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When money is an object: Financing a business sale to key employees

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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.

Any bonus payments made in cash would generally be paid as premiums to a life insurance policy during the term of the performance plan. These premiums are likely to fluctuate, but the policy can be designed with an expected premium stream and the appropriate death benefit determined. Under the incentive plan, the policy will generally be on the life of the purchaser to maximize its cash accumulation potential.

When the sale of the business is finalized, a withdrawal or loan could also be taken from the policy to make the initial payment. Policy loans are interest-bearing, and any withdrawals and loans may be taxable and reduce the death benefit.

Example: ABC Corp.’s incentive plan

Let’s look at an example of how this can work.

Sam is the owner of ABC Corporation, a manufacturer of electronic controls for industrial heating systems. He has two employees who are interested in (and in Sam’s view also capable of) acquiring and operating the business. Julie is the head of sales and Art is the chief research engineer.

Sam has determined the business is currently worth $2 million, but believes that by expanding into South America, the firm could be valued at $4 million in 5 to 7 years. Sam had one prospective buyer for the company, but he was only willing to offer $1.5 million.

Sam, Julie and Art develop a five-year plan to expand the business. Julie is charged with creating a sales team to penetrate the South American market and Art is charged with making the technical modifications required for the South American market.

If each meets his or her target, then $50,000 per year will be contributed to a life insurance policy. If targets are exceeded, up to $75,000 may be contributed. The agreement also provides that a minimum of $20,000 per year will be contributed to the policies. 

  • Julie meets her targets in years 2, 3 and 5. She exceeds in year 1 and 6 but misses the target in year 4 and 7. As a result, a total premium of $340,000 is contributed on her behalf ($75,000 in years 1 & 6; $50,000 in years 2, 3, 5; $20,000 in years 4 & 7). A universal life policy is structured with a minimum death benefit.

  • In year 10, Sam decides to retire and sells the business to the Julie and Art for $3 million. Under the terms of sale, Sam will receive a lump sum payment of 25 percent, with the balance to be paid over five years. The projected cash value in the policy has grown so that Julie and Art can take a withdrawal to basis and/or a loan of $250,000 to fund their portion of the lump sum payment. Future payments can be paid from cash flow in the business and supplemented if needed by additional withdrawals or loans from their policies. Once the sale obligation is fulfilled, they can use the policy for retirement income or other purposes.

End result

The end result is that everybody wins with the incentive plan: Employees win because they have a financial and personal stake in the business as they work to improve it; the seller wins because the value of the business has been increased and he or she can command a higher price.

The business also wins because it is now on a more secure footing and more likely to survive until the next round of business succession discussions with a future generation. Most importantly, however, the advisor wins because he or she was able to bring a creative and simple solution to the table.

The tax information and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Columbus Life does not provide estate planning, legal, or tax advice. Columbus Life cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Columbus Life makes no warranties with regard to such information or results obtained by its use. Columbus Life disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.

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