Nov 01, 2005

Fear Factor

What wakes you up at 4 a.m. if you’re a small business owner? Is it the fear that your key people won’t get it done right without you? When you’re gone for a few weeks, do you hear rumblings from trusted staff that things aren’t the same when you’re not around? Do you think about your decisions to bring family members into the business and how they will get along if you aren’t there to mediate and lead? Does your financial independence depend on the business after your retirement? Maybe it’s the tough economy or competition that keeps you up—Wal-Mart, China, 9-11, market corrections, employee turnover—it never stops because change is a constant, and it’s wearing you down. You pay a fair wage and provide a good work environment with training and opportunity, yet it is hard to find people who want to work or are even willing to show up on time. All this negative energy is killing your love of the business, and you just want out. If the right offer were to come your way, you’d take it in a heartbeat—maybe. While this may seem like an exaggeration, for many owners, it’s a grim reality and an indicator that not enough time has been invested developing an ownership and management transition plan for their business and their life.

Succession Planning

Why do smart and successful owners who make tough business decisions every day get confused and frustrated by succession planning? One reason is that business succession decisions are subjective and can’t always be measured by numbers. Another is that good succession planning forces owners to consider their values and how to spend their time and money for the rest of their lives. Many owners are scared of making the biggest mistake of their lives with their most important asset.

If you’re like many owners, you simply don’t know where or even how to begin. Often the first person you speak to regarding succession is your attorney or CPA. This makes sense because you trust them and they already know your business. You pay them for advice on legal and tax matters, and business succession is a legal and tax matter, isn’t it? Not so fast; while legal and tax advisors are great resources for specific technical advice, they often fall short when it comes to planning and helping sort through complex family dynamics and non-financial issues that often drive succession planning decisions. Often confusion and conflict surround the roles of professional advisors in the succession planning process and lead to planning failure. Business succession planning is complex because it crosses many disciplines including:

  • Business valuation;
  • Merger and acquisition;
  • Tax planning;
  • Investment planning;
  • Estate planning;
  • Management and leadership development;
  • Financial planning and cash flow modeling for post retirement;
  • Insurance for shareholder agreements; and
  • Personal insurance for health, estate liquidity and estate equalization.

A New Approach

Everyone seems to have their hand out, and you are the big checkbook for what seems to be an endless supply of costly professionals. How can you simplify and consolidate your planning so you can get the most out of your advisors? Who should lead the process? A new approach to succession planning involves using planning firms skilled at integrating family and non-financial issues with the many disciplines listed above. This approach aims to integrate the financial and estate planning needs of the primary shareholders with the needs of business and its key stakeholders. By taking a counseling approach to develop top-down clarity on your mission, values and goals, a financial strategy to serve all stakeholders can be created.

Employee Stock Ownership Plan

An important succession tool often overlooked by small business owners is to “go public privately” through an employee stock ownership plan or ESOP. While an ESOP is not for everyone, the tax benefits and flexibility for closely held companies are powerful incentives, so everyone should go through a feasibility process to rule ESOP in or out right away.

The following questions may be helpful if you are an owner of a successful private company and have considered involving your employees as part of your business succession plan.

Q: How can I make wise decisions about ownership succession if I am not ready to give up control of my company?

Business owners are rarely ready to give up complete control of their companies and as a result procrastinate until it’s too late. The real solution is to start early with a process of ownership succession that initially requires giving up only a small part of the ownership and no control. This approach sends a message to key stakeholders that you mean business and will follow through with your succession plan. A partial sale to an ESOP allows owners/sellers to convert some stock to cash while retaining 100% control of the business and the right to remain working in the company if they choose.

Q: How can I maintain family harmony through business succession if I already have conflicting goals within my family?

If there is family conflict while you are alive, imagine the problems that may develop if you weren’t around to mediate. With divorce rates in excess of 50%, it’s no surprise that most families in business struggle with conflict. Sixty-five percent of all planning failures are the result of lack of trust and communication. Trust and communication is improved through family wealth counseling and coaching through a values-based approach to business succession that includes all family members. The development of a Loving Will for the family and the business is a great way to start.

Q: What are the tax and financial advantages to an owner who sells to an ESOP?
The owner of a regular or C corporation may sell to an ESOP and elect to permanently defer capital gains taxation on 100% of the sales proceeds provided a few simple rules are followed. In addition to capital gains relief, the owner can take a business tax deduction for 100% of the cost of financing their own buy-out. For the owner of a sub-chapter S corporation the tax advantages are slightly different. Instead of capital gains relief, the owner benefits from an unusual tax provision that allows the stock sold to the ESOP to become permanently tax exempt. If 50% of the company were sold, the company’s tax bill would be cut in half permanently.

Q: If there were no tax advantages to an ESOP, would it still make sense to do one?
ESOPs allow owners to sell all or part of the company yet remain in control for as long as they want. The key is flexibility. An owner who does a partial sale to an ESOP has many options including:

  • Keeping ownership at the same percentage;
  • Increasing ESOP ownership through a future sale;
  • Reducing the ESOP through stock redemptions as people leave the company;
  • Bringing family members into the business and giving them ownership and/or control; and
  • Selling the entire company including the ESOP to a third party.

Q: Is it true that ESOPs are expensive and complicated?

ESOPs are no more complex or expensive than other approaches to business succession. 401(k) plans governed by complex ERISA rules are well received by owners and employees alike. ESOPs are easy to understand with the help of professional advisors who specialize in ESOPs. The complexity and cost of finding the right outside buyer can be very frustrating for an owner. While an ESOP transaction might cost from 3–5% of the total amount sold, a third-party sale can easily run 20–25% when you factor in all transaction fees and taxes.

The bottom line is that while ESOPs are complex, they eliminate many of the obstacles that keep owners from making wise business succession decisions. With proper guidance, ownership transition can be completed successfully and in a timely manner through ESOPs.

Q: If I want the best price for my company is an ESOP the right approach for me?

A sale to an ESOP usually results in the best after tax price for the owner. There may be situations where a strategic buyer will be willing to pay a premium above what an ESOP can pay due to a special desire for your business. More often than not, however, the flexibility available through an ESOP sale outweighs the premium a strategic buyer may be willing to pay.

Q: If ESOPs are so good, why aren’t more companies doing them?

Although employee ownership has been around for a long time, the tax incentives that created ESOPs as we know them today have only been around since 1984. ESOPs are not well understood by many owners and their professional advisors and as a result are not recommended as often as other forms of business structure. While ESOPs initially may appear complex, anything worthwhile is worth the extra effort to understand. Ultimately, ESOPs appeal to business owners who care about their people. As more owners realize the value of protecting the human capital in their companies, more will turn to employee ownership as the preferred method of business operation and the ultimate tool of business succession. wqp

About the author

Richard Tanner is president of Ownership Advisors, Inc. He can be reached at 216.328.5538, or by e-mail at [email protected].