Exit Planning Exchange

By Rob Edwards

I. OVERVIEW OF LEGAL REQUIREMENTS

A. An Employee Stock Ownership Plan (“ESOP”) is usually structured as a tax-qualified “stock

bonus” plan. Properly designed, an ESOP can offer significant financial benefits to the

sponsoring corporation while also providing employees with a valuable stock ownership benefit

at no cost to them.

1. An ESOP must cover a nondiscriminatory classification of employees who have attained

age 21 and completed a year of service (2 years if the plan provides for 100% vesting).

Employees may not otherwise be excluded solely by reason of age or service. Effective in

2007, an ESOP must provide for either graduated vesting of participant accounts, with full

vesting required after 6 years of service, or cliff vesting of participant accounts, with full

and immediate vesting after 3 years of service. Nonvested benefits are subject to

forfeiture if the employee quits or is fired before normal retirement age.

2. Employer contributions to an ESOP can be made in the form of employer stock (valued at

fair market value) or cash. ESOP contributions are tax-deductible within prescribed limits

and may be made under a formula or in the employer’s discretion.

3. Assets held in an ESOP may include employer stock and other investments. ESOP plan

assets must be held in a trust. The ESOP trustee may be an individual or individuals

affiliated with the employer.

4. The ESOP must provide for allocating contributions among participants and for

distributing benefits upon a participant’s retirement, death, disability, or separation from

service.

5. Assets held in the ESOP must be valued at least annually.

6. Benefits may be distributed in the form of employer stock or cash. The participant must

have the right to receive a distribution of stock, unless the employer is an S corporation, or

a bank prohibited from repurchasing its own shares, or the employer’s charter or by-laws

restrict ownership of substantially all employer stock to current employees or to a trust

under a qualified plan. Generally, an ESOP participant must be permitted to elect to begin

receiving ESOP benefits not later than one year after the participant’s death or retirement,

or six (6) years after the participant separates from service for any other reason.

7. If ESOP benefits are distributed in employer stock that is not readily tradable on an

established market, the participant must have a limited right (the “put option”) to require

the employer to repurchase the stock at fair market value. The future cost of repurchasing

employer stock distributed from the ESOP under the put option is referred to as the

employer’s “repurchase liability”. Distributed shares may be subject to a right of first

refusal in favor of the employer and the ESOP.

8. Voting rights with respect to employer stock of a company that is registered under the

Securities Exchange Act of 1934 must be “passed through” on all shares that are allocated

to participants’ accounts. For employer stock that is not publicly traded, pass-through

voting is required for shares allocated to participants only on mergers, recapitalizations,

liquidations, dissolutions or similar major transactions. Unallocated shares, and allocated

shares voted on matters for which pass-through voting is not required may be voted by the

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ESOP fiduciary, on a pass through basis, or as provided in the plan document. An ESOP

established by a nonpublicly traded company may also provide for per capita voting (1

person 1 vote). If per capita voting applies, the percentage of votes cast will govern the

voting of all employer stock (both allocated and unallocated shares) held in the ESOP.

9. If the employer is a member of a controlled group of corporations, the ESOP may be

established by one member with respect to the stock of another controlled group member.

10. Since 1998, ESOPs have been permitted to invest in S corporation stock without adverse

tax consequences.

11. State law often restricts the ownership of shares in a corporation which is authorized to

carry on certain professional practices (e.g., architecture, engineering, accounting,

medicine, etc.) to individuals who hold professional licenses. While ESOPs are prohibited

under the laws of most states from owning stock in such a corporation, the corporation

may be able to establish an ESOP if it qualifies to do business under the general business

corporation act of the state in which it is incorporated, if a “grandfathered” charter is

available, or if incorporation under the laws of another state is possible.

12. An ESOP may be part of a 401(k) plan or arrangement (a KSOP). KSOPs are common in

publicly-held companies. Some nonpublic companies have also adopted KSOPs to fund

matching contributions to their 401(k) plans in the form of employer stock, and to help

create a market for their stock. KSOPs which allow participants to elect to invest their own

salary reduction contributions in employer securities must comply with federal and state

securities laws.

