Selling your business to a key employee or a family member, can be one of the most rewarding paths of a successful exit from your business. The question is – Is this path right for you?
Today we’re going to talk about:
- The benefits of selling your business to a key employee.
- Challenges you, as an owner, might face when selling to an inside employee and how you can address those challenges to help ensure a smoother transition.
- The 3 most common methods of selling your business to an insider and an overview of how each method works.
Click here to watch the full video or read the full video transcript, below.
Should You Sell Your Business To A Key Employee?
Transferring your business to an insider, defined as a key employee or a family member, is the most common exit path that small business owners take.
According to a 2016 study by the Business Exit Institute, they found that 67% of business owners are choosing to transition their business to an insider.
Selling to Key Employees – Why Do Owners Choose This Exit Path?
Let’s talk about why business owners choose this path. It’s pretty attractive and I think a big benefit is that when you choose this path, your exit from your business can be more gradual. If you do some planning up front and you start this exit path, you can gradually back away from the business over a period of maybe five to ten years.
When you choose an insider and you’re not selling to a third-party buyer, a lot of times, there’s an opportunity to stay on as an advisor, a board member, or to just stay actively involved in the business.
Culturally, you’re more likely to: keep the business in the community, keep the employee culture intact, keep relationships with clients/customers and vendors continuous, so there’s no disruption.
Selling to Key Employees – What Are the Challenges?
Let’s talk about some of the challenges of transferring a business to an insider. Number one is, do your employees who you’ve identified as the next generation, are they capable? Do they want to own the business?
There’s an entrepreneur acquaintance of mine who has likened entrepreneurship to a dumpster fire. A dumpster fire, as you can imagine, smells terrible. It’s out of control and anyone with real sense, would run away as quickly as possible from that dumpster fire, call the fire department and let them deal with it.
However, when you’re an entrepreneur, a business owner, you’re usually the one sitting there with the garden hose and the bucket of baking soda, trying to put this thing out all the time. There’s lots of headaches with running a business, even though entrepreneurship is glorified in our culture.
It takes a very special kind of person to want to and have the qualities to, successfully run a business.
The other challenge of transferring a business to an insider, is that often they have no money. If your business is worth $3 million, how is that person going to come up with the money to buy your business? We really want to address the financial aspect. I’m going to go a little bit deeper into that and how we can address it.
Selling to Key Employees – 3 Most Common Methods to Transfer Ownership to Insiders
We’re going to talk about selling, bonusing and gifting of stock, in order to transfer ownership over one time or over a period of time to the next generation ownership. Each of these options have different tax consequences, different risks for you as the departing owner in terms of ensuring that you get paid, and a different amount of burden on the behalf of the purchasing employee, in paying for their ownership stake.
It’s really, really important that early on, before you make any decisions about what you do, that you talk with your CPA and make sure that your CPA is experienced and understands all of these transfer methods. In addition, you will also want to talk with your attorney, who hopefully understands all of these methods, so they can advise you appropriately as to which one makes the most sense.
Transfer of Ownership – Option 1: Selling Stock in the Company
One of the more popular methods for transferring ownership to a next generation owner, particularly when it’s a non-family key employee, is to sell stock in the company. Usually this is done through a promissory note and it’s done gradually over a period of time.
An initial buy in might be 10% or 20%. Since that purchasing owner probably doesn’t have the money to pay cash for 10% to 20% of ownership in the business, we structure that with a promissory note for you as the business owner to get paid back for the purchase of those shares over time.
Typically, now that this new incoming owner has a stake in the business, they’re going to use their ownership distributions to then repay the promissory note. This is usually structured over maybe a five to seven year time period, as far as a repayment schedule.
Again, if this is something that is attractive to you, five to seven years is a long time. Especially depending on how much you want to transfer the business, to how many people, and over what time period, we really have to plan in advance and put this into place long before you want to leave the business completely.
Transfer of Ownership – Option 2: Gifting of Stock
Option number two, that’s very popular for family transfers, is gifting of stock. Typically, what happens is, a child or another family member is gifted a certain percentage of ownership. Again, a lot of times this happens gradually over a period of time, where we maybe start with 10% or 20% ownership, and then we gradually gift more and more over time.
Where the gifting of stock becomes problematic is with taxes and the gift tax exemption. If you’re married, the cap of what you can gift in 2019 is $30,000. If your business is worth, say $3 million, and you can only gift $30,000 without any tax consequences, that’s problematic. We just gave away 1% of the business. So, it would take you like a hundred years to transfer 100% of the business under that situation.
One of the things that makes it a lot easier to gift stock and gift more than $30,000 in 2019, or in any one year whatever that cap is, is that you can eat into your lifetime unified tax credit. Basically, you can gift more than the $30,000 cap, but it’s going to potentially have some estate tax consequences and things like that.
So very important that the takeaway from this is, that if you want to gift stock in the company to a family member, it is a viable option. But you want to make sure that whoever you’re working with as your attorney, understands how to structure this, so that it doesn’t create potential tax problems for you or your estate.
Transfer of Ownership – Option 3: Bonusing of Stock
I’m going to give you an overview of how the bonusing of stocks work. It’s a little bit complex so I’m just going to give you an overview. You bonus the amount of shares you want to give. Let’s say in year one, you want to give 10% of ownership to one of your insider employees. You give that stock as a bonus and then you give an additional bonus of cash, which would then help the employee pay the taxes on those ownership shares that they were just bonused.
What this does by structuring it this way, is you actually get a tax deduction as the business owner when you bonus out the shares. When you run the numbers on it, when you look at the tax implications, often it’s a very tax efficient way to transfer ownership of the business. This option makes it a very compelling strategy to consider.
Selling to Key Employees – Is an Inside Transfer the Right Decision for You?
How do you know if a transfer to an insider is the right decision for you? It’s so important to identify the right successor and really dedicate the time it takes to make this decision.
Here’s what I’d like to offer to you today. If you want to know if an insider transfer is right for you and talk with an objective third party about whether or not this makes sense for you and your business, schedule a free exit planning strategy call. In 20 minutes, we’ll talk and I’ll ask you questions that you’ve probably never been asked before, in order to help you identify if this is the right path for you.
Schedule Your Free Business Exit Planning Strategy Call >>>https://bit.ly/2AqKMxl
THANKS FOR READING!
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