COVENANT BUSINESS PLANNING SOLUTIONS

Transferring Your Business to Your Key Employees Part IV

MODIFIED BUYOUT

Despite its catchy title, this method really is the workhorse of the group. It is the one that works best for most owners who want to:

  1. Transfer their businesses to key employees;
  2. Motivate and retain key employees; and
  3. Receive full value for their businesses

Let’s present the difficulties and opportunities presented to owners as they transfer their businesses to key employees using the Modified Buyout, through the following example:

Dan Hudson was the owner of an electronic parts distribution company, “EPD.” EPD was a 45+ employee company, with revenues of over $6 million per year and a fair market value of $5 million. At age 52, Dan planned to stay with the company for at least five more years. EPD employed a half dozen experienced senior managers and salesmen. Dan was interested in both “handcuffing” these employees to the company (making it economically rewarding to stay with the business) and, at the same time, exploring an exit strategy for himself. He thought he could achieve both goals by beginning to sell the company to his key employees.

A preliminary Exit Plan was prepared, listing the three principal exit objectives:

  1. To establish a plan for the eventual buyout of all of Dan’s ownership in the company;
  2. To begin the buyout of a portion of his interest in the company by selling to two existing key employees, Brian and Lisa.

Dan would select additional key employees at a later date to have the plan in place and effective as of March 1 of the following year. The Exit Plan recommended that Brian and

Lisa purchase up to a total of 10 percent of the ownership of EPD (represented by non-voting stock). In the future, other key employees (as yet unidentified, and probably not yet hired) would participate in the stock plan.

The plan also included a two-phase sale of the business.

 

Phase I—Sale of Initial Minority Interest

Dan would make available a pool of 40 percent of EPD’s total outstanding stock (converted to non-voting stock) for current and future purchases by key employees. Initially, five percent of the outstanding stock (non-voting) will be co-owned by Lisa and five percent (non-voting) by Brian. For purposes of the initial buy-in (and any future repurchases of that stock), the value of EPD is based on a valuation (with minority and other discounts) provided by a Certified Valuation Specialist. In EPD’s case, those discounts totaled half of the true fair market value. A lower initial value is necessary in order to make the purchase affordable by the employees as well as to provide them an incentive to remain with the company. The initial purchase price will be paid in cash. If either key employee needs to borrow funds to secure the necessary cash, EPD will be willing to guarantee the key employee’s promissory note to a bank.

Even though the key employees will not receive voting stock, there will be significant benefits to them in purchasing non-voting stock. Namely, employees would:

  1. Enjoy actual stock ownership in EPD, and the ability to receive any appreciation in the stock;
  2. Participate (pro rata) based on their stock ownership in any “S” distributions made by EPD;
  3. Receive fair market value paid by a third party for their percentage of stock (if EPD were to be sold to a third party);
  4. Participate more directly in day-to-day operating decisions;
  5.  Initially be appointed as directors to serve under the terms of the bylaws (such positions not being guaranteed); and
  6. Participate in determining which additional key employees will be offered stock out of the 40 percent pool. This determination will be based on written criteria developed by all three shareholders.

Each key employee purchasing stock will enter into a Stock Purchase Agreement with the company that provides for the repurchase of their stock in the event of death, long-term disability, or termination of employment.

 

Phase II — Sale of Balance of Ownership Interests

At the end of Phase I (three to seven years), Dan will choose one of the following courses of action:

  1. Sell the balance of the company to the key employees, at true fair market value, by requiring the employees to finance an all-cash purchase; or
  2. Finance the buyout by means of a long-term, installment sale to the employees at true fair market value

Alternatively, Dan may decide to sell to an outside third party. In either a sale to employees or to an outside third party, his intention is to retire from the company; or continue to maintain ownership in the company and continue his management and operational involvement. Dan’s Exit Plan recommended that Dan base his decision on whether to sell the balance of his stock to the key employees upon the following criteria:

  1. Dan’s analysis of the key employees’ abilities to continue to move the company forward while paying him full fair market value for his remaining 60 percent ownership interest. In other words, how much risk is there in allowing the key employees to move forward without Dan’s supervision, management, or control? How much risk is there in depleting the company of the cash flow needed to pay the departing owner for ownership? How much risk is there that business, economic or financing climates may sour, thereby jeopardizing the buyout? If Dan is unwilling to assume these risks, he must require a cash buyout by the employees at the end of Phase I or sell to an outside third party.
  2. The ability of the key employees and the company to obtain financing to pay the remaining purchase price in cash to Dan. If employees own 30 to 40 percent of the company, it is likely (at least in today’s economic climate) that financing could be obtained in an amount sufficient to cash Dan out.
  3. The marketability of the company should Dan decide to sell the company at any future point in this process.

After receiving his preliminary Exit Plan, Dan thought long and hard about the consequences of selling stock to his employees. In fact, it often takes two or three meetings before owners are comfortable with their objectives.

The technique recommended to EPD requires:

  1. Key employees who eventually will be capable of running and managing the company without the former owner’s presence.
  2. Time. Total buyout time is typically three to seven years.
  3. Owner’s willingness to take less than true fair market value for the initial portion of stock sold to the key employees (30-40 percent of total ownership), assuming the stock is saleable to an outside third party for cash.

 

In our fifth and final installment of this blog series, we’ll weigh out the advantages and disadvantages of each of these four exit options involving key employees, with a simple chart.