What to consider when transferring your business to an employee?
When a business owner determines that his/her family members are not suitable successors, it is important to consider other options to execute his/her succession plan. Transferring a business to an employee(s) can result in a number of advantages.
A higher sale price could be realized as employees are more likely to be motivated in keeping their jobs, salaries and benefits intact. For the current owner who wants to see the current employees remain on after he/she exits the business, a transfer to employees could be the best match.
As the employees are involved in the day-to-day operations, there is a greater chance of keeping customers and suppliers happy upon the eventual exit of the current owner.
The current owner might feel more at ease releasing information to employees during the due diligence process as opposed to a competitor.
Lastly, providing employees with an ownership stake is a good way to motivate and ensure they are fully committed to the success of the company.
Similar questions should be addressed by the current owner when contemplating a transfer to an employee(s) as would be addressed when transferring to a family member or outside third party. These questions include (but are not limited to) the following: experience and skills of the employee, relationships with other employees, ability to take on business risk, and the timeline of the transition.
Employee Buy-Out
Depending on the financial status of the employee(s), it may not be possible to acquire financing through a conventional lender. The owner may have to enter into a “take back” financing agreement. This is accomplished by payment of the purchase price through instalments. The owner should ensure that security is placed over the company’s assets during this period of time.
Questions to consider:
- How will the employees pay for the purchase of the business?
- Will the purchase price be firmly set or open to adjustments, such as for future earnings?
- Can the purchase be financed over time?
- Is the current owner in a position to engage in a “take back” agreement?
Potential Transfer Options:
- All of the current owner’s shares could be transferred at one time.
- Shares could be transferred in series of instalments.
- If the employees already own some shares, the business could redeem/purchase the current owner’s shares.
If the current owner receives the purchase price in instalment payments, he/she is relying on the business to remain profitable in order to finance the payments. Different strategies result in different tax treatments so this will need to be considered in the planning phase as well.
Employee Buy-In
Instead of buying shares directly from the current owner, employees can “buy-in” over a period of time. This strategy will dilute the current owner’s interest in the business and will not provide proceeds for shares held until the employees eventually buy the current owner out.
The employee buy-in could be assisted with the execution of a freeze. The current owner would transfer the value of the business into redeemable preferred shares. Nominal value common shares could then be issued to the employees which would ease the financing burden. The current owner would likely require that his/her preferred shares be redeemed over a set period of time and that he/she holds the majority of voting shares until all preferred shares have been redeemed.
A bonus (and subsequently dividends) could be issued to the employees as a means to facilitate the purchase of shares after a freeze is completed.
If the employees acquire shares directly from the company and the purchase price is less than fair market value, the difference of these amounts will result in a taxable benefit to the employee.
Importance of a Shareholder Agreement
It is important to implement a shareholder agreement when employees are taking an ownership stake in the company. A shareholder agreement should have provisions for the following:
- Death
- Disability
- Relationship breakdown
- Disagreement
Life & disability insurance should be used as a tool to fund the above events.
In Closing
Transitioning your business to an employee can be beneficial for all parties involved. This decision also comes with risk depending on how the deal is structured. Consulting with an insurance advisor, a lawyer and an accountant well in advance of your proposed transition timeline will ensure that the transition goes a smooth as possible.
Call to Action
Do you have concerns about your business transition or succession plan? An accountant is uniquely positioned to advise on your specific situation and help you find solutions that will protect your assets and preserve your wealth.
I help my clients do 3 things:
Find common sense solutions to business and estate planning concerns.
Minimize tax and maximize profits.
Preserve legacy.
Are you looking for an advisor to help you analyze and implement a business succession plan? Feel free to give me a call at 403-343-7707.