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Transferring Your Company to Key Employees White Paper

Transferring Your Company to Key Employees White Paper

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Published by Ken McCaul

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Published by: Ken McCaul on Oct 14, 2009
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10/14/2009

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Owners wishing to sell their businesses tomanagement (key employees) face oneunpleasant fact: their employees have nomoney. Nor can they borrow any—at least notin sufficient quantity to cash out the owner. Asa result, each transfer method described in thisWhite Paper uses either a long-terminstallment buyout of the owner or usessomeone else’s money to affect the buyout.The last method discussed—the ModifiedBuyout—uses both an installment buyout andsomeone else’s money.
LONG TERM INSTALLMENT SALE
A long-term installment sale typically followsthis course:1.A value for the company is agreed upon.2.At least one employee agrees to buy thecompany by promising to pay theagreed upon value to the owner.3.The former owner holds a promissorynote with installment payments over aseven to ten year period with areasonable interest rate, signed by thebuyers. The note is secured by theassets and stock of the business andthe personal guarantee and collateral(usually residences) of the buyers.4.Little or no money is paid at closing.Owners wishing to sell the business to keyemployees must understand that they aretransferring the business and receiving nothingin return other than a promise to receive thepurchase price from the future cash flowof the business. There is no other source of cash available to the employee/buyer. If the new ownership cannot at leastmaintain the business, you will not receive your purchase price. There are several planningsteps that can reduce the significant risk of nonpayment.The first step is to pay the owner what he or she wants in the form of Non-QualifiedDeferred Compensation payments, severancepayments, lease payments or some similar means of making tax-deductible paymentsdirectly from the company to the owner. Thistechnique minimizes the net tax cost of thebuyout and thereby makes more cash availableto the owner. It is discussed in a separateWhite Paper, “Exit Planning Primer,” as well asin Chapter Seven of 
The Completely Revised How To Run Your Business So You Can LeaveIt In Style
.As a second step, the owner should transfer any excess cash out of the company wellbefore she sells it.Third, the owner can enhance security through:Securing personal guarantees(collateral, both business and personal);Postponing the sale of the controllinginterest;Staying involved until satisfied that cashflow will continue;Obtaining partial outside financing; andSelling part of the business to anoutside party.
Joseph Associates International, Inc. www.BrokerChicago.com
Transferring Your Company to Key EmployeesWhite Paper
 
These techniques reduce but do not eliminaterisk. For that reason, owners typicallyundertake this type of sale only if no alternativeexists, if they don’t need the money, or if theyhave complete confidence in their employeesand in the economy to support the company’sprosperity. The most common reason,however, for exiting using the long terminstallment sale is that the owner has failed tocreate a less risky exit plan. 
LEVERAGED MANAGEMENT BUYOUT
This transaction structure draws upon thecompany’s management resources, outsideequity or seller equity, and significant debtfinancing. This structure can be an ideal way toreward your key employees, position thecompany for growth, and minimize or eliminateyour ongoing financial risk.To effectively execute a leveragedmanagement buyout, your business shouldpossess the following characteristics.A management team that is capable of operating and growing the businesswithout your involvement.Stable and predictable cash flow.Good prospects for future prosperity andgrowth. The growth of the companyshould be described in detail in amanagement-prepared business plan.A solid tangible asset base, such asaccounts receivable, inventory,machinery and equipment. Hard assetsmake it easier to finance the acquisitionthrough the use of debt, but servicecompanies without significanttangible assets can obtain debtfinancing, albeit at higher cost.Have a fair market value of at least $5million (probably $10 million in order toattract the interest of private equityinvestors).The prerequisite for a management-ledleveraged buyout is that you, as the seller, andthe management team agree on a fair value for the company. The parties then execute a letter of intent giving management the exclusive rightto buy the company at the agreed price for aspecified period of time (typically 90 to 120days). The management team and its advisorssubsequently arrange the senior bank debt tofund a portion of the transaction. This bankdebt usually requires management to arrangeto make an equity investment prior to closing. Itis at this point that the management team andits advisors seek an equity investor. They offer the equity investor a complete package of price, terms, debt financing, and managementtalent.The equity investor need only weigh thereasonableness of the projected return on hisinvestment.There are many professionally managedprivate equity investment funds that activelyseek management leveraged buyouts as apreferred investment. These private equityfunds control billions of dollars of capital for investment which they may structure as senior debt, subordinated debt, equity or somecombination thereof. This investment flexibilityenables the private equity investmentfirms to be much more nimble than your 
Joseph Associates International, Inc. www.BrokerChicago.com
 
local commercial banker. The investmentphilosophy of these private equity investors iscaptured in the slogan of a successful buyoutgroup: “We partner with management to createvalue for shareholders.”From management’s perspective, a significantadvantage to working with a private equity firmis that most will continue to invest in thecompany after the acquisition to fuel thecompany’s growth. These private equity firmswill also allow management to receive a“promoted interest in the deal.” This meansthat management can earn greater ownershipin the company than it actually pays for.To help you better understand the mechanicsof this process, let’s look at one highly-profitable medical device manufacturingbusiness with revenues of approximately $5million. The owner wanted out of the businessand was willing to sell it to management under the condition that the transaction be completedwithin 60 days. The agreed upon sale pricewas $8 million, payable in cash to the owner atclosing. The management team’s biggest andonly problem was that it had only $750,000collectively from second mortgages on their homes. Consequently, they hired aninvestment banking firm to help them arrangefinancing to close the transaction. With theclock ticking on their exclusivity period,management was motivated to make the deal.The transaction was ultimately structured asfollows:In this transaction, management owned 20percent of the equity ownership, despiteinvesting only nine percent of the equity fundsneeded to close the transaction. Six yearslater, all of the debt that had been used to buythe company had been repaid. The outsideequity investors received five times their initialinvestment and the management team reapedtheir initial investment ten-fold.Another advantage of the managementleveraged buyout is its flexibility. If an outsideprivate equity investor cannot be located under acceptable terms, the seller can elect tomaintain an equity position in the company, or subordinate a term note to the bank.As you can see, a management leveragedbuyout may enable a business owner toaccomplish the majority of his originalobjectives.
EMPLOYEE STOCK OWNERSHIP PLAN(ESOP)
An ESOP is a tax-qualified retirement plan(profit sharing and/or money purchase pensionplan) that must invest primarily in the stock of the company. In operation, it works just like aprofit sharing plan: the company’s contributionsto the ESOP are tax-deductible to the companyand tax-free to the ESOP and its participants(who are essentially all of the company’semployees).In the context of selling at least part of thebusiness to the key employees, the ESOP isused to accumulate cash as well as toborrow money from a financial institution.
Joseph Associates International, Inc. www.BrokerChicago.com

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