Your business-owning clients have nightmares, and as an accounting professional who cares about them, you do, too. But here’s a nightmare scenario your business-owning client might not have considered: Let’s say they own a business they have spent decades building up, and the value of the business represents the majority of their wealth. No one else in the family works because the business provides the owner with a good enough income. The business has weathered the peaks and valleys of economic cycles; however, because of the pandemic, it is now struggling.
If the business owner dies, staff may continue to operate the business on a day-to-day basis. But if word spreads that the owner is gone and clients with outstanding invoices don’t pay, the business will develop cash-flow problems. Meanwhile, if the family no longer has the owner’s paycheck coming in to pay household expenses and they have no interest in running the business, they may look for a quick sale. If the business is sold for a fraction of its value under ideal conditions, the family will suffer, and longtime employees will lose their jobs.
This scenario happened because there was no business succession plan in place. Here are some options for your business-owning client who needs a succession plan:
1. Sell the business to employees
Your client may decide to sell the business to their employees. This involves setting up an employee stock ownership plan (ESOP). The first step is setting up an ESOP trust. The company either contributes cash to the trust or borrows money from a bank. This cash is used to buy all or some of the shares of stock belonging to the owner. They have effectively sold the business (or a portion) to the ESOP trust. The business is valued independently. Assuming cash from the firm was used (and no debt), shares are allocated to company employees on a fair basis. These shares are part of the employee’s 401(k) plan. The employees’ ownership of the shares vests over time, and employees leaving the company are cashed out. This requires the ESOP trust to have cash on hand to buy back those shares from departing employees.
The owner can still be involved in running the business in this situation if they still retain some shares. The employee-owned company will have a board of directors that includes employee shareholders. There are significant tax advantages for the owner, company and employees. For example, if the employees’ shares are held within their 401(k) plans, they are in a tax-deferred environment.
How accountants can add value: The business needs to be independently valued, the ESOP trust needs to be established, the funding and structure need to be determined, the trust needs to be administered and tax reporting needs to be addressed.
2. Merge the business
Your client may be planning to retire and needs an exit strategy. Perhaps another business owner in a similar or complimentary field knows your client, and they get along well. Your client may decide to merge the two businesses, taking on a percentage ownership of the newly combined business. Your client can still be active in the business, and both businesses are independently valued to arrive at a realistic value for the combined new entity. Responsibilities are defined, and the business owner must live up to his or her obligations.
If the business owner dies, the family or the owner’s estate owns a stake in the combined company, which is an ongoing business. The expectation is the other partner(s) would buy them out.
How accountants can add value: The business needs to be valued, a good merger partner needs to be found and that business needs valuation, too. The terms of the merger agreement need to be set, and the responsibilities of each party need to be spelled out.
3. Buy key person insurance
What if your business owner has partners? What if the business doesn’t generate enough cash flow or have large enough reserves to easily buy out a partner? One solution is to buy a life insurance policy for each partner or owner. This is called key person insurance. These policies are owned by the business, and the business pays the premiums. When a death occurs, the policy pays the death benefit to the business, allowing the business to compensate the deceased partner’s estate for the value of their shares.
How accountants can add value: This is primarily an insurance purchase, yet the accountant is involved because of their fiduciary role. As an accountant, you can determine if this is the best and most cost-effective coverage and whether the policy should be cancelled.
4. Sell the business to a buyer
This takes advance planning. The business owner makes a conscious decision to sell, understanding they will be involved after the sale and paid over time. The business will need to be in good shape. A buyer must be found, either through a business broker or personal connections, and they will agree on terms. In many cases, the value of the business is in the customer base and the revenue they provide. The business owner may be involved for a few years, transitioning the clientele into the new business. Payments to the owner are made based on how well this has been accomplished.
There are instances in which a sale can happen more quickly and the owner can be out of the picture after the sale. If your client owns an oil well, for example, the value of the business is primarily the value of the oil underground. If your client owns a fast-food restaurant at a busy airport, they are doing a volume-based business, so the owner’s presence would have little effect on the business’s profitability. When there’s goodwill involved and the customer base needs to transition, the owner’s involvement and the payment period will be prolonged.
How accountants can add value: The business needs to be valued, a buyer needs to be found, the terms of the sale need to be negotiated, the payment schedule must be defined and the responsibilities of each party need to be spelled out.
Your business-owning client needs a succession plan. The alternative can be a nightmare scenario.
This blog was originally published as a column on AccountingWEB and can be read in its entirety here.