Exit Plans, Succession
Selling your business is tough. What is even tougher is realizing the urgency in transferring the ownership and control to someone else. Handing over the keys come easy for some, and very challenging for others.
Books have been written just on exit and succession planning so it is difficult to cover every angle in our over-arching book. But there are some general concepts to consider.
Most small business owners fret over two things as they get older- what the heck to do with his or her day, and income. The first worry is like nailing Jello to the wall. Do you go into the office to open the mail? Is your only responsibility maintaining client relationships? Are you a mechanic at heart, and still want to tinker with cars but not sign checks?
It is amazing how many owners want to stay on in some capacity, and then realize that the daily grind stinks, they are not needed as much as they envisioned, and how fun not knowing the time or day can be. But at first, the control aspect.. the what will I do with my day aspect is a big challenge. Remember, most small business owners got into business by turning a hobby into a profession, and while it became a job on many levels, at the core it remained a passion. Tough to give up.
Just like Brett Favre- a case where a person needed the game more than the game needed the person. That is tough to accept. But then again, father time is undefeated. So, get over it.
Income is one of the other concerns. If I just sell my business, will I have enough income? It depends on two variables- what you need and how long will you need it. More challenges. More Jello.
So, what does a small business owner do?
Selling can be nearly impossible. Remember, the United States Board of Tax Appeals defines fair market value as, “The price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts.”
Face it. Some businesses are much easier to sell, and some are not. Do you have a lot of competition? If you do, that might be good since competitors might be looking to increase market share.
Is your business unique? Makes a boatload of money, but very specialized and isolated with few competitors. Selling these types of business is much more difficult. Sure, you can always find an investor who wants to learn your craft, but that is not as easy as selling your Subway franchise to another Subway franchisee.
These are things that small business owners need to consider.
What about selling the company to one or two or three key employees? Perhaps. This can solve a lot of concerns right away.
First, you know the employees. You trust them. They might even share the same passion you do for the business. You’ve trained them to do things your way, which might or might not last, but at least you feel more comfortable than an unknown.
You can dictate the transition. So instead of a cliff-type transition where you lock the doors at 5:00PM on a Friday and hand the keys to the new owner at 8:00AM on a Monday, you can slowly slide towards phasing out. But then again, as Def Lepperd once said, “It is better to burn out than to fade away.” Just kidding. Perhaps fading away is better.
Income can be generated by guaranteed payments or stock purchase loans. For example, one common way to sell your company to other key employees is have them buy a small percentage from the company. Let’s say you have two people. The company sells 5% to each of them, and over time the new owners use their distributions to payback the buy-in.
When the buy-in is complete and a date has been established for transition, the company buys 90% from you. This will probably be financed, but cash certainly works. So, the company owns 90% of the stock, and the remaining controlling interest is now owned by the two key employees. They run the company. You are out, or at least fading away.
You have to be careful, and you will certainly need an attorney for these arrangements. S Corporations cannot have two classes of voting stock, so if you sell 10% to a key employee, he or she is an owner with voting rights from the beginning. He or she will receive a K-1, with taxable income. Depending on the tax consequence, there might need to be a split between the shareholder distribution being used for payback of the buy-in and personal income taxes.
During the buy-in period, termination for cause would require the forfeiture of the shares at a predetermined value. Same with death, divorce and incapacitation. Again, more lawyer stuff.
There truly are a million ways to structure these buy-ins. The Watson CPA Group recently represented a business owner who wanted to setup an account for three key employees. Profits exceeding a predetermined amount was placed into an account that would pay life insurance premiums. An insurable interest existed on each key employee for the company since their services were valuable. And if the key employee separated from the company, the company recovered the cash value of the life insurance policy.
It was intended for this account to grow in value plus the cash surrender which would be a sizeable down payment on the acquisition of the business ten years later. In these deals, valuation technique must be established at the onset.
In another deal, a client of ours did a similar cash account and arrangement with just one of his key employees. There was not a life insurance element. Basically it was a deposit of profit percentage each year for five years. The account could only be used as a down payment for acquisition. Need to be careful how this is structured too so it doesn’t appear to be a second class of voting stock.
In both of these deals we represented the business owner. However, had we represented the key employees, we would have asked some basic questions such as how is profit margin determined? Should officer wages, depreciation and amortization be backed out? Does the employee or group of employees get first right of refusal? In other words, what prevents the business owner from selling to someone else? Is there a poison pill to that effect? Is there guaranteed seller financing? If so, what are the terms?
Again, many variations. Many dangers. Seek legal advice. Seek our advice.
Taxpayer’s Comprehensive Guide to LLCs and S Corps
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