13. An ESOP must comply with all Internal Revenue Service and Department of Labor rules

and requirements applicable generally to qualified employee benefit plans.

B. Special qualification requirements apply to “leveraged” ESOPs. A leveraged ESOP is designed to

use borrowed funds (an “exempt loan”) to purchase employer stock, with the loan repaid from

future employer contributions to the ESOP, plus dividends on the shares purchased with the

exempt loan proceeds. An exempt loan almost always involves a guarantee or extension of credit

(this may take the form of an installment purchase obligation) between the ESOP and a

“disqualified person” (usually the sponsoring employer and/or its shareholders) that would be

prohibited in any other kind of employee benefit plan.

1. A leveraged ESOP must be designed to invest primarily in “qualifying employer

securities”. This generally means either voting common stock with full dividend rights, or

preferred stock that is readily convertible into voting common.

2. A leveraged ESOP must provide for the release of financed shares that are held in the

ESOP’s suspense account as the exempt loan is repaid. The release of employer stock

under the ESOP must be made under one of two alternative methods. One method allows

the release of employer stock in proportion to the repayment of principal and interest on

the exempt loan. The other method allows for employer stock to be released in proportion

to the amount of principal only repaid on the exempt loan.

3. Employer stock of a company that is not publicly traded held in a leveraged ESOP must be

valued annually by an independent appraiser.

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4. A participant age 55 or older with 10 or more years of participation in a leveraged ESOP

must be offered the option to “diversify” his or her ESOP account. The option is

exercisable annually over a period of 5 years, and allows a qualified participant to direct

the investment of 25% of the employer stock that has ever been allocated to the

participant’s ESOP account (including any stock diversified under prior elections) into

investments other than employer stock. If the leveraged ESOP does not offer at least three

investment options inside the ESOP, the participant must be allowed to cash out the

diversified amount or to have the diversified portion of the account transferred to another

qualified plan which offers three or more investment options. In the sixth and final year of

the option period, the participant must receive a similar one-time option covering 50% of

the account. Cashout distributions are eligible to be rolled over into an IRA. KSOP

arrangements which allow investment in publicly traded stock are subject to more rapid

diversification requirements.

5. Leveraged ESOPs benefit from certain favorable rules:

(i) Effective for plan years beginning in 2002, the general limit on deductible

contributions to individual account plans was increased from 15% of covered

compensation to 25% of covered compensation. However, an employer taxable as a C

corporation may deduct all contributions to a leveraged ESOP which are used to pay

interest on an exempt loan, plus loan principal payments up to 25% of covered

compensation. S corporation deductible contributions are limited to 25% of covered

compensation

(ii) Dividends paid on employer stock held in a leveraged ESOP are tax deductible if they

are distributed currently to participants in cash, used to repay an exempt loan the proceeds

of which were used to acquire the employer securities with respect to which the dividend

is paid, or at the election of the participant, invested in the plan in employer stock.

Distributed dividends are also exempt from the 10% penalty tax on early distributions to

employees under age 59 1/2. Distributions with respect to employer stock of an S

corporation are not deductible, and are subject to the 10% penalty tax if the recipient is

under age 59 1/2.

(iii) Dividends on C corporation stock and S corporation distributions may also be used to

repay an exempt loan, provided that employer stock equal in value to the dividends (or

distributions) paid on allocated shares is allocated to the participants’ accounts.

(iv) A leveraged C corporation ESOP is permitted to allocate forfeitures and interest on an

exempt loan under a special provision of Section 415 of the Internal Revenue Code, if not

more than one-third of employer contributions for the year are allocated to highlycompensated

employees. If this special rule applies, the only amount taken into account

for Section 415 purposes is the principal reduction on the exempt loan. Interest on the

exempt loan, deductible dividends and forfeitures of employer stock acquired with an

exempt loan are not included in calculating the maximum permissible allocation. A stock

bonus or profit-sharing plan, in contrast, must include all allocations of principal, interest

and forfeitures in computing the Section 415 limitations.

