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How Businesses can Pass the Torch without Getting Burned

Family businesses, and the families that own them, are the strength of America. But, the statistics of family business survival are discouraging. In fact, out of every 100 family-owned businesses, only a third of the businesses get passed to the second generation. A mere three of those businesses will survive into the fourth generation.

No one wants to think about after-death scenarios for their business. But, without a succession plan, key employees may leave, the business could be dismantled and lifetimes of hard work and sacrifice could go down the drain. Succession planning is disaster planning.

Many small businesses have substantial funds invested in equipment but that equipment isn’t worth much on the open market. Such business owners may be far more interested in grooming an employee to buy them out and take over the business.

A sale to key employees is a great option for companies that don’t sell to outsiders (third parties). We have found that owners choose to transfer their companies to key employees for different reasons, including these seven:

  1. Some owners believe that they owe their employees something. They believe that their key employees have helped to create the company and they certainly have contributed to the company’s success. The owners believe these employees “deserve” the opportunity to purchase the business.
  2. A variation on this “owe” idea is that some owners want to provide their key employees with the same opportunity to become financially successful that the owners had.
  3. Other owners choose this transfer method because they already have promised their employees that they would sell to them. They feel committed to following through on this often vague promise.
  4. Some owners believe that the only way to continue their legacies, to “do right” by their customers or to carry on the culture that they have worked so hard to create is to transfer ownership of their companies to their key employees.
  5. Some owners are convinced their companies are valuable only to the key employees who work there. Historically, businesses worth less than $2 million (businesses with free cash flow of $300,000 or less) hold little attraction to outside third parties.
  6. Some owners are motivated by maximizing their own income. They may believe that key employees will pay more for their companies than will any other type of buyer. This assumption, in turn, may be based on another assumption that the business is not attractive to, or would be misunderstood by, outside buyers.
  7. Some owners use the gradual sale of ownership interest to key employees as a way to motivate those employees to stay with the company.

Even though an owner may see the reasons to sell their company to a key employee, how might they accomplish this?

Having Your Employees Cash You Out Of Your Business

Many, probably most, business owners would like to sell their businesses to their employees, except for one nagging problem: The employees have no money. Owners cannot risk selling a business to employees who have no cash.

What can be done? Owners can create an incentive compensation plan for key employee group. Design the plan so that the bonuses increase as the profits of the business increase. Instead of paying key employees the full bonus, the company can defer a portion of it and promise to pay the balance at a future date, if each member remains with the company.

This is an example of a plan called a nonqualified executive compensation plan and it can be made subject to vesting. Since this involves planning ahead, the business owner can evaluate each member of the key employee group to determine which employees would serve best as owners.

The owners can offer to sell the key employee group a significant portion of the company (typically about 30-45 percent of the overall ownership of the company). If the plan is well designed and funded, there could be hundreds of thousands of dollars of deferred bonus money belonging to the employees at the company level. The key employee group can buy another 20 percent of the stock using an installment note.

With the key employees now owning and having paid for 40 percent ownership or more of the company, they can secure bank financing to purchase the balance of the stock.

This plan won’t apply to all business scenarios. Typically, the owner will want to spend five years funding the executive compensation plan. The owner should communicate the plan to a cooperative bank that will understand their intentions well in advance. Finally, this plan requires a strong management team interested in owning a company financially fit enough that it can use most of the available cash flow to pay down the purchased debt.

But what happens in case of a sudden, significant event? Another corrective action is to establish a buy-sell or business continuity agreement that controls the transfer of the business ownership. The events that trigger this agreement could be the death or permanent disability of an owner, the sale or transfer of stock between owners or an outside party or the retirement of an owner.

Family business owners that remain focused on the near future and work only in their businesses invariably neglect to put a buy-sell agreement in place. A written and funded buy-sell agreement allows for the orderly disposition of the business. The agreement can be made among shareholders of a corporation or partners of a partnership, or between a key employee and the owner. The agreement obligates the remaining business owners, key employees or the business itself to purchase the interest of the owner.

A buy-sell agreement creates a market for the business interest, allows the business to operate without interference from the owner’s heirs, provides liquidity for the deceased owner’s estate, and establishes the value of the business for federal estate tax purposes.

Helping family business owners to plan for the future successfully will help preserve an important part of the American business landscape. 

Irving Katz of San Juan Capistrano, Calif., specializes in succession, exit, retirement and estate planning for business owners. He is the author of Family Business Blunders: Seven Mistakes Family Businesses Make and How to Correct Them Before It Is Too Late. Contact him at [email protected].

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