Using Life Insurance To Finance The Sale Of A Business To Key Employees

After months of consultation with a business owner, the business succession plan is in place. The business will be sold to the key employees when the owner retires in five to 10 years. This is a fairly common result these days when there is no readily available buyer for a business or a business owner’s family has no interest because they have their own careers and family life, often in a different location. Frequently the reason is simply that the children have observed how hard their parent(s) worked in the business and they are not willing to take on the stress and concern of being a business owner.

What If the Employees Have No Money?

Now comes the hard part—designing a plan that provides fair value to a business owner at a time and in a way that key employees can afford to purchase the business, while maintaining its viability. This situation is significantly different from selling to an outside party (who has the resources to come up with the purchase price, and the payment structure is part of the negotiation for the sale) or transferring ownership to a family member (through gifts, and the transfer of ownership may not take place until the death of the business owner).

With a sale to key employees, the business owner wants a sale that will be closed at a certain time with buyers who typically do not have the resources either personally or through bank financing to pay at closing. In many of these situations, the business owner, who has a strong desire to see the business continue, ends up selling for a substantially reduced price based on what the key employees can afford to pay. What they can afford to pay is usually based on annual payments that the cash flow of the business will support.

While this achieves a transfer of the business, the new owners have no “skin in the game” because they have contributed very little to the purchase price. This situation may bode poorly for the future success of the business, especially when projected cash flow does not materialize—and future success of the business is critical for the seller to receive installment payments.

From the perspective of a seller’s family, such a plan can be a source of financial and emotional resentment. They will receive less than full price for an asset that was a major part of the business family’s estate.

So how can you help resolve the issues of “skin in the game” and improve the price paid for a business? A typical solution is to recommend that the owners and the key employees reduce their compensation and set aside money to build funds so that the key employees can finance the future transfer of the business.

Since small businesses do not typically over-compensate employees, the suggestion that the employees take a reduction in current compensation is often impractical—even considering the potential of increased gains in the future.

The business owner may be in a similar position because cash flow from the business is supporting his lifestyle beyond his cash compensation and he may be unwilling to make sacrifices. If this is the case, the business owner will definitely feel that he is giving the business away!

Incentive Plans

A better solution might be to implement a plan that provides incentives for employees and rewards them for additional effort in increasing the value/profitability of the business. This can be a mutually beneficial arrangement because the employees are rewarded for performance and likely to have greater feelings of “skin in the game,” plus the value of the business increases at the same time.

To get started, a business owner and employees need to prepare a plan for the future with defined goals and performance metrics. This business plan then needs to be broken down according to the areas of expertise of each employee. Each of the employees must accept responsibility for their part of the plan. They also need to have the ability and authority to implement their part.

The business plan could include such items as expansion into new geographical  markets, expense reduction, new product development and launch, improved accounting processes and distribution restructuring. While such a plan can be limited to those key employees who will purchase the business, it will generally include other employees in management positions.

At the end of each designated period (monthly, quarterly, yearly, etc.), results are evaluated and bonuses are paid. A side benefit of this approach is that if an employee consistently fails to meet goals, then he should not be an owner of the business.

Second, the question of how bonuses are to be paid must be addressed. There are a wide variety of options, including stock, cash and deferred compensation. The key here is to build funds for the employees who will purchase the business, so that they can provide an up-front payment to the business owner at time of sale.

A combination of stock and cash will make the most sense. If other employees are included, the options could be cash or deferred compensation. There are a variety of ways to structure the bonuses for tax purposes, which will affect when and if the contributions are tax-deductible. The appropriate plan should be determined by a business’s tax advisors.

For key employees, the majority of bonuses should be in cash; yet a small amount of stock is recommended to ensure that the employees have some ownership in the company before the sale.

One option is for cash to be contributed directly to a life insurance policy to build value and provide a death benefit to the company and/or the employee’s family in the event of premature death. If the cash is to be paid directly to a life insurance policy, then the business may agree to contribute a minimum level of funding in the event that the plan goals are not met. Premiums should be contributed to such a policy during the term of the performance plan. Since these premiums are likely to fluctuate, the policy can be designed with an expected premium stream and the appropriate death benefit determined.

At some point, when the sale of a business is to be completed and the initial payment is due, a withdrawal or loan can be taken from the policy to complete the transaction. After that, depending on individual and company needs and how the policy is owned, premiums can continue to be paid or the death benefit reduced, and loans or withdrawals can be taken for retirement purposes. Policy loans are interest bearing. Withdrawals and loans may be taxable and may reduce death benefits. Let’s look at an example of how this can work.

ABC Corp’s Incentive Plan

Sam is the owner of ABC Corp, a manufacturer of electronic controls for industrial heating systems. He has three employees who are interested in (and, in Sam’s view, capable of) acquiring and operating the business. The employees are: Julie, head of sales; John, chief financial officer; and Art, chief research engineer.

Sam has determined that ABC Corp is currently worth $2 million but feels that if it could expand into South America, its worth might be closer to $4 million in five to seven years. There was one prospective buyer for the company, but he was unwilling to offer more than $1.5 million because of “random and irregular evolutionary” accounting practices.

Sam, Julie and John develop a seven-year plan to improve the business’ financial basis and to plan for expansion. Julie is charged with creating a sales team to penetrate the South American market, John is charged with implementing a standard chart of accounts and improving financial accounting, and Art is charged with making the technical modifications to the product required for the South American market.

If each meets his target, then $50,000 a year will be contributed to a life insurance policy; if targets are exceeded, up to $75,000 may be contributed. In addition, the agreement provides that a minimum of $20,000 a year will be contributed to individual insurance policies.

Let’s look at one of the employees. Julie meets her targets in years two, three and five. She exceeds in years one and six, but misses the target in years four and seven. As a result the following premium amounts are contributed on her behalf: $75,000; $50,000; $50,000; $20,000; $50,000; $75,000; and $20,000, for a total premium of $340,000. The universal life policy is structured with a minimum death benefit.

In year 10 Sam decides to retire and sells the business to the employees for $3 million. Under the terms of sale, Sam will receive a lump sum payment of 25 percent ($750,000), with the balance to be paid over five years.

The projected cash value in Julie’s policy has grown so that Julie can take a loan of $250,000 to fund her portion of the lump sum payment. Julie’s portion of the installment sale can be paid from cash flow in the business and supplemented if needed by subsequent loans or withdrawals from the policy. Once the obligation is fulfilled, Julie can use her policy for retirement income or other purposes.

The End Result

The end result is that everybody wins with an incentive plan. Employees win because they are committed and have worked to improve the business. A seller wins because the value of the business has increased and he receives a higher selling price. The business wins because it is on a more secure footing and more likely to survive until the next round of business succession discussions with a future generation. And the advisor wins because he was able to bring a creative solution to the table.

This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. This material is being provided for informational purposes only. It is not intended to be and should not be construed as legal or tax advice. Columbus Life does not provide legal or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. An attorney or tax advisor should be consulted regarding specific legal or tax situations.

Author’s Bio Hugh F. Smart, JD, CLU, ChFC JD, CLU, ChFC, joined Columbus Life Insurance Company as assistant vice president and director of the advanced markets group in July 2009. 

Hugh F. Smart  for the July 2012 issue of Broker World Magazine.

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