One way the owner of a privately held
business can successfully exit the
marketplace is to sell out to a family member (see last month’s Smart Business). Another is to sell to a key employee or a group of employees.
Either way, the process can be difficult.
“There is always a sense of loss because
the business has been the owner’s baby for
so long,” says Joel J. Guth, an advisor in
the Citigroup Family Office at Smith
Barney, a division of Citigroup Global
Markets. “Former owners who are ultimately happy have a common thread.
They took the time to perform a thorough
exit-planning strategy; they set their objectives; they understood what they were trying to accomplish; they found the most
efficient way to transfer ownership of the
business to someone else; and they had a
mission for what they were going to do —
and be — after the sale.”
Smart Business talked with Guth about
how to successfully sell a business to employees.
Why sell a company to a key employee or a
group of employees?
In some cases, the owner truly feels the
employees have been critical to the
growth of the business and therefore owes
them the opportunity to buy the company.
Sometimes, the owner feels he has had a
fantastic opportunity to accumulate wealth
and wants to pass it on to people who are
near and dear to him. Thirdly, an agreement with key employees could exist from
when they were first hired. It could be that
there is no other market for the business
— that the only true buyers are employees
of the company. Lastly, the owner might
believe that if he sells to a key employee
he may have a higher probability that the
culture or mission of the company will
remain intact.
What are the risks?
Selling to one, two or a group of key
employees has many of the same risks or
disadvantages as selling to a family member.
First, are the key employees qualified
enough to continue to run the business in
the owner’s absence? Sometimes the business has outgrown the management group.
It might have been a great management
group when it was a $10 million company,
but now it is a $40 million company, and
management is not as well equipped to
handle the larger size. The owner has to be
willing to perform an honest appraisal of
that management group.
The second risk is that normally, the
employee group does not have the ability
to write a check for the purchase, which
means the owner’s payout has to be based
on the future success of the business. The
owner has to be very comfortable that this
group can continue to run the company
profitably.
Finally, there is always the risk that this
type of sale may require the former owner
to transition the responsibilities or nurture
key relationships or employees after the
sale is complete.
If you are selling to key employees, what are
your options?
The owner could sell the stock outright,
which is not probable, because most employees will not have enough money to buy
the company.
The owner could establish an Employee
Stock Ownership Plan (ESOP), which is a
leveraged transaction enabling the company to borrow on the cash flow of the business. The company uses the loan to purchase stock.
An owner can choose an installment sale
where employees are going to buy the business over time, primarily using the cash
flow of the business to purchase stock.
Which is the most popular?
ESOPs are getting a lot of press right now
due to some real advantages. For instance,
if the ESOP is structured correctly, the former owner can avoid paying capital gains
on the stock if he reinvests the proceeds in
qualified investments like stocks and
bonds. For other types of transactions,
he’d be required to pay taxes on that
amount. Another benefit of using an ESOP
is that the owner gets cash up front, unlike
many other mechanisms. This means he
may be able to leave the business immediately due to the fact that he is not tied to
the future success or failure of the business. Lastly, he does accomplish the objective of giving the company back to the
employee group.
Of course, setting up an ESOP can be
complex, expensive and may involve disadvantages such as significant debt financing
and various requirements that are related to
the special tax treatment. It is important to
evaluate whether an ESOP structure makes
sense for each specific situation.
Citigroup Family Office is a business of Citigroup
Inc., and it provides clients with access to a broad
array of bank and non-bank products and services
through various subsidiaries of Citigroup, Inc.
Citigroup Family Office is not registered as a broker-dealer nor as an investment advisor. Brokerage
services and/or investment advice are available to
Citigroup Family Office clients through Citigroup
Global Markets Inc., member SIPC. Joel Guth is a registered representative of Smith Barney, a division of
Citigroup Global Markets Inc., that has qualified to
service Citigroup Family Office clients.
Citigroup, Inc., its affiliates, and its employees are
not in the business of providing tax or legal advice.
These materials and any tax-related statements are
not intended or written to be used, and cannot be used
or relied upon, by any such taxpayer for the purpose
of avoiding tax penalties. Tax-related statements, if
any, may have been written in connection with the
“promotion or marketing” of the transaction(s) or
matters(s) addressed by these materials, to the extent
allowed by applicable law. Any such taxpayer should
seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
JOEL J. GUTH is an advisor in the Citigroup Family Office at Smith Barney, a division of Citigroup Global Markets. Reach him at (614) 460-2633.