Selling your business: the inside deal

Most New Hampshire business owners’ most valuable asset is their business itself. However, unlike most other assets, where markets and mechanisms for transferring these assets are well known, many business owners are not fully aware of the options available when transferring ownership of a business.

When evaluating options for a transitional transaction, a threshold consideration is whether the transfer will involve “insiders” — people familiar with the business, such as existing managers, existing employees or the business owner’s family members – or “outsiders” — unrelated third parties, including strategic buyers or financial buyers.

When it comes to insiders, each buyer group has its own advantages and disadvantages:

• Transfer to existing management: For many privately held businesses, the most logical buyer of the business is the existing management. The existing management is familiar with the business’ operations and is usually in the best position to continue the business’ operations with little, if any, disruption. The existing managers are often motivated by the fact that by acquiring the business they will ensure their continued employment, whereas, continued employment is much less certain in connection with a transfer to an outsider.

When exploring the possibility of a transaction with existing managers, the business owner must take a hard and honest look at the management team to determine if it is capable of operating the business as owners. The business owner also must approach any discussions with managers carefully, since a misstep could result in a backlash, lead to disgruntled employees and create uncertainty among key employees regarding their future and the future of the business.

The business owner also must consider how to structure the transaction. Existing managers do not often have sufficient capital or the access to capital required to complete the transaction. This can result in the business owner taking a lower purchase price or accepting payment of the purchase price over time.

• Transfer to employees: Another option is to transfer the business to the employees through an employee stock ownership plan. An ESOP is a benefit plan whose primary purpose is to purchase stock of the business and hold that stock for the benefit of the business’ employees. In most ESOP transactions, the ESOP purchases the business owner’s stock by using contributions made by the business to the ESOP (which in most cases are deductible to the business) or by obtaining a loan from a bank or other financial institution.

If structured properly, a transfer to an ESOP will allow the business owner to defer any gain he or she otherwise would recognize on transfer of his or her ownership in the business, which for most privately held businesses in New Hampshire can result in significant tax benefits not found in other transactions.

In many cases, business owners transferring ownership through an ESOP experience an increase in employee morale and productivity because the employees see themselves as owners of the business. In addition, the transfer can be structured to allow the business owner to transfer ownership over time, which allows for an orderly transition of ownership.

In order for a transfer of ownership to an ESOP to be successful, the business must have sufficient cash flow to support the funding of an ESOP at a level that will allow the ESOP to fund the purchase of the business owner’s interest in the business. In addition, there are ongoing administrative costs associated in administering an ESOP after the transaction is complete, including obtaining annual valuations of the business and preparing annual reports for the participants in the ESOP.

• Transfer to family members: While this strategy can have very good results, if not structured properly or thoughtfully, this strategy can damage the business and the business owner’s family.

To do so, the business owner must develop a comprehensive plan on how the transfer will take place. This plan should be documented either in his or her estate plan or through other agreements with the appropriate family members and the business.

Failure to properly document the intentions of the business owner can lead to highly contentious disputes among the business owner’s family. Once the plan has been developed, the business owner should communicate his intentions to the family, advisers and, when appropriate, key managers. When proceeding forward with this strategy, business owners also must thoroughly examine the family members to whom they will be transferring ownership and determine if they are capable of operating the business.

Transfer to family often requires payment over time out of the business’ profits and may result in a lower purchase price than one the business owner might have otherwise been able to obtain.

Many issues must be addressed when evaluating and structuring transfer of ownership of a business. Failing to properly plan for and evaluate the available options will put at risk the business owner’s most valuable asset and, potentially, his or her future financial security.

Patrick Closson, an attorney in the corporate department of McLane, Graf, Raulerson & Middleton, advises clients in the areas of acquiring and selling business entities.