Planning Your Exit
By Tyler Friesen
It’s never too early to begin planning a graceful exit from your business. Whether you are moving to the next investment, turning the family business over to the next generation, or selling to other owners, planning early can help ease the transition for a business owner. This article will discuss some practical options for transitioning businesses to family members, key employees, and unrelated parties. Even if the transition will not be completed for a number of years, starting now can help put the pieces in place for a smooth future transition.
SALE TO A FAMILY MEMBER
Some owners choose to pass their businesses to the next generation in their family. Often, this involves bringing the family member into the management of the organization, along with a current transfer of an ownership interest. This trial period allows the business owner to train the family member and evaluate their interest in the business. Transfers of a business to family members usually involve a sale, a gift, or a combination of both. A sale may take place over time through the use of a promissory note from the family member to the owner. Another option, if the family member is an employee, is to transfer part of the interest as compensation through the use of restricted stock agreements. Restricted stock agreements would permit vesting of the stock over time and inclusion of the stock in the family member’s income over time. As a result, the only cost paid by the family member for the stock received in this fashion is the actual taxes on the value of the shares as they vest. This permits a slow transfer of ownership and also spreads out the cost to the family member. An alternative, which is often used, is simply gifting an ownership interest to a family member.
For transfers that take place over a period of years, one of the above techniques is often used as a first step in order to vest a minority interest in the business. As part of the plan, the remainder of the ownership interest would then be transferred to the family member at a later date. Depending on the purpose of the transfer, either step can be structured so that the owner either receives income over time, or the owner gifts the interest to the family member. Most commonly, a combination of sale and gift (or transfer by bequest at death) is used to transfer the business to family members. As you can see, there is significant flexibility in the tools to transfer a business to the next generation. Depending on the goals of the current owner, these tools can provide a stream of income for retirement and/or provide the next generation with a head start in the business world.
When planning for the next generation, owners will often think about dividing the business equally among their children. However, in many cases, it is more appropriate to think of the estate as a whole, distribute the business to the children who are active in the business, and make greater distributions of other property to children not involved in the business. This avoids potential problems between family members who are actively managing a business and those family members who may not understand or be involved in the business. Non-business heirs may be far more concerned with personal cash flow, rather than reinvesting in the future of the business. It may also be important to realize that an equal division may not be fair to a business heir who has foregone other opportunities to help out the family business or otherwise contributed significantly to its success.
SALE TO KEY EMPLOYEES
Owners may also plan to sell a business to their key employees. This is often overlooked in small and mid-sized businesses. The key employees know the business, are invested in the community, and may see the purchase of the business as a way to increase their future income. For owners, key employees are often a known asset that may help continue the business in the same manner as the current ownership. One type of transfer to key employees involves the transfer of a minority interest as part of the compensation of the key employee over time, and providing an option to the remaining ownership interest to the key employee at a later date. This provides a current incentive for the key employee to stay on, and it also begins to involve the key employee in management decisions. However, this does not currently transfer control of the business to the key employee.
Another alternative is to have the key employee purchase a minority interest currently and then give the owner the option to sell the remaining portion of the business at a future date. Normally, both of the above options would provide for repurchase or divestiture of the minority interest should the employee be terminated or voluntarily leave the business. No matter what option appears the most attractive, key employees are a valuable and often overlooked partner in transitioning a business.
In either of the above transactions, and in any case where ownership interests are divided among several shareholders (especially unrelated parties), an owner should implement an agreement that restricts stock transfers. This agreement is often called a “Buy-Sell Agreement.” Buy-Sell Agreements restrict the transfer of stock or ownership interests. It provides for either repurchase or redemption of the interest upon such events as death, disability, retirement, voluntary termination, involuntary termination, and other events (e.g., bankruptcy or divorce). A Buy-Sell Agreement is a key component in making sure the business is not transferred to outsiders and providing for repurchase of an interest in situations where the transfer of stock would be important to the future operation of the business.
SALE TO OTHER OWNERS OR THIRD PARTIES
Other transaction options include selling to other owners or selling to outside parties. A sale to other owners usually occurs either through a direct sale between the selling owner and the purchasing owner, or through the company purchasing or redeeming the interest. Depending on the taxation of the entity, redemption may provide a lower effective cost for the transfer. However, in entities where the income flows through to the members or shareholders, sales generally provide similar effective costs. In either case, selling your interest to other owners usually is the most cost effective way to transition out of a business. Current owners generally understand the business model and the value of the business. If the business is doing well, they will likely want to increase their ownership in the business. A major sticking point for these sales is often price, but if the relationship is good between the ownership group, an agreement usually can be reached. Appraisals are also a helpful tool in determining the value of the business.
Sales to unrelated third parties have greater complexity, but you may be able to attract larger, better financed parties. Third party purchasers usually take an in-depth look at the financial statements of the business. So, having an understandable and accurate financial statement will be key to marketing your business. Owner salaries and related party expenses that may reduce profitability on paper may require adjustments to help potential suitors determine the true profitability of the business. The focus here is to make your business look profitable and positive on the income statement and balance sheet. In sales to outsiders, the purchaser will often want to purchase through an asset sale rather than a stock sale. Asset sales are attractive to purchasers because they help limit the liability of the purchasing party, and an asset sale generally results in greater depreciation deductions for the purchaser. However, asset sales may not provide the favorable capital gains treatment of a stock sale. Regardless of the form of sale (asset versus stock sale) the parties can structure their deal so that it is a win-win for both parties. Accordingly, with more careful planning and the right agreements, the seller can often get the benefit of favorable capital gains tax treatment on most of the sale proceeds, and the buyers may still get tax deductions for most, if not all, of their purchase price.
As with all important steps in the life of a business, it is important to begin transition planning early. This permits you to develop a plan, see how it progresses, and change course if necessary. For example, bringing in family members early will permit you to try the transition, and change direction if necessary. Whatever your plans are for exiting your business, starting early and consulting with your advisors will help get you to your goals.
If you would like more information on planning for the transition of your business or any of the matters addressed in this article, please call a member of our Business and Taxation Group.