Exiting owners are often surprised to learn that deal structuring and taxes can be the largest obstacles that need to be overcome to execute a successful exit strategy. When it comes to the structure of the actual business sale, there are several options available to both the seller and buyer (or successor). Deferred payments spread over a period of years can offer greater flexibility and lower taxes than strict ‘buy-outs’ to both the seller and buyer, and can allow those owners not emotionally prepared to leave their fields to stay on in key managerial roles. These deferred payments over time also offer ‘buyer protection,’ and are especially useful when a family member or employee within the company is purchasing the business.
Deferred payments can be split into two general categories- either earn-out payments or seller financing.
Earn-Out Agreements
Earn-out Agreements can satisfy a selling owner’s desire to receive compensation for anticipated future profits, as well as the buyer’s reluctance to over-pay for this potential, but not guaranteed, future value. Incentives within the agreements are often tied to pre-negotiated revenue or profit goals. In these instances, the buyer may pay more money to the seller in the end, but be satisfied that the risks of his/her investment are also being shared by the exiting owner. Earn-out agreements essentially help a buyer to protect what he/she is buying, and potentially allow the exiting owner to stay on in a managerial role within the company. If you are continuing with the company after an exit transaction, you should know your own personality and be aware of the shift in power dynamics, as many business owners have difficulty working beneath a new management team.
Seller Financing
Sellers of smaller businesses will often self-finance much of the total transaction value of the business- this arrangement is particularly useful when the business will be transferred to current employees or family members who cannot provide the full balance on closing the deal. Seller financing entails the seller accepting a portion of the risks associated with the success of the business upon his/her exit, as the owner retains the title to the business until the purchase price, plus interest, is paid off in regular installments over a specified period of time.
Some important considerations for exiting owners considering self-financing are at what rate of interest, and secured by which assets? As a general rule, seller financing interest rates can be based upon current market commercial loan rates, and the note can be secured by the company’s tangible assets (i.e.- plant, property, equipment, inventory, etc.) Of important note is the risk assumed by the selling owner who still holds the ‘paper’ on the business after his/her exit- an exit can fail if the company flounders in the owner’s absence, and the buyer is unable to maintain payments on the purchase. In such a case, the owner risks a default on the self-financed loan, and may have to return to a business that is financially weaker than when he/she left it.
Deferred Payments as a Result of Tax Structuring
A dollar paid at closing is subject to taxation today- as such, if your tax rate will be lower in the future, it may make fiscal sense to defer (or spread out) payments over several years. Again, it is important to remember that it isn’t what you sell the business for that counts, but what you keep after taxes and advisory fees. For most exiting owners, the bump up in tax brackets from a complete sale in one year would send a significant portion of the proceeds to Uncle Sam and negate the profits that you, the exiting owner, need to enable enough passive income to continue your lifestyle.
Deferring payments to decrease one’s tax threshold over multiple years can be particularly useful to those Baby Boomers who plan to retire with the proceeds of their business sale. Upon entering retirement, it is likely that the owner will be generating significantly less income each year than he/she had while owning the business, and so will be able to receive partial payment for the business without passing into the upper tax brackets. This strategy could save the exiting owner more money that can be used to meet post-exit/retirement expenses.
Though deferring payments and not receiving all of your cash at closing may initially seem a shock, there are many potential financial, emotional and tax structuring advantages to spreading purchase payments out over a number of years. It can be, for those business owners who aren’t quite ready to leave their field yet, but want to ‘take some chips off the table,’ the most profitable and enjoyable way for them to wind down a satisfying career while taking advantage of lower tax thresholds.
Deferred payments also allow current employees or family members to gradually assume control of the company without securing financing from a bank or similar outside loan. As with all components to the exit process, a carefully planned-out analysis of what you, the exiting owner, want from your business exit, and knowledge of the risks and benefits that exist with each option, is crucial to a successful and prosperous business exit.