COVENANT BUSINESS PLANNING SOLUTIONS

Transferring Your Business to Your Key Employees Part I

Owners wishing to sell their businesses to management (key employees) face one unpleasant fact: their employees have no money. Nor can they borrow any - at least not in sufficient quantity to cash out the owner. But even without cash, there are ways to transfer your business to your key employees. Let’s identify each of those methods. Each, as described in this blog series, uses either a long-term installment buyout of the owner or someone else’s money to affect the buyout. The last method - the Modified Buyout - uses both an installment buyout and someone else’s money.

This is the first of a five-part blog. In this first blog, we’ll talk about Long Term Installment Sales. In Part II, we’ll discuss Leveraged Management Buyouts. Part III will cover ESOP’s (Employee Stock Ownership Plans) and in Part IV we’ll be covering Modified Buyouts.

In the fifth and final blog we’ll weigh the advantages and disadvantages of each of the four exit options involving key employees, with a simple chart. But first, let’s talk about our first option:

 

LONG TERM INSTALLMENT SALE

A long-term installment sale typically follows this course:

1. A value for the company is agreed upon.

2. At least one employee agrees to buy the company by promising to pay the agreed upon value to the owner.

3. The former owner holds a promissory note with installment payments over a seven to ten year period with a reasonable interest rate, signed by the buyers. The note is secured by the assets and stock of the business and the personal guarantee and collateral (usually residences) of the buyers.

4. Little or no money is paid at closing.

 

Owners wishing to sell the business to key employees must understand that they are transferring the business and receiving nothing in return other than a promise to receive the purchase price from the future cash flow of the business.

There is no other source of cash available to the employee/buyer. If the new ownership cannot at least maintain the business, you will not receive your purchase price. But there are several planning steps that can reduce the significant risk of nonpayment.

The first step would be to pay the owner what he or she wants in the form of Non-Qualified Deferred Compensation payments, severance payments, lease payments or some similar means of making tax-deductible payments directly from the company to the owner. This technique minimizes the net tax cost of the buyout and thereby makes more cash available to the owner. This technique minimizes the net tax cost of the buyout and thereby makes more cash available to the owner.

As a second step, the owner should transfer any excess cash out of the company well before they sell it.

Third, the owner can enhance security through:

  1. Securing personal guarantees (collateral, both business and personal);
  2. Postponing the sale of the controlling interest;
  3. Staying involved until satisfied that cash flow will continue;
  4. Obtaining partial outside financing; and
  5. Selling part of the business to an outside party.

These techniques reduce but do not eliminate risk. For that reason, owners typically undertake this type of sale only if no alternative exists, if they don’t need the money, or if they have complete confidence in their employees and in the economy to support the company’s prosperity. The most common reason, however, for exiting using the long-term installment sale is that the owner has failed to create a less risky exit plan.

 

In Part II of this blog, you’ll learn about Leveraged Management Buyouts as another option for owners wishing to sell their business.