All business owners eventually face the difficult dilemma of planning for the future of their companies when they can’t or don’t want to run them. When a business owner looks to future company ownership, there are a variety of options to consider. Many of them result in instant liquidity for the owner, while some require the owner to wait for a longer period of time. Regardless, each of the following options has pros and cons that an owner should carefully consider prior to exiting a business.
Sale To A Third Party
The most common practice for exiting a business is for a business owner to sell the company to a third party. Potential third-party buyers often fall into two broad categories: private equity (PE) investors and strategic investors. PE investors have very different investment philosophies than strategic investors. PE investors generally own many businesses and look for opportunities which don’t require them to take over the day-to-day operations of the business, often relying on the business owner and its management team to continue running the business. As a result, PE investors often require sellers to keep some “skin in the game” by rolling over (maintaining significant ownership) a portion of their stock, which provides additional potential upside to the seller along with risk on such retained ownership. In contrast to PE investors, strategic investors (businesses that are in the same industry as the business owner) are more likely to have professionals that will take over the day-to-day operations of a business since they have experience operating in the business’s industry. In addition, strategic investors generally will purchase all of the seller’s interest in the business, which gives a seller more liquidity but removes the seller’s ability to benefit from any future upside in the business.
Sale/Transition To Family Members
Many business owners feel a moral obligation to pass the company on to their relatives, which can help ensure the owner’s and the company’s legacy and provide multiple benefits for future generations. If executed properly, the sale or transfer of the company to family members may involve intricate estate planning techniques, depending on value of the business and complexity of the owner’s estate. The most popular transfer techniques include gifting of ownership interests and sale of interests. If the gift or sale is structured properly, the Internal Revenue Service allows discounts to the valuation of the equity allowing major tax savings to family members. This involves careful tax planning and should be accomplished in consultation with attorneys and accountants.
A business owner should consider the problems that often arise when a business is passed on to family members. Handing down a business past the first generation is very complicated and requires careful planning. For example, owners often want to designate one child the primary owner but want to treat all their children fairly, which often complicates planning. It is important for the family member owners to have a shareholders agreement that governs the management of the company and the control of the shares. Family members often have disputes over the company when a thorough shareholders agreement is not in place. Also, a business owner should consider which family members will be active in the business and which will not be involved and consider how to properly treat each of them. Mixing business and family often leads to difficulties, much of which can be avoided with proper planning.
An example of poor transition planning recently arose when a client transferred a family business to the client’s two children, with one child receiving 60% of the business (the “Majority Child”) and the other child receiving 40% (the “Minority Child”. The client gave a larger percentage to the Majority Child since the Minority Child had married into wealth. Since a shareholders agreement had never been put in place between the two children, disputes over the operation of the company eventually caused the Minority Child to sue the Majority Child over failure to make tax distributions, taking of an excessive salary and the eventual firing of the Minority Child as an employee of the company. A thorough shareholders agreement put in place at the time of transfer could have prevented this dispute.
Sale/Transition To Employees
Employees of a company are often logical buyers of a business since they already have knowledge and experience with the company and loyalty to the long-time business owner. Often, the largest obstacle for the employees is the ability to find the capital necessary to fund the purchase.
One method for funding a purchase by employees is through an employee stock ownership plan (ESOP). In an ESOP, the company sets up a trust fund into which it will contribute shares of its stock or cash to buy existing shares from the owner. Alternatively, the ESOP can borrow money from a lender to buy the shares, with the company making annual contributions to help repay the loan. The company can use the proceeds of the loan to provide liquidity to the company’s owner.