November 21, 2018

Boomers Seek Business Succession

When the “great recession” was in full bloom, the oldest baby boomers were approaching age 65 and the many business owners among them lamented missing the opportunity to “sell high.” Beginning in 2011 and every day since, over 10,000 boomers have reached age 65. Now that we are in an unprecedented period of economic growth, boomer business owners are resolved to transition in the best possible manner, but how will they do it exactly?

Every business and ownership situation is unique. Rarely today does an owner give way to children who have grown up in the business. More often the owner’s children are professionals of some sort and are unlikely to drop what they’re doing and work in the business. It’s great how much money is chasing quality acquisitions, but selling often has a profound impact on the business and its culture as new ownership “optimizes” headcount and creates profit in pursuit of additional value. A sale to key management is possible but is the next generation of management ready for ownership and will the seller remain at risk for a sizable portion of the purchase price? Sorting through all related issues with trusted advisors takes time and patience, but savvy boomers are not missing another window!

Selling to an Employee Stock Ownership Plan (ESOP) is becoming increasingly popular because of their flexibility for transitioning ownership and management while preserving culture and rewarding employees. A vital factor is that an ESOP is tax exempt. A Subchapter S corporation owned 100% by an ESOP will never again pay tax on its profits. Thus, all debt associated with the buyout can be paid down very rapidly. Selling owners remain in leadership roles during the transition on their own schedule and have continuing influence on the payment of their purchase price during that time.

In a typical ESOP scenario, the company “redeems” stock from the owner in exchange for cash on its balance sheet and/or borrowed from a bank and a note payable over an agreed amount of time. Simultaneously, the company sells such stock to an ESOP in exchange for a note payable (hence the term “Leveraged ESOP”). The ESOP purchase agreement obligates the company to contribute enough money each year to the ESOP for payment of the ESOP note. Payments on the ESOP loan trigger stock allocations to employee participants. The bank financing and seller note might be scheduled for payoff within 7 years whereas the loan between the ESOP and the company may be paid off over 20 years. With a longer ESOP loan, long time employees are rewarded while employees joining the company in years ahead also become owners through the ESOP.

Because business owners cannot be both sellers and buyers, an independent trustee negotiates a fair deal for the ESOP and stays on through the transition. Owners will receive agreements covering employment terms, board composition and company governance, and warrants (think “stock options”) allowing them a portion of post-sale growth for taking on the risk of getting paid over time. The sellers and trustee are commonly aligned in creating a stock appreciation rights arrangement for the next generation of management to receive retention and performance incentives. The parties also work together to ensure continuity of leased facilities and bank relationships, as well as any needed clean-up of corporate records.

For owners desiring to leave a legacy and ensure the future of loyal employees while realizing a fair financial return, the ESOP offers a rare balance. It’s ok if considering an ESOP leads to a different path. After all, every situation is unique and taking advantage of this timing window is the goal for boomers.