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Sweet marketing music

Tanner Montague came to town from Seattle having never owned his own music venue before. He’s a musician himself, so he has a pretty good sense of good music, but he also wandered into a crowded music scene filled with concert venues large and small.But the owner of Green Room thinks he found a void in the market. It’s lacking, he says, in places serving between 200 and 500 people, a sweet spot he thinks could be a draw for both some national acts not quite big enough yet for arena gigs and local acts looking for a launching pad.“I felt that size would do well in the city to offer more options,” he says. “My goal was to A, bring another option for national acts but then, B, have a great spot for local bands to start.”Right or wrong, something seems to be working, he says. He’s got a full calendar of concerts booked out several months. How did he, as a newcomer to the market in an industry filled with competition, get the attention of the local concertgoer?

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by Dyanne Ross-Hanson
September 2008

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Law

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Internal transitions

Dyanne Ross-Hanson,
Exit Planning Strategies LLC:
651.426.0848
drh@exitplanstrategies.com
www.exitplanningmn.com

Internal moves
may work when
exiting firm

UP TO 75 PERCENT of the typical business owner’s net worth is tied up in the business, according to the Institute of Independent Business. That’s $5.7 trillion, according to the Federal Reserve.

If you or your clients are among the 9.5 million owners reaching the age of retirement you may want to ask, “What is my exit strategy?”

Exit options typically fall into one of four categories: sale to an outside party, sale to an inside party, passive ownership or liquidation. The best strategy is dependent upon many factors, including desired departure date, owner’s financial security, company value, legacy goals and management capabilities to name just a few of the options.

Given the choice most owners would prefer to transition to internal buyers, such as co-owners, key employees and family. Why? Internal buyers know the company, its culture and its customers better than anyone. However, internal buyers often lack one key ingredient for a successful transition: money.

Does that mean internal transitions cannot work? Not necessarily. We will discuss four strategies to consider when the owner’s objective is to transition to insiders. Special mention should be made that transition to family members entails unique planning strategies beyond the scope of this article.

Installment sale. This method begins with the buyer and seller agreeing to a price. The seller holds a promissory note based upon a reasonable interest rate with installment payments made over a 3-7 year period or longer. The note is often secured by the assets and stock of the business.

Payments are typically made from the cash flow of the business. This strategy works best when the owner doesn’t need a lot of cash from the business and has complete confidence in both the buyer and the company’s future. The installment sale is typically used when no other alternative exists.

A gradual sale

Modified buyout. This method utilizes the concept of discounted stock value combined with tax favored payments including deferred compensation, consulting fees, real estate lease payments, qualified retirement plan contribution increases, etc. The idea is to make the transition affordable for the buyer yet maximize the value received by the seller.

It is a strategy that allows the owner to maintain control, assess successor’s capabilities, minimize overall tax impact and still offer flexibility should the owner’s objectives change. During the initial phase, the owner gradually sells a minority interest at a discounted price. A qualified valuation expert can validate various discounting methods.

The difference between fair market value and discounted value can be made up with one or more of the tax favored payments mentioned above. The buyer pays for the stock with personal funds or financing or in the case of a Subchapter S corporation from the pro-rated share of distributions. Each incremental sale occurs only after previous purchases are paid for in full.

Once the buyers have acquired more than 45 percent the modified buyout moves into the second phase. Provided the owner is confident of the buyer’s capability to successfully operate the company, he or she sells the remaining shares in a lump sum at market value.

Most banks are willing to finance this type of purchase given a track record of experienced management, existing ownership interest and favorable cash flow. Should the owner lack confidence in the buyer’s capabilities he or she retains the right to change direction, for example, to retain the balance indefinitely, sell to an outside party or sell to an ESOP.

Employee Stock Ownership Plan (ESOP): Given the right circumstances this strategy can offer substantial tax benefit, allowing the seller to cash out if desired. An ESOP is a tax qualified retirement plan that invests primarily in the stock of the company. Contributions to the plan are tax deductible.

An ESOP can borrow money from the bank if necessary to purchase stock. Provided certain requirements are met, the owner can reinvest the proceeds into ‘qualifying securities’ and pay no tax until those securities are sold.  Both principal and interest payment made to the bank offer current tax deduction to the ESOP.

Employees own shares (indirectly) through the ESOP in direct proportion to their compensation as a percentage of payroll. Key employees can also obtain direct ownership and control through a purchase of ownership prior to sale to the ESOP. While set-up can be complex and costly the strategy is worth discussing with your advisory team.

Starting fresh

Old company/new company: In those situations where company value is too high (unaffordable), the owner desires to limit ongoing liability and/or company cash flow is not strong enough to support a  modified buyout, the establishment of a new entity may just be the ticket.

With this strategy a new entity is formed, typically an LLC or limited liability corporation. The owner invests capital and is given a minority but controlling interest in the LLC. Successors own non-voting interest and contribute capital or sweat equity.

Next, the original company leases equipment, office or warehouse space and in some cases even employees to the new entity. All overhead, work in process, etc., is also transferred to the new entity. A  management/ operation agreement establishes terms for the new entity, including such things as owner’s involvement but most importantly allocation of profit and loss.

Assuming profits accumulate they are used to repay the owner his or her initial investment as well as purchase any leased property.  In essence the owner and successors establish a new capital structure that allows sharing and eventually transition of future value and earnings. It involves minimal debt and does not involve any stock sale. It allows the owner to retain control, test the successors’ capabilities as well as motivate and retain them. Last but not least it retains all equity and value of the original company.

Yes, internal transitions can and do succeed. All it takes is identifying the owner’s objectives, understanding the various strategies available, and allowing enough time to execute the plan.