(As published in the Summer 2019 issue of Artisan Spirit)
Lillian had a problem. Against all odds, she’d managed to build a successful spirits business, selling her specialty, a truly weird (but utterly unique) habanero-flavored whiskey, into 47 of the lower 48 states. For some reason, she just couldn’t crack New Hampshire. In any event, her hooch was quickly becoming the hottest item in taquerias (other than tequila and tacos, of course) and she was doing well.
But she was tired. She’d put her nose to the grindstone years ago and left it there — pushing harder and harder as she tried to make the business a success. Now the business was booming but her nose was a nub. She was exhausted and ready to quit.
Lillian wasn’t a quitter, however. And even if she wanted out, she didn’t want to leave behind her two star employees: Mayford and Bertha. Those two had been with Lillian since the venture was little more than a dream. They’d worked hard too. But without the stress that flows from the responsibilities of ownership, they were still eager to continue. What’s more, they were interested in elevating the business to the next level, capturing New Hampshire and perhaps even taking the product global.
Lillian had a choice. She could cozy up to a larger producer and see if the business could be sold (a prospect she hated) or she could try to transition the business to Mayford and Bertha. But unless they were hiding it well, neither Mayford nor Bertha appeared to have the wherewithal (alone or together) to buy the business.
This problem, or some variant of it, crosses my desk with some regularity. And regardless of whether the entrepreneur wants to pass along all of the business or simply some portion of it, the fundamental challenges remain the same. You can’t easily sell something to someone if they can’t afford to buy it — and you may not even be able to give them a part of it without also giving them a problem. So what is Lillian — or someone similarly situated — to do?
To answer that question, we have to know what it is that Lillian really wants. For example, does she want to be out of the business entirely — and the sooner the better? Alternatively, does she want to retain some portion — maybe even a controlling portion — of the business indefinitely? Lillian’s answers to these and similar questions must inform her thinking about how to proceed.
If she wants to wash her hands of her habanero-whiskey empire completely within the next month or two, and is insistent on passing it along to Mayford and Bertha, then her options are actually somewhat limited. She can sell it to them outright — but unless they can come up with financing then she may need to adjust her expectations about the value of her business or either the timing or the completeness of her exit. For example, it might be possible for her to achieve a complete exit through the use of an employee stock ownership plan (ESOP) — but even if such a plan is feasible it will take some time and effort to establish. Conversely, she might be able to achieve a quicker exit if she provides seller financing — but in most cases that will mean that she is likely to remain tied to the financial success of the venture well beyond the date of sale.
Alternatively, if she wants to retain some portion of the business, and simply wants to bring Mayford and Bertha into an ownership position — possibly a position that increases in size over time — then she will have more options her disposal. In any event, there are a host of things that Lillian needs to consider as she approaches the problem. Those include the following:
An employer can’t really make a gift to an employee. On several occasions, I’ve had entrepreneurs ask me if it is possible to simply gift shares of stock or LLC membership interests to key employees. And being reasonably kind-hearted (for a lawyer, at least), I appreciate the sentiment. It feels good to give. Unfortunately, the law itself isn’t a soft touch. And so in situations where an employer gifts anything of value to an employee, the law (tax law, specifically) will treat that “gift” as taxable compensation.
For Lillian and her trusty employees that means that if she tries to simply give them an interest in the business (let’s assume she’s running a corporation and therefore giving them shares) — and not require them to pay anything for it — they’re going to get taxed on the value of that interest at the time of the “gift.” And since Mayford and Bertha work for the company, the company itself is also going to have a withholding obligation with respect to that compensation.
In practice, this can be a real problem. If Lillian’s business is worth $1 million, and she transfers shares equaling 10 percent of the ownership to each of her two employees, then she’s saddled each of them with somewhere in the neighborhood of a $24,000 tax problem — and no cash to satisfy the tax. (I’m making some assumptions here with regard to their tax filing status and the like, but bear with me.) Can’t you just imagine the joy on their little employee faces when they open that gift?
ESOPs aren’t always the answer. ESOPs are a bit like cold sores. They seem to come and go at random. Well, actually the ESOPs don’t come and go — the recommendations to use ESOPs come and go, with consultants and advisors (often those who will receive a fee if an ESOP structure is used) periodically popping up to talk about how they’re a great solution to Lillian’s problem. And they can be. But they can also be a miserable failure in certain circumstances. I’ll explain — but first a shorthand explanation of what an ESOP is and how it is supposed to work — using Lillian as an example.
If she wants to use an ESOP (a type of retirement plan that holds company stock), Lillian will sell her shares to a newly created ESOP trust. At the same time, the trust will borrow money to pay Lillian for her shares. The business itself will be on the hook to use its earnings to make tax-deductible cash contributions to the trust to pay off the loan. The stock in the ESOP will be credited to employees as the loan is paid off. Sounds good, right? We get to transfer ownership and there’s a tax advantage. Feels like a good deal.
It certainly can work. But in practice a number of things can be problematic. First off, it may be difficult to find a lender who is willing to step in to make the loan to buy Lillian’s shares. This could be because the business isn’t spinning off a ton of cash and lenders don’t see it as a good credit risk. Alternatively, it could be because lenders don’t like to lend in situations where they can’t actually own the collateral securing the loan — and lenders are justifiably spooked by the question of whether they can actually own a spirits business without having the appropriate licenses in place at the bank. In any event, no loan means no cash to buy the shares. This makes Lillian sad.
