Randel Law, Inc., Your Business and Succession Planning Lawyer as well as Corporate Transparency Compliance

Corporate and Securities Law Attorney Focusing on Helping Businesses Obtain Liquidity and Transition to New Ownership Through Exit and Succession Planning as well as Comply with the Corporate Transparency Compliance Act

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Seven Keys to Successful Succession

June 10, 2021 By Rick Randel

Rick Randel Successful Succession
 
An internal succession or ownership transition plan is a great option for many businesses. Rather than selling to an outside buyer, an internal succession plan involves the founders or current owners (sometimes referred to as G1 for Generation One), selling their shares to their senior associates or key employees (G2 for Generation Two). Business that are ideal candidates for internal plans include professional service firms and financial advisory firms. 
 
For those of you considering an internal succession or advising clients considering one, take a look at this list of seven key factors that I’ve learned over the years make an internal succession more likely to succeed (this is not really a “how to” article but rather the key ingredients for a successful transition):
 
  1. G1 and G2 have many personality traits in common (you could even take an assessment tool like Meyers-Briggs or DISC to see if you are aligned).
  2. A reasonable difference in ages but not too wide of a gap (10-20 years is ideal; it’s important for G2 to be experienced and know how to run a business, but still young enough that they want to keep working for another 10-20 years).
  3. The people in G2 each have their own book of business.
  4. G1 and G2 have shared visions/values and common goals for the firm (if some parties want to maximize profits but other parties want to balance profits with lifestyle goals or treatment of employees, that may not be a good mix).
  5. The flexibility and willingness to adapt or change the terms of the plan based on changes in circumstances.
  6. This one is huge: trust.  It’s essential for the parties to trust each other, so neither side gets suspicious that the other is trying to take advantage of the other.
  7. Most important of all: start the process early! Especially if you don’t even have a G2 yet. G1 needs to hire a G2 and groom them to take over the business before G1 can get bought out. 
G1 can rest assured that planning the transaction is not the same thing as exiting, and G1 can maintain control until they are ready to pull the trigger.  G2 can buy in gradually in tranches and/or pay part of the purchase price up front and the remainder over time, to lessen the cost and spread out the payments.  I talk about some of these strategies in previous posts, including Ownership Transition Plans and Top Ten Tips.  
 
I hope you’ve enjoyed this list of Seven Keys to Successful Succession.  Please feel free to share with others or reach out to me if you have any questions or comments. Thanks!
 
Rick
 

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.

Filed Under: Business Succession Planning, Ownership Transition, Selling A Business Tagged With: exit and succession planning, exiting my business strategy, internal succession plan, key ingredients for a successful transition, ownership transition plan, succession planning

Building the Business through Ownership Expansion

October 4, 2014 By Rick Randel

Building the Business through Ownership Expansion Rick Randel San Francisco Bay Area Business AttorneyBusiness owners often hesitate to give away a piece of the pie when it comes to sharing ownership of their business.  But if they wind up with a smaller piece of a bigger pie, they come out ahead.  Sharing ownership (also known as giving equity) can create a bigger pie by helping to attract, retain and incentivize personnel, whether it’s senior team members at the top, or all employees.  This is especially true when getting equity convinces key rainmakers to stay with the firm, rather than bolting to start a competing firm and take customers with them.

 

Ownership Expansion Benefits

Equity simply means an ownership stake in the business (for example, shares of stock in a corporation, or membership interests in an LLC).  Expanding ownership offers business owners a number of benefits, including:

 

  • Incentivizing key employees to contribute to the bottom line.
  • Incentivizing “rainmakers” to bring in more business and decreasing the likelihood that they will take customers to a competing firm.
  • Increasing employee retention, which reduces turnover and training costs, improves customer satisfaction, and increases productivity.
  • Providing cash to the owner, if the tool selected involves the owner selling some of his/her shares.
  • Providing for continuity of the business and liquidity to the owner(s) upon retirement, when used as a component of an ownership succession plan.

 

Ownership Expansion Tools

Methods for expanding ownership vary depending on the owner’s objectives, the party or parties receiving the equity, tax factors, etc.  The following alternatives represent some of the tools in our kit for expanding ownership in corporations:

 