(v) An ESOP participant who receives a lump sum distribution of employer stock will

only be taxed on the ESOP’s cost basis for the stock. The “net unrealized appreciation”

(the difference between its fair market value at the date of distribution and its cost to the

ESOP) is not taxable until the stock is sold. This favorable tax treatment extends to

distributions from stock bonus and profit-sharing plans.

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6. To guard against the possibility of self-dealing, leveraged ESOP transactions are subject to

special regulatory scrutiny to ensure that the transaction is primarily for the benefit of

ESOP participants and their beneficiaries. Purchases and sales of employer stock held in a

leveraged ESOP are subject to fiduciary rules enforced by the Department of Labor,

including the requirement that the ESOP cannot pay more than “adequate consideration”

for employer stock.

7. For newly formed ESOPs, and existing ESOPs after 2004, severe tax penalties are

imposed on S corporation ESOP sponsors for any year in which “disqualified persons”

collectively own or are deemed to own 50% or more of the corporation. A “disqualified

person” is a person who (i) individually owns 10% or more of the S corporation’s

“deemed-owned” shares, or (ii) collectively with other family members owns 20% or more

of its deemed-owned shares. Deemed-owned shares are the individual’s allocated ESOP

shares, a proportionate share of any unallocated ESOP shares, and any “synthetic equity”

owned by disqualified persons. Synthetic equity is broadly defined to include the right to

acquire stock of the corporation or to share in the corporation’s value or growth through

equity-based compensation. These rules are complex, but will generally preclude small S

corporations with ten or fewer employees from adopting an ESOP. Corporations with up

to 50 (or more) participating employees will also need to carefully monitor their ESOP

program to ensure compliance.

II. ADVANTAGES OF LEVERAGED ESOP FINANCING

 

A. Section 1042 Rollover for Selling Shareholder. If a leveraged ESOP owns at least 30% of the

company after purchasing employer stock, a selling shareholder who has held (for at least 3 years)

employer stock that was not acquired in a distribution from a qualified plan or in an employmentrelated

transfer, may qualify for nonrecognition of gain under Section 1042 of the Internal

Revenue Code if the seller reinvests in “qualified replacement property”. Qualified replacement

property includes stocks, bonds, notes and other evidence of indebtedness issued by active U.S.

operating companies. In order to qualify for the rollover, the qualified replacement property must

be purchased within a 15-month period beginning 3 months before the sale, and the employer must

consent to the nonrecognition treatment and agree to pay a 10% excise tax in case of certain

premature dispositions of the acquired securities within 3 years after the sale. In addition, the

seller, the seller’s family members and 25% or more shareholders are prohibited (or restricted in

certain cases involving a selling shareholder’s lineal descendants) from receiving allocations of

acquired shares. Sales of S corporation stock are not eligible for the tax free rollover.

B. Tax Benefits for ESOP Sponsor. Because the ESOP sponsor can deduct its entire ESOP

contribution, principal as well as interest paid on the ESOP loan becomes, in effect, tax-deductible.

This affords ESOP financing an immediate advantage over a conventional loan, although the

liquidity necessary to fund the employer’s future repurchase liability (see I.A. 7.) needs to be

considered. In addition, the increased contribution and allocation limits, and deductible dividends

available to leveraged C corporation ESOPs (See I.B.5) add even more flexibility to leveraged

ESOP financing.

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III. PRINCIPAL REASONS FOR A COMPANY TO ADOPT AN ESOP

 

A. Business Succession. A leveraged ESOP creates an immediate market for the sale of a founder’s

stock. The founder benefits by deferring income tax on the sale proceeds, and the employees

benefit by acquiring a significant interest in the employer without any cost to them.

B. Financing Vehicle. A leveraged ESOP can be used as a vehicle to obtain financing for the

employer, with a full tax deduction allowed for ESOP contributions used to repay principal as

well as interest.

