When you build a business, you build a culture, a legacy that you want to continue. However, your next generation may not be keen or competent enough to take over the business. Handing over business management to someone incompetent, even if they are your own kids, is unfair to stakeholders who helped you build the legacy. Now you can create a succession plan and retain ownership within the trusted inner circle by passing the business to management or employees who built it with you. Would you get paid for it? Yes. Employee Stock Ownership Plans (ESOPs) and Management Buyouts (MBOs) are structurally very different. They serve different purposes and differ in tax implications, liquidity needs, personal financial needs, leadership competence, and availability of financing.
How a Management Buyout Works
In a management buyout, a select group of managers shows interest in buying the company and arranges for funding through personal savings, bank loans, or private equity backing. These are the people who have helped build the business, and now they are willing to put skin in the game and take ownership and the associated financial risk that comes with the ownership.
While the MBO may not get you a premium price for your business, it will help you retain business legacy and continuity. The business transition is usually faster in MBO, as internal leaders take on higher roles. However, there is also a risk of failure if the new management cannot access sufficient financing or handle ownership responsibilities.
Why does this risk arise?
Sometimes a business needs a fresh approach to thrive, which MBO may not provide, since it is run by the same leaders. While managers may be good at operations, they may lack the ownership skills of strategic decision-making and risk management.
How ESOP Works
In ESOPs, employees acquire the business over a period using the company’s cash flows and bank debt. Unlike MBO, ESOPs take a longer time to build and acquire the company and are administratively intensive. The company establishes a trust that buys shares on behalf of employees using its cash flows. These shares are vested in employees as part of their compensation upon achieving certain milestones, such as tenure or revenue targets. Employees are motivated to contribute to the company’s success because they are part-owners.
The business owner benefits because they can transfer their shares to the ESOP trust and receive payments over time, thereby realizing capital gains over time. Employees and the business benefit as most ESOPs are funded using the company’s cash, reducing the need for debt. The company is run by professional managers, and ESOP representatives vote on major decisions.
The ESOP structure is administratively demanding, requiring annual valuations and trustee oversight. Unlike MBO, employees are not managing the company but are owners. Hence, ESOPs work when the business is profitable and self-sustaining, meaning it does not depend on the business owner to generate profits.
Which One is Your Ideal Succession Plan
While you look for succession planning alternatives, consider ESOPs and MBOs only when you want to retain ownership with the internal team, even if you don’t get premium value for your business. Between ESOPs and MBOs, the right structure depends on your personal financial needs, your business’s health, your level of involvement in the business, and your financial structure.
Personal finances: If your personal finances are messy and need quick liquidity, MBO is the way forward. But if you want a steady cash flow for several years, ESOPs are a great option.
Business health and personal involvement: If your business cannot sustain without strong leadership, MBO is the right choice, as you can train the managers to succeed in the business. But if the business is process-driven and can keep operating without leadership interference in every small decision, ESOPs are a good option. Most tech companies choose ESOPs as the business becomes self-sustaining once it reaches scale and doesn’t need many strategic changes.
Finance structure: In both MBO and ESOPs, the company’s debt will increase. One should consider the capacity of the businesses and the management to pay off debt. If the debt weakens the business’s capital structure, MBO may not be a good strategy. ESOPs, on the other hand, use the company’s own profits to fund the purchase, which is a better succession plan for keeping the business’s finances strong.
Seek Professional Help
There are many other factors to consider before implementing ESOP or MBO in succession planning. Whichever method you choose, such large-scale transactions involve complex legal and financial considerations. Having a professional accountant, tax advisor, and business consultant can help you with business valuations, purchase agreements, regulatory compliance, and transaction structuring.
Contact Black and Gill LLP in Toronto to Help with Succession Planning
Talk to a professional accountant to help you implement the succession plan in a compliant and tax-efficient manner. To learn more about how Black and Gill LLP, in West Toronto, can provide you with the best accounting and taxation services, contact us online or call us at 416-477-7681.