Picture this scenario: A business owner and two employees agree on a succession plan in which the owner sells the business to the employees when the owner retires in seven years. The problem? The employees have no money to buy the business.
So begins a classic dilemma when a business is to be sold to employees: how to avoid effectively “giving” them the business by providing them with the funds they will use for the purchase. To assist the business in achieving future success, the new owners generally must have a significant financial interest.
Is the most common solution best?
However, the most commonly proposed solution often ignores this reality.
An initial plan may call for the employees or the business to purchase life insurance on the existing owner. But the employees generally don’t want or can’t afford to pay for the insurance because they aren’t getting paid enough to be willing to reduce current compensation.
A variation on this could be to do a double-bonus executive bonus plan, so the employees get the cash to pay the taxes associated with the insurance premium or the employer loans the money to pay the taxes.
While this plan sounds reasonable, in practice, the owner is providing the funding for the employees to purchase the business and the employees have no real financial stake in the business because they did not pay anything for it.
If the owner dies and life insurance was purchased on the owner, then the plan works for the owner’s family members because they receive cash for the interest in the business. But even in this case, did they really receive the value of the business?
In many situations, the business owner sets a price that is less than fair value because he or she has a strong desire to see the business continue. The price, based on what the employees can afford to pay, ignores the opportunity cost of the premiums for life insurance. Could the cash have been used to increase the value of the business or provide additional compensation to the owner?
Using an incentive plan
A better solution is to implement a plan that provides incentives for the employees and rewards them for additional effort to increase the business’s value and profitability. This mutually beneficial arrangement rewards employees for performance and gives them greater skin in the game, all while increasing the value of the business.
So, how to create the best incentive plan?
First, the business owner and the employees should prepare a business plan with defined goals and performance metrics. Each employee would accept responsibility for his or her part of the plan, including the ability and authority to implement it.
At the end of each period, results would be evaluated and a bonus may be paid. A side benefit of the plan: An employee who consistently fails to meet goals may be deemed unsuitable to serve as an owner of the business.
Second, the plan should address how a bonus will be paid and structured. A bonus will usually be paid in cash or in stock and can be structured either as an executive bonus plan or non-qualified deferred compensation.