A business owner’s investment in the company often represents the biggest asset in his or her portfolio.  Sometimes the owner needs to access the cash locked into that value, whether to meet an emergency, fund retirement, or diversify.  In one real-world example, Chuck (not his real name), the founder and owner of a successful business with annual revenue around $8 million, was in his 60s when his daughter got into Stanford.  Around the same time, he realized he hadn’t saved enough for retirement, Although Chuck had a decent portfolio of investments, his most valuable asset was his business.   Chuck began to wonder how to unlock the value wrapped up in his company.

He could just sell some shares.  However, because his company was privately held, he couldn’t just instruct his broker to sell on the open market.  He would have to find a buyer in the private market, which can be difficult.  And even if he could find a buyer, the sale would have to comply with state and federal securities laws. (And although this didn’t apply in Chuck’s case, when there is more than one owner, the sale has to jump through all the hoops required by the company’s buy/sell agreement.)  And on the tax side, Chuck’s entire gain would be taxed in the year of sale.

Solutions for Owners

Because private sales can be so challenging, expert legal and financial advisers have designed alternative ways for business owners like Chuck to tap into their business investment. Chuck’s team considered several options:

• Adopt an Ownership Transition Plan (also referred to as a management buy-out)
• Use the Buy/Sell Agreement for Liquidity
• Sell the Business (merger/acquisition)
• Adopt an Employee Stock Ownership Plan (ESOP)

This article focuses on the Ownership Transition Plan, a formal arrangement where the current owner or owners sell their stock to the next level of “up and coming” leaders in the business, over a period of several years. This requires a “next generation” of qualified, hardworking senior team members who are good rainmakers and leaders, and are committed to the success of the business. Ownership Transition Plans are ideal for service businesses.  Professional design firms (e.g., architectural, engineering) use them frequently to seamlessly transition ownership within the firm.  But they can be used successfully by businesses in any industry.  Other benefits include:

Deferred Compensation

In addition to receiving cash from the buyers, the owners may also receive cash from the company in the form of deferred compensation. Because it is a liability of the company, deferred comp lowers the company valuation, making the share purchase price more affordable for the buyers.  Although taxed at ordinary income rates, the deferred compensation is usually “grossed up” to balance the impact.  And the gain on the sale of shares is spread out over several years, rather than accruing in the first year.

 Employee Incentives

Ownership Transition Plans also give businesses a competitive edge in employee recruitment and retention.  Companies with a plan are better able to retain motivated employees who might otherwise leave and/or start a competing firm. Equally as important, the business is positioned to attract top talent for whom an established Ownership Transition Plan represents a path toward an equity or ownership position.

Let’s get back to Chuck. Under the Ownership Transition Plan his company adopted, in the first round Chuck sold 3% of the outstanding shares to each of 5 senior employees for $90,000 each. This meant $450,000 to Chuck for 15% of his business. He received 20% in cash up front and the other 80% will be received, with interest, over five years.  He will be taxed as the money is received.  Additional rounds are anticipated as Chuck gets closer to retirement.  With a secure plan in place, the generation purchasing from Chuck will eventually sell to the next generation, thereby assuring the continuity of the business.

Chuck’s plan involved adopting a company shareholder agreement and other documents including an offering memorandum to the purchasers.  The plan wasn’t cheap and took more than a year to implement.  But in the end, Chuck’s investment in an Ownership Transition Plan meant he could access the value locked into his business and assure its continued success.

This article is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter.  You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.