C. Employee Productivity. An ESOP can serve as a means of enhancing employee productivity by

providing substantially all employees with an economic stake in the financial success of their

employer. A sound ESOP communications program is essential to help ensure that this benefit is

realized.

IV. ILLUSTRATION OF ESOP BENEFITS

 

A. Leveraged ESOP. Assume that DEF Engineering, a C corporation, is valued at $2,000,000 and

that D, the principal owner, wants to sell a 70% interest in the company to an ESOP for

$1,400,000. The ESOP will borrow the funds and repay the loan in level annual installments over

7 years at 9%. The following table illustrates the potential ESOP tax savings in this transaction

compared with a stock redemption:

COMPANY

REDEMPTION ESOP

1. TOTAL INTEREST AND PRINCIPAL PAYMENT $2,013,018 $2,013,018

2. TAX DEDUCTIBLE PORTION $613,018 $2,013,018

3. TAX BENEFIT AT 34% $208,426 $684,426

4. NET AFTER-TAX COST (1 – 3) $1,804,592 $1,328,592

As illustrated above, the potential federal tax savings to the Company in this example is $476,000, which

represents the difference between the after-tax cost of a stock redemption loan versus an ESOP loan.

B. Additional Rollover Benefits. If D makes a qualifying Section 1042 rollover, the total tax

benefits in the transaction are significantly increased. If D had only a nominal tax basis in his

stock of DEF, his federal tax savings could be as much as $280,000. The total federal tax

benefits for the employer and the selling shareholder in the $1,400,000 transaction illustrated

could amount to as much as $756,000, or 54% of the sale proceeds. Additional tax savings for

both the employer and the selling shareholder may be available under state law.

C. Nonleveraged ESOP Financing Alternative. As an alternative to the leveraged ESOP illustrated

in IV. A. above, it is possible to obtain many of the ESOP’s financing advantages with a

nonleveraged ESOP or even a profit-sharing plan in conjunction with a loan to the company.

This technique involves a redemption of stock by the company which then makes tax-deductible

contributions of employer stock to a qualified plan each year in an amount equal to the principal

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value paid down on the loan during the year. Because the fair market value of contributed stock

is tax-deductible, the company has, in effect, obtained a deduction for the principal repaid on its

loan. This alternative method has some advantages and some limitations in comparison with

leveraged ESOP financing:

1. Advantages.

(i) Avoids prohibited transactions problems.

(ii) Allows use of a profit-sharing or traditional stock bonus plan.

(iii) If the value of stock increases over the loan period, the number of contributed

shares is reduced. This results in less dilution of shareholders’ equity, and spreads

dilution over a greater period.

(iv) Greater flexibility.

2. Limitations

(i) A selling shareholder cannot obtain a tax-free rollover.

(ii) Financing may be more difficult to obtain for a stock redemption than for an

ESOP.

(iii) Higher deduction limits apply to a leveraged ESOP, so larger deductible

contributions are permitted.

(iv) A leveraged ESOP may have a greater effect on employee productivity.

 

Rob Edwards is a partner with Steiker, Fischer, Edwards & Greenapple, P.C.

The Foundry Corporate Office Center

235 Promenade Street, Ste. 497,

Providence, RI 02908

tel. – 401/632-0480

 

By Michael Oleksak

In the early days of my consulting practice, I met with the owner of a small manufacturing business. The owner had just learned he had inoperable cancer and confided that he would be dead in about six months. He did not have a succession plan but hoped his daughter, who was then 22 years old, would take over the business.  The owner wasn’t sure because he had not discussed this plan with his daughter yet.  Ultimately, the business owner turned to his accountant, who was also a close family friend, to oversee the transfer of the company to his daughter while the accountant stayed on as advisor. Because it was cancer, the owner had time to draw up a will and organize his estate.

His succession plan for the company, however, started with hoping his daughter would take over its management. His exit strategy had been determined by his health.

