Owners are often too busy running their companies to take the time to properly plan far enough ahead to their eventual departure from the business.
Tim Jochim, chair of the Business Succession & ESOP Practice Group at Kegler Brown Hill & Ritter, says that there’s often some kind of catalyst, such as a health condition, that forces an owner to begin the process.
“Succession planning should be a 10-year process, minimum, before an owner exits,” says Jochim. “It’s a planning issue, and owners should set up the process relatively early on.”
Smart Business spoke to Jochim about what business owners need to consider during the succession planning process.
What are the management issues that owners face when considering exiting the business?
The key to the long-term success is the management quality of the business, no matter who owns it. This is an area where owners of closely held or family-owned businesses probably don’t spend enough time, especially early on in the planning and development stage. They have to recruit, develop and retain good management. If it’s a family business, it becomes a little more complicated. If the owner/founder wants the family in the business and tries to devise something that is fair to the individual members of the family, that fairness he’s seeking within the family may not necessarily be best for the business. Further, you may have the complication of outside managers or executives interacting with family members.
The business should come first. If family members are involved in the business, they should a) work their way up within the business, and b) spend some time at an outside business so they gain a broader perspective of what the management process is like.
What are some of the options for transferring ownership?
The options are relatively simple and straightforward. If it’s a family business, usually there’s going to be some combination of gifting, bequest and purchase by family members. If you started a business with other investors, then generally there’s a cross-purchase agreement funded by life insurance where, if one person leaves, the others have a right to buy his or her stock. If no one wants to buy it, the company has a right to redeem it. If the company doesn’t redeem it, then the exiting shareholder can sell to the outside. Usually in the buy-sell agreement, there is a built-in process a cross-purchase or redemption and if none of those is implemented, then the outside sale comes in to play.
On rare occasions, the company does have an opportunity for an initial public offering.
In an employee stock ownership plan (ESOP), the advantage is that the purchase of the stock is deductible. It’s expensable and it is pretax dollars. So if I’m an owner and the ESOP buys my stock, it’s funded or paid for by the company, but the company can deduct that expense. If the company is a C corp., they can structure it so that they don’t pay the capital gains tax or the Ohio income tax associated with any gains from the sale. That’s two advantages of the ESOP.
How can owners decide which options are right for them as well as their companies?
An ESOP is not appropriate for all companies. Values and culture are really the drivers for owners/founders who do ESOPs. In many instances, they could sell at a higher price to an outside buyer, but they want to share their success with their employees, and they want their company to remain independent.
The decision should be made on a case-by-case basis. There are instances where it may not make sense to remain independent. You could be in an industry where the small players are getting squeezed out, and the industry is consolidating and you don’t have the technical or managerial talent to keep going. In this case, it would make strategic sense to sell to a quality, larger outside buyer. Or if you’re the type of owner who wants the last buck, a third-party sale may be a better option.
How do taxes and the financial needs of the exiting owner factor into the decision?
There are three types of taxes to consider. There are taxes upon sale of the company, taxes to the company and estate taxes. Sellers are going to pay, at a minimum, capital gains taxes and the applicable state tax on any gain, depending on the structure of that sale.
In an outside sale in an auction situation, generally that will yield a higher price than selling to an ESOP. However, as noted before, the seller has tax benefits in selling to the ESOP that he doesn’t have on the outside sale. Also, if the ESOP company is an S corporation, the profits of the company are tax-exempt to the extent of the ESOP ownership. ESOPs, as a shareholder, pay no federal or state income tax at all. That’s a little secret that most owners are not aware of. Over the past few years, many of my clients that are S corp. ESOPs went out and made acquisitions. Why? Because business was slow, the prices of the targets were low due to the recession and these companies had built up a lot of cash over several years of being S corp. ESOPs.
One of the things that frequently comes up in business succession discussions is the federal estate tax. When the owner/founder dies and the value of the company is high let’s say greater than $10 million there’s probably going to be significant federal estate taxes to pay. But with proper planning, you can reduce or eliminate this tax. If the ESOP buys the stock, a common tool is for the seller to set up an irrevocable life insurance trust. The proceeds of that trust are generally outside of the estate, so they are not subject to the estate tax. The owner can sell to the ESOP, or even sell at a lower price to the ESOP, and use some of the proceeds to set up an irrevocable life insurance trust which then provides enough proceeds to the family upon the death of the owner/founder to offset any estate tax. If a charitable trust is combined with the insurance trust, it is likely there will be no federal estate tax at all.
Tim Jochim is chair of the Business Succession & ESOP Practice Group at Kegler Brown Hill & Ritter. Reach him at (614) 462-5443 or at email@example.com.