There are several directions you can take when it comes to selling your business, including selling to a third party, gifting or selling to your children or selling to a group of insiders, such as co-owners and employees. Insiders are intimately familiar with the business, fit its culture and have bought into the long-term strategic vision of the company, making them an attractive target to buy the business.
If you think selling to insiders is the best course for your business, the next step will be deciding on how to sell to them. There are several ways to structure a transaction that recognize the typical cash flow restrictions of insiders. To decide on the best approach, you’ll have to take into consideration a number of factors, including tax consequences, risk, financing requirements and how soon you’re looking to retire.
Following are three ways owners can sell their business to their adult children, employees or other insiders that don’t entail receiving 100% of the proceeds on the date of sale. While deferring proceeds may result in additional risk for the seller, it provides flexibility in situations where the buyer doesn’t have the capability to pay 100% of the purchase price up front.
1. Sell, bonus or gift stock over time
One way to transition a business over time is to sell, bonus or gift shares of stock on an annual basis. These are usually small interests in the company, and the current owner maintains control of the business during the initial transfer. The owner holds on to a majority interest (greater than 50%) of the voting shares during this time period.
When the seller is willing to turn over control of the company, the other shareholders and the company would buy out the majority interest. This process may take longer and usually requires more financial planning, but it can be a successful way to transition a business to company insiders.
2. Sell 100% of the business in an installment sale
The IRS defines an installment sale as follows: “A sale of property where you’ll receive at least one payment after the tax year in which the sale occurs.” For example, a seller may receive 10% of the purchase price per year for 10 years, transferring a pro rata number of shares to the buyer upon payment.
Installment sale pros:
- An installment sale may result in a tax benefit for you as the seller as the overall tax liability is spread over the installment period as opposed to receiving a lump sum payment and recognizing the full tax liability at close.
- The seller receives additional proceeds in the form of interest income on the balance owed.
- An installment sale requires less bank debt and reduces the risk of bank default.
- Buyers are typically willing to pay a higher multiple in installment sales to incentivize the seller to spread payments over a number of years and to compensate for the additional risk this creates for the seller.
- If the installment proceeds are tied to business performance, the seller could receive consideration for earnings growth achieved during the installment periods that would otherwise be discounted in a lump sum payment at close.
Installment sale cons:
- Installment sales can be risky for the seller if business performance decreases.
- Depending on the type of financing utilized by the buyer, the seller may have to wait until the debt is paid off to receive full value, which could take five to 10 years.
- Uncertainty surrounding future tax rates could potentially result in a higher tax liability should tax rates increase.
3. Stock redemption
In a stock redemption, the company buys out one or more shareholders, thereby increasing the ownership of the remaining shareholders. For example, let’s say you have two adult children who each own 10% of the company. You own the remaining 80%. To sell the business through a stock redemption, the company would buy your 80% interest. The two shareholders would then become 50/50 owners of the company. There are several pros and cons to using this method:
Stock redemption pros:
- The proceeds from a stock redemption are treated as capital gains for tax purposes, which are currently taxed at a lower rate than ordinary income.
- Contrary to an installment sale, the debt obligation is held by the company, and interest payments are reported as a deductible expense on the company’s corporate return.
- By using company assets as collateral, it is easier for the company to secure debt financing than if an insider were to try and get the same financing on their own.
Stock redemption cons:
- This method does not work for companies with only one shareholder, as other shareholders will be needed following the redemption.
- Redemptions must meet a number of detailed tax requirements, such as the seller having “no interest other than as a creditor” in some circumstances.
- Depending on the financing terms, proceeds to the seller may still be structured as an installment sale.
In addition to the above options, there are other ways to match the seller’s expectations with the financial capability of the management team.
One option that can manage the risk to buyers and sellers is through an earn-out. In an earn-out, the seller is paid a higher purchase price contingent upon the earnings of the business over a certain time period. For example, the purchase agreement could indicate that if revenue grows by $1 million before a certain date, the sale price increases by $100,000. If the company does not achieve this financial target, the additional proceeds are not paid out, and the purchase price is decreased. Earn-outs are an option that can be used with the various scenarios listed above to help limit risk to the buyers while giving the seller an opportunity to receive a higher purchase price over time.
Starting the process
If you are starting to plan for a transition and are considering your options, the first step is to talk to professionals who have experience in assisting owners with these types of decisions. Your trusted advisor will work to understand your financial goals and objectives to find the best plan that meets your needs.
The experienced transaction specialists at Wipfli can help you determine which option is best for you and your business.
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