Prepare for Sudden Changes in Management or Ownership

Imagine you were this business owner’s commercial banker. Your small-business borrower drops this situation in your lap. Your first reaction is disbelief: This middle-aged man looks healthy. Then you become sad because you know and like this person.  But when you hear the owner’s succession plan is to hope he can leave the company to his young daughter, you wonder: “What experience does this just-out-of college daughter have?  Have I even met her?” This leads to more questions.

• How will employees react?
• How will customers react?
• How will you as a lender react?
• What is the future of this company?
• Will it stay financially healthy enough to repay the loan?

No question, the lender’s risk just went up. Should the interest rate rise as well? Is there a change of ownership clause in the loan agreement?  The owner’s terminal illness is not his fault. It is, however, his responsibility to prepare for eventualities like his own untimely death. His family, employees and company rely on his leadership and foresight to anticipate future issues.

By the same token, it is the commercial lender’s duty to ask tough questions to protect the bank’s position. Even if there is a change of ownership clause, you as the lender are in the same boat as your borrower. You want the company to succeed so the loan will be repaid or taken over at some point by another lender. No other lender will want to step in now unless the conditions can be improved with a defined succession plan along with increased collateral or financial support.

Understand the Owner/Manager’s Exit Strategy

Commercial lenders should address this risk by understanding the exit strategy of every owner/manager in their loan portfolios (if these owners even have an exit strategy).  The exit strategy will have a big influence on the strength of your credit as well as on the viability of your relationship with the company.

The exit strategy can lead to a conversation about whether the owner has a will and a succession plan. If the owner has not made a will, this could mean that ownership of the company’s shares is undecided or that the shares could land in the hands of under-prepared family members in case of the owner’s sudden death.

Case in point: Miami Dolphins owner Joe Robbie, a successful real estate attorney, did no estate planning before his death. His heirs had to sell the Dolphins franchise and Joe Robbie Stadium at fire-sale prices to pay estate taxes. The family fractured over the crisis, and Robbie’s legacy is not his successful real estate development career but the poor planning that harmed his family.

As a lender, you need to ask about an owner’s succession plan and whether the firm has the management depth and clear operational assignments to survive a surprising end to the owner’s life or incapacitation. A lender who asks these questions can prompt a business owner to develop a strategy and address shortcomings, thereby alleviating the lender’s concerns about unforeseen occurrences.

What are the possible outcomes for an owner-managed business besides the dire circumstances just addressed? Let’s look at two, both with different implications for the commercial lender: internal transfer and external transfer.

Internal Transfer

An internal ownership transfer could be (1) a sale to the management team, known as a management buyout; (2) a sale to employees via a tax-advantaged employee stock ownership plan (ESOP); or (3) a gifting of shares, usually to the next generation of the family, also with significant tax benefits. If the internal transfers are for less than 50 percent of the ownership shares of the company, the owner may stay in control of decisions and finances by controlling the voting stock.

Influence on relationship with lender. With an internal transfer, the lender should already be familiar with management if there is a change. With a management buyout, the lender should know the individuals taking over and must make a decision about whether the new team can lead the company despite the increased debt to finance the transaction. If not, the bank will ask to be paid out of the loan.

With an ESOP, the transaction will often be for less than the control of the company, a way for the owner to share with loyal employees by giving them an equity stake. A lender’s decision making should be the same, however, given greater debt on the books to finance the purchase. Gifting of company shares may be done in stages, so the current owner or management team may still be in control.

In all of these scenarios, what role will the current commercial lender play? No outside financing source will know the debt-service capability of the company better than the current lender, making it likely that the current lender will be the first invited to stay on to provide loans and services, including financing an internal transaction or ongoing operations.

All these scenarios could be subject to a change of ownership clause in the loan agreement, allowing the lender to opt out if not satisfied with the new ownership structure.

External Transfer

An external transfer would be a sale, either to a strategic buyer (such as a competitor) or to a financial buyer (such as a private equity investor). Because the external transfer will likely be for at least a majority of the shares, the owner will likely be out of the picture in a few years.

