Business succession planning for founders of privately held business enterprises can take many paths. One of the most common exit plans is ownership transfers to management or key employees and it is easy to see why: transferring ownership to key employees creates shared values-based goals and can give owners ample time to make their exit. There are many ways to make this transfer, such as long-term installment sales, leveraged management buyouts, employee stock ownership plans (ESOPs), and modified buyouts. This article only talks about certain modified buyouts and selling the business over time. To help understand this type of business succession planning, this article uses a hypothetical technology company called Tech Co. to illustrate the following techniques and information.
One of the main questions faced in succession planning is how to properly motivate the future leaders of the business to continue the legacy the founder created, which is what makes ownership transfers to key employees so attractive. Key employees who one day will become owners are as interested as the founders are in building value, training future owners, and making the business more profitable, stable, and better managed. Employees who have been with the business for years are more likely to maintain the culture, legacy, and mission of the business, and the investment in the community.
Transferring ownerships of a business to key employees can be more gradual than selling to a third party or using other transition techniques. Once a founder starts on this exit path, they can gradually back away from the business over a period of maybe five to ten years, all while still receiving income and maintaining control. This is especially important as it allows time for key employees to gain experience in running the business without a founder continuously present. It may also allow for the use of some tax-deductible payments from the company to the founder.
Example: Tech Co. has one founder (“Founder”) and several employees, two of which have been with Tech Co. for many years. Founder considers these two employees crucial to the success of Tech Co. and would like them to manage the company one day. After confirming that the two employees desired a greater role within the company, Founder began gradually preparing them for ownership, such as including the two employees in her decision-making process for the company and inviting them to participate in important meetings. This allows Founder to confirm the two employees are prequalified to run Tech Co. through on-the-job training and observation—she knows their capabilities and their dedication to the values of the business. These key employees are motivated to stay with and grow the company, just like Founder.
Ultimately, slowly transferring ownership to a company’s key employees allows a founder to separate ownership interests from control and governance of the company while also being more likely to keep the business in the community, keep the employee culture intact, and keep relationships with customers and vendors continuous, so there’s no or limited disruption. There are two common methods that founders use to transfer ownership to key employees: (1) selling equity (or granting equity and thus diluting the founder) and (2) gifting from the owner or bonusing equity from the company.
1. Selling Equity
Of the two common transfer methods, selling equity is generally the more popular option. This can take the form of the founder of the company selling their equity to key employees, generally with an initial cash buy-in with the remainder paid off over time with a promissory note. It can also happen with the employees buying the equity directly from the company and diluting the ownership. There are also many other ways to sell equity from the company that are not discussed in this article.
Example: Tech Co.’s Founder has decided to make the two employees co-owners of the company. She is the sole owner and would like to sell to each of the employees 5% of her equity, making her a 90% owner. Founder and the employees agree that the employees should pay 20% of the purchase price up front, with the remainder paid off with a promissory note. Founder has the company’s counsel prepare the necessary agreements and structure the promissory notes in such a way that ideally the employees can use their estimated future ownership distributions to repay the promissory note over time. Founder plans to continue annually transferring small amounts of her ownership to the two employees. If, before the transfer is complete, Founder decides to postpone her exit date or even sell to an outside party, she now has motivated employees onboard, which can help Tech Co. continue to prosper.
2. Gifting or Bonusing Equity or Issuing Options
Gifting equity is a popular option when the key employees are also family members. Generally, a founder will gift a child or another family member a certain percentage of ownership, often starting with 10% or 20% ownership, and then gradually gifting more over time. Gifting equity can be a problem for taxes and gift tax exemption purposes, so it is important to consult with a tax professional before attempting.
Bonusing equity generally occurs through employee stock options—a common form of equity compensation, especially among startups and tech companies. However, other equity such as Restricted Stock Grants and other units can also be used. An employee stock option is an agreement that gives employees the right to buy a specific number of shares of company stock at a specified price, within a particular time frame. Although tax and securities laws impose some of the rules that regulate stock issuances and options, others are at the company’s discretion. Using employee stock options as an exit strategy can be complex due to the nature of such plans, so it is important to consult with a legal professional before implementing.
Example: After reviewing all her alternatives, Tech Co.’s Founder ultimately decided to continue selling her equity directly to the two key employees. At the end of each fiscal year, Founder continued to sell 10% of her equity until she no longer had a controlling interest in Tech Co. As she slowly sold her equity to the two key employees, Founder was able to control her exit out of the company, while ensuring the key employees would be able to maintain company culture, maintain existing customer and vendor relationships, and minimize disruption.
Business succession is a long-term process filled with challenges—even unexpected opportunities—and careful planning and periodic review is crucial. Selling your business to a key employee can be one of the most rewarding paths of a successful exit from your business. If any of these methods are used, other protections, such as employment agreements and shareholder agreements, are needed. To determine if this is the right exit strategy for your company, you should consult with a legal professional.