Chapter 7
Selling to employees and management

For many business owners, transferring the business to employees or managers isn’t much different from handing it down to family. Consider that you spend more time with your key employees each day than you do with your family. The sense of mutual loyalty can run just as deep, and these business “families” can be just as dysfunctional as real ones. Indeed, aside from financing, transition to non-family employees might follow precisely the same path as a family succession.

Financing of sales to employee and management generally fall into two categories: leveraged buyouts (LBOs) or employee stock ownership plans (ESOPs). In an LBO, a small group of usually senior managers – usually three to five managers – uses the assets of the company to secure financing to purchase the business from the owner.

Selling to management through an LBO is very much like selling to a third party. There are several key differences, however, that make it a special situation. Most importantly, you choose the purchasing group. You already have a relationship with the buyer. And the buyers already know the company inside and out.

Transition considerations
As you may recall, our discussion of grooming a successor in Chapter 4 was intended to be generic enough to apply to both family and non-family successors. Regardless of whether you choose an employee buyout or stock ownership plan, you must select solid and experienced managers and ensure they are trained. Without a management group, employee purchase should not be an option.

Earlier, we touched on the concept of golden handcuffs in the context of family succession. The tool is even more important in an employee succession, as the would-be successors likely aren’t as confident that they ultimately will get the business. In addition, you can use shares of the company for bonuses and compensation to set the stage for eventual transfer of control. But stock or stock options don’t bind you to a sale to employees, assuming you don’t give away control of the company. If you eventually sell to a third party, just recognize that some of your employees may receive some of the proceeds.

If you aren’t comfortable offering actual shares in your company to employees, an alternative to true stock is a phantom stock program, in which employees receive compensation that appreciates according to a valuation of the business. When the employee leaves, phantom stock is paid out just as if the employee owned real stock. In some cases, phantom stock may even be converted to actual common stock in the company.

Employee stock ownership plans
When we discuss ESOPs, we are not talking shares of stock – real or phantom – that you might give employees as bonuses. An ESOP is a special instrument established according to formal rules set by the Internal Revenue Service. Given its oversight by the IRS, it probably doesn’t surprise you that ESOPs are quite complex and require a specialist to establish and maintain. The plan must cover a wide range of employees and cannot discriminate in favor of top management.

So why do it? ESOPs offer a tax-advantaged way for you to gain liquidity and provide incentives to employees. If you structure an ESOP properly, you may sell your stock and defer capital gain taxation by reinvesting in marketable securities. Your company can get an income tax deduction for the stock that it purchases and places in the ESOP. Whether the company funds the ESOP or a bank finances, the company is responsible and receives a tax deduction.

You might assume at this point that a disadvantage of ESOPs is that you won’t get as much out of the company than you would with a sale to a third party based on market value. But you would be surprised how close your net proceeds are between the two methods. By the time you receive the tax deductions and favorable deferred capital gains, an ESOP is almost the same and may even be better.

Remember, a third-party transaction is based on negotiation, and you may settle for a lower price than you want. Also, expenses and lost time in selling to a third party add up over time and come out of your bottom line. And usually a buyer purchases assets, so you must recognize proceeds at ordinary income rates. The difference between ordinary income rates and capital gains can be significant especially when the capital gains can be deferred.

Even if an employee succession is not feasible or desirable in your case, don’t reject an ESOP without some research. It may be possible to use an ESOP to obtain preferential tax treatment through a third-party purchase.

We have discussed the three principal ways of exiting your business in situations where the business continues. We will wrap up our discussion of transition methods in Chapter 8 by addressing the limited option of taking the company public and the regrettable but sometimes necessary option of liquidating the business.