Influence on relationship with lender

With external transfers, it is likely that the private equity group or strategic buyer will have its own stable of lenders. By keeping the lines of communication open with the company and the prospective financing team, as well as expressing interest in taking at least a piece of the financing, however, the current lender may well have a role in the new loan or be kept on to provide some services.

Exit Strategy: Not Always Obvious

Commercial lenders are not often thought of as trusted advisors to a company’s business owners. Trusted advisors are generally the company’s CPA, attorney, and, sometimes, the owner’s investment advisor. The fault is not with the banker. Decades ago, the relationship was closer. However, successful lawsuits for lender liability cases have influenced lenders’ behavior. As such, lenders never want their actions to be interpreted by judges as having exerted undue influence over a borrower’s business decisions. Lender liability can result in big financial penalties against the lender.

For this reason, commercial lenders are often out of the loop when it comes to a critical factor influencing the strength and viability of their borrowers: the owner’s exit strategy. Much conversation between a bank and the owner-manager of a business focuses on the owner’s managerial role. It can be hard to get an owner to talk about ownership issues because these often require a discussion of personal and family issues. However, the owner’s exit strategy can have a huge influence on the health of the company and on the bank’s relationship with the company.

A good commercial banker provides numerous services to the owner-managed business, generating considerable fees for the lending institution. Apart from the fees and interest from the loan, the relationship probably also provides income for the bank from cash management services, trade services, account fees and balances.

Sometimes, when the lender is successful in engaging the owner in discussions of exit strategy, the loan and services may be lost anyway. Recently, a 12-store retail chain in the Northeast was sold to a large national retailer. Over the previous year, the lender had actively reviewed all the options facing the owner and the second-generation owners of the family business. In the end, the acquiror will pay out the family members for their shares, and the acquiror’s bank at the corporate level will take over the financing and services. Even with this outcome, the former lender had a good understanding of risk throughout the life of the loan and was able to anticipate some form of upcoming change.

Sources of Strategic Information

The lending officer typically meets regularly with the borrower’s chief financial officer, treasurer, vice president of finance, or controller to discuss the quarter’s results and trends. The lender can use these meetings to ask about ownership issues, including whether the owner has a will, who the beneficiary is regarding the company’s ownership, if there is a succession plan and whether or not there is an exit strategy. If the lending officer is aware of upcoming changes in ownership, the lender can protect the bank’s position as the preferred commercial lender.

The lender can help focus the owner-manager on the future by asking probing and thought-provoking questions about the owner’s will, succession plan and exit strategy. If the owner is reluctant to discuss these issues, the lender should take this as a signal that such plans may not exist.

If there is a board of directors, or board of advisors, the lender should ask these questions:

• Where will the business be in five years?

• Does the owner want to own the business in five years?

• Does the owner want to be managing the business in five years?

• Does the owner have a will?

• Who is currently the beneficiary regarding ownership of the company?

• Is there a succession plan if the owner gets hit by a bus on the way to work?

• Does the owner simply envision the spouse or other relative taking over if something happens?

Owners Want Their Businesses to Live On

Given the personal nature of these questions and their implied reminder of the owner’s mortality, these can be difficult topics to discuss openly. But the commercial lender is a key stakeholder in a business, and asking such questions protects the bank’s interest and capital.

Ultimately, most owners would like their businesses to carry on and thrive even after they are no longer active participants in it.

Creating and sharing details of a will, succession plan and exit strategy with their lender can help build toward a longer, successful existence for the business.

 

Michael Oleksak was a lender for 17 years at Bank of Boston. He is a principal at Trek Consulting LLC, Woburn, Massachusetts and co-founder of the Exit Planning Exchange. He works with small and medium-sized businesses to increase value and prepare for exit. Contact him at oleksak@ trekconsulting.com.  www.trekconsulting.com

© Copyright 2010 Michael Oleksak. All rights reserved.

 

 

By Michael Oleksak

Over the next several decades, millions of U.S. businesses will be sold, merged, recapitalized, gifted, closed, or liquidated. In any of these events, both the owner and the company’s value will benefit from advance exit planning. Financial executives, whether internal or external, play a key role in educating company owners on the basics of exit planning.

