policy is critical if it is to serve these multiple functions.
- Each year employees buy small amounts of stock until they have purchased and paid for approximately 35% to 40% of the ownership (usually non-voting). You can also grant them additional stock bonuses as part of their incentive plan. Ordinarily, this stage takes five to eight years.
- Assuming the business continues to be profitable, paid-up owners of 40% of a company are normally able to secure bank financing to purchase the remaining balance of the owner's stock. Skip's buyout plan kept him in full control of his business until he received all of his money. Because he maintained control, he significantly reduced the risk of not receiving full value. He successfully cashed out of his business because he did not wait to start his exit planning until he was ready to leave. BY STARTING BEFORE HE WAS READY TO LEAVE, HE WAS ABLE TO CHOOSE HIS SUCCESSOR, EXIT ON HIS TIMETABLE, AND LEAVE WITH THE CASH HE WANTED.
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