Cashing Out

I was recently on a networking trip with some businessmen where we found ourselves playing an extensive amount of golf. During one of the rounds, I partnered with a friend who owns a successful construction company. He revealed that he wants to transition himself out of his business and retire to (surprise!) play more golf. Over the course of our conversation, he told me that he has considered various exit strategies that could provide him with a smooth business transition while maintaining the legacy that he’s built with his company. After discussing these options with a few financial advisers, he ultimately decided to sell his business to his employees. As we discussed the particulars, I realized that this is indeed a very viable and attractive option to consider when retiring. 

This topic may seem a little familiar. In Big Picture’s , I identified three options available for business succession: liquidate your business, sell your business to an outside party, or pass your business down to your heirs. This month, we’ll focus on a fourth option: sell your business to your employees.

In general, there are two paths to consider when selling your business to your employees: through a management buyout (MBO) or an employee stock option plan (ESOP). Assess the pros and cons of both options before deciding which route is the best fit for your company.

Transfer Ownership to Management

Just as the name suggests, a management buyout involves current management of the company using their own funds to purchase the company’s stock. They become the new owners of the business, and the former owner is cashed out. Although an MBO typically only involves upper management, it’s a very effective way to keep your business running successfully because you are essentially retaining the same personnel. 

If you’ve dedicated time to mentoring your management team over the years, then they’re likely already running the business, making critical decisions, and are responsible in large part for your shop’s continued success. This buyout option is an excellent way to maintain that. On the other hand, if an MBO sounds like an exit strategy that interests you but you don’t think your current management team has what it takes to ensure the continued success of the business, then honing the team’s skillset should become your highest priority and your sharpest focus. Many business owners have this discussion years in advance so the management team is fully prepared when the time is right for transition.

One frequent obstacle with the MBO approach is raising sufficient funds to purchase your company. In an MBO scenario, each individual manager is responsible for securing the funds required to purchase their portion of the company. One option to consider if this situation arises: If the business is profitable and has positive cash flow, a financial institution will typically be willing to lend funds to an individual or group of individuals acquiring a stake in a lucrative business.

To assist your management team in the acquisition, you may allow them to buy the stock over a period of time – maybe three to five years. That will, of course, make the purchase easier to manage because your team doesn’t have to come up with 100 percent of the funds all at once. At the same time, this can put you at risk if you end up funding the acquisition over time. If the business begins to struggle, then your payment stream could be in jeopardy. To protect themselves from this scenario, some owners stay involved in the business until all the cash has been paid out (perhaps in the capacity of a board member or in an advisory role). There are various options for you to maintain some control to mitigate your risk and help the process come to a successful completion.  

Sell Stock to Your Employees

The second method to sell your business to your employees is through an employee stock option plan. The simple definition of an ESOP is a qualified retirement plan that allows employees to invest in stock in your business. ESOPs provide a popular and effective way to reward your employees for their service and dedication, and allow them to become owners in your company. Often ESOPs are implemented in programs that allocate merely a portion of the stock to become available, with the current ownership still maintaining the majority of the stock. The use of an ESOP to sell your business is different. In this case, you’ll use an ESOP plan as a method to transfer the sale of your business, or 100 percent of your company stock. This is typically accomplished by having the ESOP borrow money from a financial institution to finance the buyout of the shares. The loan is secured by the assets and stock of the company and is repaid by the company’s cash flow. 

Some of the advantages are the same as the MBO option. Your current management team continues to run the business, often with your involvement at some limited level. Your employees are rewarded for their commitment to the company and are now able to have a stake in the future growth of the business. An ESOP also allows a much wider range of employees to participate in purchasing shares of the business. Under this succession method, business owners have the added advantage of higher flexibility with the timing of the succession and the level of involvement they can have during the transitionary time. Many business owners using ESOPs phase out their involvement over time, as agreed upon in the ESOP plan documents. Because the ESOP is funded from the cash flow of the business, a slower phase-out period may make complete sense for both parties. This could ensure continued success with the business while simultaneously securing the deal through the profitability of the company.

There are also some significant tax advantages with the ESOP approach. If your company is an S corporation, future business income is not taxed if an ESOP owns the company. If your company is a C corporation, the proceeds from the sale of your stock to the company’s ESOP may be tax deferred. Additionally, payments by the company to the ESOP used to purchase the business owner’s stock are tax deductible. For a full understanding of the tax issues associated with an ESOP, you will need to consult an accounting professional.

Many scenarios of an ESOP buyout require the payments to the exiting owner to be paid out in installments. This can create some disadvantages to you as the seller. Because the ESOP buyout is being funded by the operational success and cash flow of the business, this can put additional cash flow strains on the company. As such, there is an inherent risk to the cash payouts from the business to the selling ownership. The worst-case scenario is that the business fails and the payments for the business buyout stop altogether; this risk can be mitigated if the loan from the financial institutions to the ESOP pays the majority or all of the purchase price up front. However, this approach also can create a heavy cash burden on the corporation. Ultimately, the best approach with your ESOP buyout should be a balance of shared risk among all parties. 

One other disadvantage of the ESOP is that it’s fairly expensive to adopt and implement. Depending upon the complexity and scope of your individualized plan, the cost of putting the plan together and executing it will typically run between $20,000 and $40,000 to the company. It’s crucial to weigh the advantages and disadvantages of both routes to decide which buyout option is the best fit for your organization.

Leave Your Company in Good Hands

After evaluating the options of an MBO vs. an ESOP, my golfing buddy, er, I mean, networking associate, chose the ESOP approach for the succession of his business. The opportunity to reward his employees for their years of service and the comfort of knowing that his business is in good hands moving forward outweighed the challenges and disadvantages. Use the information shared here, like my friend did, to help you determine if an employee buyout is an approach that can work for you when the time comes to plan for your business succession.