If you are the lead financial officer of a privately-held business, such as CFO or VP Finance, part of your fiduciary duty is to protect the company from the risk of an unplanned change of ownership, through sudden death, of both the shares and the operation of the business.  You also play an important role in increasing the company’s value by strengthening it for the possibility of a future transition or transaction.

Whether you are an internal or external financial advisor, you should make the business owner aware of three things every owner must have: a will, a succession plan, and an exit strategy.

The will protects the ownership of the firm in case a tragedy or sudden death affects the owner.  With a will, the shares will stay out of probate court and land in the hands of the person or people chosen by the owner, thereby ensuring some sense of business continuity.

The succession plan will help with the orderly transition of the operation of the business if the owner is suddenly incapacitated.  The exercise of preparing a succession plan will also help establish whether internal management is strong enough to handle running the company without the owner.

The exit strategy will be the catalyst to determine whether the company is ready for some other entity to assume ownership. Are the books and records, processes and systems, management and employees, business model, brand, public image and reputation desirable enough for someone else to pay to acquire it? If the answer is yes, the next question is would the acquirer be external or internal?

Exit Options

The owner’s external exit options are sale to a strategic buyer or sale to a financial buyer or private equity group. Internal transfer options include a management buy-out, a sale of shares through the Employee Stock Option Plan (ESOP), or gifting of shares, usually to the next generation of the owner’s family. Each of these five exit options has a different valuation range, with external transfers generally having higher values. The owner will also relinquish control of the firm after the external transaction, giving up the ability to subsidize his or her lifestyle through internal expenses. The external exit option also eliminates the owner’s control over his or her legacy, so the owner must determine his or her financial and emotional readiness to exit the business.

If the owner is emotionally ready to leave the business, but needs the highest financial return, as the financial advisor you can recommend that a sale to a third party strategic or third-party financial buyer should be considered. Under these arrangements, it’s important to calculate investment banking and legal fees, as well as taxes, because all will be subtracted from the amount of the check the owner will cash at the end of the day. Due diligence by the third party buyer will be thorough. If there are family members working in the business, their employment may be at risk if the current owner is not calling the shots.  The owner may be required to bridge any financing or value gap with seller notes or earn-outs over time.

A management buyout (MBO) creates a different risk to analyze: is the management team capable of continuing to generate enough cash to pay out the owner over time? Some industries lend themselves to MBO’s better than others, such as construction. Such a deal will require outside financing from a bank or another source, and management may be required to pledge personal assets to support a bank loan. Seller notes will also likely be part of the financing. After the buyout, the owner may still be involved and may retain some financial expense benefits under the deal. The further in advance this option is considered, the better the owner can prepare the team for the execution.

An ESOP is a tax-advantaged, though administratively complex, way for the owner to take some money off the table by selling shares to employees and management. Under a buyout or transfer through an ESOP, the owner will likely remain in control if less than 50% is sold, and will continue to have some personal expenses paid by the company.

Gifting is also a tax-advantaged way to transfer ownership, usually to (hopefully capable) family members. The owner can stay in control and have expenses paid for by the firm. This option will cause complications in relationships, especially as you get deeper into the second and third generations of the family.  Capable outside consultants with experience in family business issues should be considered to help smooth out issues.

All the options that financial executives can suggest for exit strategies carry different valuation ranges, with external transfers having higher valuation ranges (and higher tax impacts). However, a clear awareness of each will help the owner and the company mitigate risk and prepare for the future.

Published in Financial Executive

Michael Oleksak was a commercial lender for 17 years at Bank of Boston. He is a principal at Trek Consulting LLC, Woburn, Massachusetts and co-founder of the Exit Planning Exchange. He works with small and medium-sized businesses to improve performance and value and to prepare for exit.

Contact him at oleksak@ trekconsulting.com - www.trekconsulting.com

© Copyright 2010 Michael Oleksak. All rights reserved.