But even if a lender is identified and funding is secured, the basic structure of the arrangement puts the business at risk. The loan repayment obligation can be a strain on cash flow, hampering the company’s ability to make future investments in the business and leaving the company with inadequate working capital until the loan is repaid. In addition, if the business suffers any downturn while the loan is outstanding the lender may get nervous and call the loan. Making matters worse, if times do turn bad and the company is forced to lay off a worker or two, the company may be required to pay them for the value of their interests in the trust (i.e., their ownership stake in the business) some time after they leave the company.
Finally, there’s the basic problem that Lillian’s business may be too small to even make the ESOP work. Depending on the complexity of the situation, an ESOP can commonly cost in the neighborhood of $100,000 to set up — and there are annual maintenance costs as well. So even if Lillian is able to find a lender, it may be so expensive to get this put into place that the tax advantages it might offer in a larger deal simply don’t materialize.
So with all that in mind, what’s Lillian to do? Lucky for us, Lillian is a fictional person. So let’s take advantage of our ability to rewind the tape and offer Lillian some advice before she gets so frustrated that she’s ready to throw up her hands and quit. With a little bit of planning on the front end, she can manage this problem such that it is less difficult to transition ownership later on.
Lillian should bring Mayford and Bertha along early. If Lillian knows early on that she’s got two star employees, she should seriously consider offering them a stake in the business early on. This does many things — most of which are good. First, by allowing them to acquire an ownership stake in the business, Lillian will be encouraging Mayford and Bertha to think like owners of the business (because they will be). That shift of perspective, from employee to owner, will likely make them more reliable, productive and valuable employees. They will have skin in the game and will want even more to make the business a success.
Second, by giving them the opportunity to acquire ownership, Lillian may actually be able to reduce the cash hit to the business of their overall compensation. This may seem counterintuitive, so let me explain. Remember when we said that if Lillian gifted shares that would be taxable? It was taxable because it had value at the time of grant. Even if they don’t appreciate the tax hit that comes from that award, Mayford and Bertha will still appreciate that they are receiving something of value when they get the shares. And since the resulting tax hit is only a percentage of the value of the shares, the incremental discomfort they feel is less than the value of the award.
It is true that employees often feel more sharply the pain of the tax hit than they do the joy of the stock award. Therefore, Lillian, if she’s feeling particularly generous, might cause the company to give Mayford and Bertha — in addition to a stock bonus — some modest cash bonus to help to cover the tax bill from the shares.
But here’s the trick: unless Lillian and Mayford are making a whole lot of money, the company will get a tax deduction for the value of any bonus paid — stock or cash. So the company will be able to deduct as an ordinary business expense cash and stock compensation of — say $175,000 (assuming for the sake of argument $50,000 in salary, $100,000 in stock bonus and $25,000 in cash bonus) — but the cash flow impact to the Company will only be $75,000. [Note: this is an extreme oversimplification of the actual tax analysis — which could use enough ink to fill multiple issues of this fine publication — and is simply meant to illustrate the general principle. Please consult with your accountant or tax advisor before moving forward.]
Moreover, Mayford and Bertha can still purchase their ownership interest — it need not be awarded as a bonus. It is true that starting earlier is likely to impact the valuation at which her employees buy in. But again, by making her employees think and behave like owners Lillian is likely reducing employee turnover and increasing the business’ likelihood of success. If she wants to go this route, Lillian should strongly consider allowing the employees the opportunity to buy in at set intervals (e.g., at the end of every year) so that it is easy to determine an appropriate value for their shares at the time. To encourage ownership, Lillian may even want to provide Mayford and Bertha with an annual cash bonus intended to help pay the cost of the share acquisition. By providing this type of an opportunity in sequential years, it is possible for a company provide a meaningful ownership stake to key employees without ever putting the employee in the position of having a hefty tax burden or requiring a major cash outlay at any one time.
Regardless of how Lillian chooses to approach the issue — either by stock awards or allowing her employees the chance to buy-in — she will want to be sure that she works with her accountant and attorney to put the structure in place. The accounting must work — both from a cash flow and a tax perspective. And the appropriate legal pieces must be put into place to ensure that Lillian’s business doesn’t inadvertently trip over a legal requirement (e.g., securities considerations associated with the transfer of the shares) or creating a perverse incentive for her employees (e.g., she will likely want to put forfeiture provisions in place in a shareholders’ agreement so that neither Mayford nor Bertha can extract value from the company by leaving early and demanding cash payment for the shares).
Finally, Lillian will want to work with her advisors to ensure her approach to this problem is part of a comprehensive plan intended to get her to her ultimate objective of exiting the business — in whole or in part — on her terms and timetable. By doing so, she may be able to approach the ultimate transition of ownership in a streamlined fashion — having engaged employee owners who are ready to take the reins and who need only to fund the purchase of just over a majority of the business (rather than 100 percent). Since a smaller purchase is required under this scenario, it may be easier for the company to find financing. Alternatively, Lillian may herself be amenable to Seller financing — where she sells her remaining stake for a promissory note payable over time. But in either case, Lillian will have positioned herself in the best possible posture to achieve her objective of having captured the value in the business she built and transitioning it to her employees for its future growth.