Selling Your Business, The Inside Deal

Photo of Patrick Closson
Patrick C. Closson
Director and Chair, Corporate Department and Chair, Healthcare Group
August 1, 2006

For most New Hampshire business owners their business is their most valuable asset. 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 to them when considering transferring the ownership of their 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, who are not existing owners of the business or otherwise affiliated with the business.

The transfer of ownership to insiders has benefits and drawbacks that are not found in transactions with outsiders. Because insiders are familiar with the business, the due diligence process is oftentimes much less rigorous than in transactions involving outsiders. However, these transactions often involve a buyer (or buyer group) that has little available cash and must borrow a significant amount of the purchase price or require the seller to finance a portion of the transaction, which can result in a purchase price to the business owner that is lower than what the selling business owner may be able to realize in a transaction with an outsider.

Insider transactions usually involve the existing management team, the owner’s family or the employees of the business. 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 oftentimes 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 the business’ existing managers, the business owner must take a hard and honest look at the existing management team to determine if they are capable of operating the business as owners. This change in responsibility can be dramatic and some good managers do not have the skills to be successful owners. The business owner must also approach any discussions with the existing managers carefully as a misstep during these initial discussions can result in a negative backlash against the business owner and the business, lead to disgruntled employees and create uncertainty among key employees regarding their future and the future of the business.

The business owner must also consider the structure of the transaction and may need to be creative with regard to how it is structured. In many management transactions the existing managers do not have sufficient capital or the access to capital required to complete the transaction. This can result in the selling 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 of the business by creating an employee stock ownership plan (ESOP) to purchase the business owner’s ownership in the business. The 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 owners 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/she otherwise would recognize on transfer of his/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 to the business’ employees through an ESOP experience an increase in employee moral and productivity based on the fact that the employees see themselves as owners of the business. The ESOP allows the business owner to transfer ownership in the business to long-term employees that may have helped the business owner to build the business. In addition, the transfer to the ESOP 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 with administering the 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: Another option available to some business owners is to transfer the ownership of the business to members of his/her family. This option requires that the business owner have a family member to whom their ownership interest can be transferred. 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.

If a business owner elects to transfer their ownership to his/her family members, the business owner must develop a comprehensive plan on how this transfer is going to take place. This plan should be documented either in his/her estate plan or through other agreements with the appropriate family members and the business. The failure to properly document the intensions 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 his/her family, his/her advisors and, when appropriate, his/her key managers. When proceeding forward with this strategy, business owners must thoroughly examine the family members to whom they will be transferring ownership and determine if they are capable of operating the business.

As with a transfer to the business’ managers, a transfer to the business owner’s family oftentimes requires payment over time out of the business’ profits and may result in a lower purchase price than what the business owner might have otherwise been able to obtain if he/she sold the business to an outsider.

There are many issues that need to be addressed when evaluating and structuring a transfer of ownership of a business. Assessing the threshold issues, evaluating your options and proceeding with a course of action based on this analysis will ensure that the business owner’s objectives are achieved. Failing to properly plan and evaluate the available options will put at risk the business owner’s most valuable asset and, potentially, his/her future financial security.