  • Restricted Stock.  This is probably the simplest method, involving just the grant or sale of actual shares to the individual.  Typically, the company has the right to repurchase the stock if the recipient leaves within a certain period (hence the term “restricted”).  Note, if the person doesn’t pay full value for the shares, the shares will be treated as compensation and therefore taxed.  There are ways to help the person pay the taxes.    One arguable downside of restricted stock is that the recipients are true shareholders with the right to vote, receive information, call meetings, and be paid dividends (if any are declared).
  • Restricted Stock Units (RSUs).  A variation on restricted stock, RSUs grant the shares to the individual at the end of the vesting period instead of the beginning.  The downside for recipients is they don’t have the option of being taxed at the beginning, when the value is low (as they can with restricted stock).  They are taxed at the end, when the value is (hopefully) higher.  RSUs are similar to options; the difference being that with RSUs, there is no “exercise” – the stock is simply issued (and an exercise price is not required).
  • Stock Options.  If the tax hit to the recipient is too great to use restricted stock and the company can’t afford to pay it for him/her, we sometimes select stock options as the most effective tool.  If the recipients are employees, they get favorable tax treatment (generally, no tax upon receipt or exercise of the options; taxed as capital gain upon sale, assuming certain conditions are satisfied).  This is also a common way to get stock into the hands of numerous “rank and file” employees, rather than just one or two key individuals.
  • Ownership Transition Plan (OTP).  Sometimes referred to as a “management buy-out,” this tool involves key senior team members gradually purchasing shares over several years, coupled with gradual “sell-downs” by the owners.  After a designated time period, the owners own little or no stock and retire.  If the owners are too young for this, the other alternative is an “ownership expansion plan” that does not include the “sell-down” part (or provides that the sell-down will occur at a future date).  This works best for service companies where the owners (including the new owners receiving equity) have business development responsibilities, and where the owners want the company to continue indefinitely, rather than be acquired or go public.
  • Employee Stock Ownership Plan (ESOP).  Although the mechanics can vary, in the typical ESOP, the corporation contributes money to a trust (a deductible expense), and the trust uses the money to purchase shares from the founder(s).  The founder(s) pay no capital gains tax, if the business is a C corp.  The trust holds the shares on behalf of eligible employees, and when employees leave they get paid for their “shares.”  An ESOP makes sense for companies that are consistently profitable, (b) have a fairly large payroll, and can afford significant up-front expenses plus annual valuation and maintenance expenses.
  • Phantom Stock and Stock Appreciation Rights (SARs).  Although technically not equity (they are basically a promise to pay a bonus in the future), both allow the recipients to benefit from increases in the company’s value, so they are generally included when talking about sharing equity.  People use these terms differently and the differences can become blurred.  However, in both cases, the recipient (usually an employee) is allocated a certain number of imaginary “shares” that go into his/her account.  The number of shares is often increased each year.  When phantom stock vests or the employee leaves, he/she is paid the full value of the shares.  With SARs, he/she is paid only the increase in value since the grant date.  A benefit to the owners and the company is that recipients do not have the same rights as shareholders, such as voting rights.  The company is not obligated to pay dividends, but in many cases, the plan includes “dividend equivalents.”
  • Employee Stock Purchase Plan (ESPP).  A “qualified” ESPP must be offered to all employees and requires extensive “jumping through hoops” specified in the tax laws.  Assuming an ESPP meets all the tests, employees receive favorable tax treatment.  Qualified ESPPs are generally only adopted by large publicly traded companies.  Unqualified ESPPs take many forms:  some are similar to qualified ESPPs without the tax benefits, others are basically grants of restricted stock (see above) that are implemented under an actual “plan” document adopted by the board of directors.  These are typically awarded to a broader base of employees, rather than straight restricted stock with no plan.

 

Limited Liability Companies.  Most of the above alternatives don’t work for LLCs.  The most common forms of expanding ownership in LLCs are either straight grants (or sales) of membership interests (similar to restricted stock above), or grants of what are called “profits interests”.  A profits interest only allows the recipient to share in appreciation in the value of the company from the grant date forward.  If the company were liquidated the day after the grant, the recipient would get nothing.  Profits interests are generally considered to be the LLC equivalent of stock options, especially with regard to the tax treatment of the recipient.  They also resemble SARs, in that they reward the recipient for gains in company value after the interest is granted.  Profits interests can be granted in specific instances, or under a broader profits interests plan.

 

Owners can realize many benefits by expanding ownership in their company.  And they have many tools at their disposal.  Many companies use a mix of these tools to get equity into the hands of their employees or other interested parties.  There are many nuances and complexities to each tool, so any business owner who is thinking about adopting one or more ownership expansion tools is encouraged to seek qualified legal and tax advice before moving forward.

 

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.

 

Filed Under: Equity Compensation, Ownership Expansion, Ownership Transition Tagged With: equity compensation, ownership expansion, ownership transition plan, san francisco bay area ownership expansion, san francisco bay area ownership transition, silicon valley equity compensation, silicon valley ownership expansion, silicon valley ownership transition

Ownership Transition Plans: Converting Business Value to Cash for Owners

October 4, 2013 By Rick Randel

Ownership Transition Plans Converting Business Value to Cash for Owners Rick Randel Corporate Attorney San Francisco Bay AreaA 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.

Filed Under: Business Succession Planning, Ownership Transition Tagged With: business investment, converting business, deferred compensation, employee incentives, ownership transition, ownership transition plan, san francisco bay area converting a business to cash, san francisco bay area deferred compensation, silicon valley converting a business to cash, silicon valley deferred compensation

Randel Law, Inc.
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San Ramon, CA 94583
ph: (925) 855-3215
fax: (925) 855-3216

rick@randellaw.com

 

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