In the next few years, your businesses may transition to a different owner. Aside from passing on the business to a family member, you may also want to consider selling the business to your employees. Not only do employees sometimes share the entrepreneur’s vision and passion for the business, their experience means they may also understand the strengths, weaknesses, and opportunities in the business and market. In addition, the other employees may already know and trust the successors you choose, so there is less fear of change and an opportunity to make a smooth transition.
That does not mean that this type of sale is without drawbacks. Employees may not have the cash flow or credit necessary to fund a straight buyout and, in many cases, the entrepreneur ends up financing the sale. Selling the business to your employees could also create conflict if other employees feel that they have been passed over or if they do not accept the successor. This can lead to internal power struggles and turnover, which can be detrimental to the business. The successor’s leadership and management skills may also require development, as a good employee does not necessarily always make a good leader.
A sale to employees requires a little bit more flexibility, but some advance planning can provide you with some tax-effective solutions. Some sale structure options are as follows:
The business finances the sale
The future owners can purchase the assets or shares of the company from the seller through a holding company. The new owners can then use inter-corporate dividends from the business to repay the previous owner. Typically, this would involve leveraging the business to fund the buyout. You may need professional tax advice for this option, as an improperly structured transaction may result in significant tax consequences.
The owner finances the sale
In some cases, the seller will accept a delay in receiving the proceeds of the sale, and future cash flows from the business will finance the buyout. Where the sale proceeds are deferred, there is an opportunity to defer a portion of the tax on any capital gains over five years, or until the proceeds are repaid. This option may be attractive to the seller, who often requires employees to put up enough of their own money to ensure their vested interest in the business. If, however, the business is financed with third-party debt, there may be limited security for the seller financing. In this situation, the seller will be more interested in getting their cash as soon as possible. The seller may choose to retain some form of voting or veto control until they have been repaid.
A third party finances the sale
The employees may be able to bring a third party, such as a venture capital fund, to the table. An employee purchase may be attractive to third parties because of the knowledge and experience that they bring to the table.
No matter which option may be best for you, it is important to remember that employees that become owners may need additional training and development to take their leadership skills to the next level. This process can take some time, as the employees need to learn how to think of the business in a different light and manage the business from a different level. That’s why you should keep these issues in mind long before you decide to retire and step away from the business.