Many midsized Baby Boomer business owners are now facing the single most important financial decision of their lifetimes: how to successfully exit from their businesses.
For most, their company is their economic and financial lifeline. Many have thought about transferring the business to their children or management team (“insiders”), but have not gauged their passion for owning a business and haven’t tested their management skills. Furthermore, few, if any, of these “insiders” have any money. So, like most owners, they are waiting for a white-knight buyer to appear on their doorstep with saddlebags of cash, and in the meantime do nothing. This is hardly a successful course of action, as many midsized companies are not saleable to an outside third party.
There is a better way! A properly designed “insider” transfer plan can provide the owner with more after-tax money than a third-party sale while keeping the owner in control of the process until all or most of the purchase price is received. It also allows the owner to remain active in the business while gradually reducing day-to day responsibilities, giving them time to build up personal assets to meet their retirement goals before they exit.
The biggest challenge with an “insider transfer” is that the process is risky for three reasons:
1. The insiders usually have no money.
2. Successors’ management skills/ownership skills and commitment are untested.
3. Owners lose control of the business if they make a transfer before they are completely cashed out.
A two-step insider exit plan addresses these issues. It does this by systematically transitioning management and ownership responsibilities over time as company cash flow improves, keeping the owner in control until they receive the full amount needed and minimizing taxation on the company’s cash flow, which is the ultimate funding source.
Step 1: Sale of non-voting shares
If the insider group’s management and ownership skills are untested and need development, the owner should create a written plan to systematically transition management and ownership beginning today. This transition period usually takes several years to complete.
The first step is for the company to be recapitalized so that it has voting and non-voting shares. Then the owner will typically make a pool of approximately 40 percent of the non-voting shares available for current and future purchases from key employees, 5-10 percent of which is sold to one or two key employees. These shares are only sold if certain financial benchmarks are met by the company and ownership is vested over time to motivate the key employees to stay with the company.
For this buy-in and others, including any future repurchases of that stock, the shares are priced at the lowest defensible value – that is, the minimum value that can be placed on a company as determined by a valuation professional. The use of lowest defensible value makes the purchases affordable for the key employees, which allows the transfer to happen more quickly. It also allows the owner to re-purchase shares if the insider group fails along the way and another exit route needs to be implemented.
Step 2: Sale of voting shares
After the 40 percent non-voting shares are sold (usually over the course of three to seven years) and the business continues to be successful, the insiders purchase the 60 percent of the voting shares, preferably with the proceeds of a bank loan. At this point, the key employees should be fully vested in the non-voting shares, and the owner has remained in control until paid in full.
Keeping the owner in control until they accumulate the money necessary to retire is a critical part of a successful insider exit plan. It also provides the owner with maximum flexibility. For example, instead of selling the remaining 60 percent to the insiders, the owner may decide to sell to a third party, with the non-voting shareholders often following suit.
One of the major mistakes made by business owners and their advisors is to assume that the only way for the business owner to get the cash they need from the business is solely from the sale of their shares of stock.
This is a costly assumption where company cash flow is the source of all payments to the business owner. It is important to keep in mind that the money must first be taxed at normal graduated tax rates (assume 35 percent) before it is paid over by the insiders to the owner who generally will be taxed at 20 percent on the gain from the sale of their shares. This is classic double taxation which this two- step process seeks to minimize. That is why concurrent with the aforementioned stock sales, a large portion of the owner’s retirement money comes from direct payments in the form of annual distributions, compensation payments, and deferred compensation, all from the increased cash flow generated by the insider group.
At this stage, the owner is stepping back and working part-time. The benefit of using direct payments to help fund the transfer is that this income is taxed only once.
For business owners contemplating an exit from their businesses, an insider transfer may be their only viable option. There are four keys to successfully implementing a transfer to insiders. First is time: Execution of a successful insider transfer takes many years to accomplish. Second, ownership is only transferred if the insiders grow the company’s cash flow. Third, the plan’s design needs to be tax-sensitive and finally, the plan should be in writing and everyone needs to be held accountable. The two-step technique outlined above helps owners implement those keys and unlock the door to their successful exit.