Internal Sale with Modified Buy-Out
This internal sale method works best for most owners who have the following goals:
Transfer their business to key employees
Motivate and retain key employees
Receive full value for their business
Let’s look at a short case study regarding the concept of Modified Buyouts.
Donna is age 52 and wants to remain in her business for at least 5 more years. She would like to “handcuff” her senior managers and salespeople to the company (making it economically rewarding for them to stay with the company) and at the same time, explore his own exit strategy. Her plan is to accomplish both goals by beginning to sell her company to the key people.
A draft Exit Plan was prepared for Donna, listing three primary goals:
Establish a plan for the eventual buyout of all of Donna’s ownership of the business.
Begin the buyout of a portion of her interest by selling to two existing key employees, Michael Brooks and Alice Patton. Donna would select additional key employees at a later date.
Have the plan in place and effective as of March 1st of the following year.
The Exit Plan recommended that Michael and Alice purchase up to a total of 10% of the ownership of EPD (represented by non-voting stock). In the future, other key employees (as yet unidentified and probably not yet hired) would participate in the stock purchase plan. The plan also included a two-phase sale of the business.
Phase One: Sale of Initial Minority Interest. Donna will make a pool of 40% of EPD’s total outstanding stock (converted to non-voting stock) available for current and future purchases by key employees. Initially. Michael and Alice would each own 5% of the outstanding stock (non-voting).
For purposes of the initial buy-in (and any future repurchases of that stock), the value of EPD is based on a valuation (with minority and other discounts) provided by a Valuation Specialist. In EPD’s case, those discounts totaled half of the true fair market value. A lower initial value is necessary to make the purchase affordable for the employees and to provide them an incentive to remain with the company. The initial purchase price will be paid in cash. If either key employee needs to borrow funds to secure the necessary cash, EPD will be willing to guarantee the key employee’s promissory note to a bank.
Phase Two: Sale of Balance of Ownership Interests. At the end of Phase One (three to seven years), Donna will choose one of the following courses of action:
Sell the balance of her interest to the key employees at the true fair market value by requiring the employees to finance an all-cash purchase.
Finance the buyout by means of a long-term installment sale to the key employees at true fair market value. Alternatively, Donna may decide to sell to an outside third party. In either a sale to employees or to an outside third-party, her intention is to retire from the business and not to continue to maintain ownership in the business and continue her management and operational involvement.
Benefits to Employees. Even though the key employees will not receive voting stock, there will be sufficient benefits to them in purchasing non-voting stock, as they will be able to do the following:
Enjoy actual stock ownership in EPD and the ability to receive any appreciation in the value of their stock.
Participate (pro-rata) based on their stock ownership in any S-Corp distributions made by EPD.
Receive market value paid by a third party for their percentage of stock (if EPD were to be sold to a third party).
Participate more directly in day-to-day operating decisions.
Initially, be appointed as directors to serve under the terms of the bylaws (such positions not be guaranteed).
Participate in determining which additional key employees will be offered stock out of the 40% pool. This determination will be based on written criteria developed by all three shareholders.
As each key employee purchases stock, they will enter into a stock purchase agreement with the company that provides for the repurchase of their stock in the event of death, long-term disability or termination of employment.