Posted In: Business Transactions & Corporate Counseling & Mergers, Acquisitions and Divestitures
Business Blog: Exit Planning - Considering the Future of Your Business
By Megan C. McClung on July 25, 2019
As a leader of your business, you are well-equipped to handle the countless challenges involved in keeping your business running. But your experience and know-how may not prepare you for the ultimate challenge that you, and other business leaders, must face: identifying a succession plan to transfer the business to new owners.
Implementing an effective succession plan is not an easy task to undertake. In fact, roughly 75% of all businesses fail to survive past the first generation of owners.1 Over 85% fail by the third generation, and more than 95% fail after that.2 However, seeking expert advice can help you relinquish ownership of the business while positioning the business for a successful future.
A popular succession plan is the management buy-out (MBO or buy-out). Buy-Outs are rewarding for many entrepreneurs because control of the business is transferred to management from within the organization itself. An MBO is an excellent way to keep your business independent and ensure its continued operation. In fact, buy-outs are becoming increasingly popular with younger family businesses, where ownership can be transferred to people who have knowledge of the business, possess relevant experience, and who already have a stake in the business’ continued success.
Typically, an MBO is implemented through buy-sell agreements and stock options. Buy-Outs require decisions regarding who should own how much stock and at what price. Price can be based on a formula that considers the business’ assets and performance or on an external estimate of the business’ value. With a sale among colleagues, the sale price can be highly negotiable and can include continuing compensation arrangements, whereby the business commits to pay the former owners for a specified number of years. Such continuing compensation arrangements reduce future earnings (and therefore the value) of the business, which can actually make the sale easier from a financing perspective.
Many possibilities exist for financing buy-outs. First, the new management must determine how much stock can be purchased immediately. Second, the company will have to buy back any stock held by the owner that is not being purchased by the new managers personally. Typically, the company uses bank loans to purchase stock from the owner. Although this type of leveraged buy-out is attractive for its simplicity, it has several drawbacks, including (i) committing future profits to pay for the stock purchase, (ii) pledging the company’s assets as collateral for the bank loan, and (iii) using post-tax dollars to make payments on the stock. In this type of leveraged buy-out, taxes and financing costs may cause every dollar of stock purchased to eat upwards of $1.50 of the company’s pre-tax income.3
Seller financing is an alternative to bank-financed buy-outs. In a seller financed buy-out, the business purchases the selling owner’s stock under notes or loans from the selling owner. The purchase price is paid to the seller over a period of years. Although this type of leveraged buy-out can be attractive for businesses because it reduces costs and allows for more favorable financing terms (given the selling owner’s confidence in the new management team), seller financing still looks a lot like bank financing (i.e., payments must be made with the business’ post-tax dollars and must include at least commercially reasonable interest). Because seller-financed buy-outs extend the payment term over a period of years, the selling owner should seek expert legal and tax advice to minimize any potential negative tax consequences.
A buy-out can also be structured as an installment purchase of the selling owner’s stock. An installment purchase is attractive because it allows the new management and business to purchase the stock over a period of years, but it can be difficult to implement in accordance with IRS rules. Legal instruments, such as trusts can be used to hold the stock until the new management and/or company can buy it, which minimizes the potential for negative tax consequences to the selling owner.
Alternatively, an Employee Stock Ownership Plan (ESOP) may be used to transfer a business to its employees, while retaining control among a chosen management team (typically, the primary shareholders). An ESOP is essentially a retirement plan for the company’s employees. Like a 401(k), an ESOP is a qualified plan designed to benefit all employees. It must be non-discriminatory (i.e., it must not provide a greater benefit to one class of employees over another).
The company can purchase stock from selling shareholders with money loaned from the ESOP itself. Because the loan is made through the ESOP (a qualified retirement plan), payments of principal are made with pre-tax dollars. The purchased shares are held in the ESOP trust, under the control of a trustee appointed by the company’s board of directors. The ESOP trust in turn makes annual contributions of stock to employee accounts. Not only can the business benefit from purchasing stock through an ESOP, but also selling shareholders can benefit by receiving tax breaks if certain circumstances are met.
Administration of the ESOP requires annual valuations by an outside party. The first valuation is more expensive than subsequent annual valuations, which often cost a few thousand dollars annually. The implementation of an ESOP also requires that the business adequately address the concept of repurchased liability by creating a market for employees to redeem their vested shares upon certain events (e.g., death, retirement).
Alternatively, especially for family-owned businesses, recapitalization may be an effective succession plan to begin transferring the value, but not control, of the business to the successors. Recapitalization is more commonly appropriate when transferring a business from parents to the next generation. To recapitalize, the business issues two classes of stock: voting preferred stock and non-voting common stock. The non-voting stock is transferred to the successors through sale or gift; whereas, the business retains the voting preferred stock until the owners are ready to transfer control.
Other exit strategies include selling to an outsider (i.e., someone who is not currently involved in the company), such as an existing customer, supplier, or competitor. The sale may occur as a lump sum sale or as an installment sale that spreads the payments and tax implications over a number of years. The sale may be structured as an asset sale, a sale of stock, or a combination of both. The market and other factors may dictate the nature of the sale. However, as a business owner, you are typically motivated to sell the stock in your business to take full advantage of the lower capital gains tax rates (a sale of assets usually subjects a portion of the gain to ordinary tax rates). In sales to outsiders, potential buyers will perform due diligence regarding the company’s competitors, suppliers, substitutes, products, services, customers, business scope, and market capitalization. Based on its market analysis, a potential buyer will make an offer to the company. Both parties can negotiate price, and, in the end, must mutually agree on a purchase price.
One type of third party sale is the management buy-in (MBI or buy-in). Typically, buy-ins occur when there is no obvious successor for the business (i.e., when there is no family to take over), and an outside investor feels that the business is underperforming and could generate greater-than-current-yields with a change in strategy and/or management. Upon acquiring the business, the buyer will often replace the current board of directors and management team with the buyer’s own representatives. An MBI is attractive because the new management can help grow the company and continue its operations. Current employees may also be motivated due to new changes in management.
1. Brad Franc, Why Business Succession Plans Fail and How to Beat the Odds YPO (2019), https://www.ypo.org/2019/04/why-business-succession-plans-fail/ (last visited May 20, 2019).
2. Brad Franc, Why Business Succession Plans Fail and How to Beat the Odds YPO (2019), https://www.ypo.org/2019/04/why-business-succession-plans-fail/ (last visited May 20, 2019).
3. Ohio Employee Ownership Center, Business Succession Planning Options, http://www.oeockent.org/exit-planning/planning-options/ (last visited May 20, 2019).
This blog is intended to provide information generally and to identify general legal requirements. It is not intended as a form of, or as a substitute for legal advice. Such advice should always come from in-house or retained counsel. Moreover, if this Blog in any way seems to contradict advice of counsel, counsel's opinion should control over anything written herein. No attorney client relationship is created or implied by this Blog. © 2024 Brouse McDowell. All rights reserved.