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Business Exit Strategy
Working most of your life running a successful business is a great accomplishment especially when it is your own business but as we get on in life one must realize that some form of an exit strategy is necessary. What do we do? What are the options? Well, there are three choices: a family member chooses to continue the business, a competitor is available to sell the business too or a key employee capable of operating the business wishes to take over.
We will look at the third option of a key employee wanting to continue the business. Assumptions are: there is one owner owning 100% of the common shares and the shares are currently worth $1,000,000. The owner is 60 and wants to retire at age 65 or 70. A key employee is aged 45. Since the key employee started sales and profits have improved. The owner does not wish to lose his key employee thus makes an offer to buy into the company.
Tax lawyers then restructure the owners’ common shares exchanging them for $1,000,000 of preferred shares. Two classes of common shares are issued. The company charter is changed to provide discretion as to the payment of dividends between different classes of common shares. Class A common and class B common. Initially the shares have very little value.
The owner incorporates a new holding company and the key employee incorporates a new company. The owner then transfers his $1,000,000 shares to the new holding company subscribing 70% of the common share to the original company. (700 class A) 30% of the common shares are subscribed to the key employees’ new company. (300 class B)
A tax lawyer drafts a Buy Sell Agreement. If the owner dies the original company has to purchase the preferred shares and the 700 common shares from the owners’ new company. The preferred shares for $1,000,000 and the 700 common shares class A for fair market value. If the key employee dies the original company has to purchase the 300 common class B shares from the key employees company.
When the owner retires the original company has to purchase the $1,000,000 preferred shares and the 700 common class A shares from the owners new company for fair market value. The key employees’ salary is adjusted to reflect his holding company being given 30% of the future growth of the original company. As a key man there is incentive to build the company.
Currently, the original company earns $200,000 annually after tax, and has a fair market value of 5 times $200,000, which equals $1,000,000. After 10 years the company is earning $400,000 annually after tax and the company is valued at $400,000 times 5 equaling $2,000,000. (Preferred shares of $1,000,000 and common shares of $1,000,000.) The original company has to purchase the preferred shares from the owners’ holding company for $1,000,000 and the 700 common shares for $700,000. These shares have to be purchased from the owners’ holding company at retirement as per the Buy Sell Agreement. This is the owners’ retirement BUSINESS EXIT STRATEGY.
To fund the Buy Sell Agreement and to assist in the financing of the purchase of shares from the retiring owners’ holding company the holding company purchases a Joint Last to Die Universal Life policy on the lives of the owner and his wife for efficient tax sheltered savings. The owner and beneficiary will be the owners’ holding company.
The key employee will purchase a Joint Last to Die Universal Life policy on the lives of the owner and his wife and the owner and beneficiary will be the key employees company.
The Joint Last to Die coverage will not be used to fund the Buy Sell Agreement but instead a 10 year term policy will be purchased on the owners life to fund the Buy Sell Agreement. The original company will pay for and be the beneficiary of the term insurance.
Ten year term will be purchased on the key employee to fund the Buy Sell Agreement with the original company owning, paying and being the beneficiary.
If either the owner or the key employee should die, 100% of the death benefit of the term insurance will be credited to the capital dividend account of the original company. This will fund the agreement.
A similar application of the above solution can be applied to the involvement of a family member or a competitor wanting to buy a business. Note this addresses one issue of the people involved, that being death, but do not forget the other issue and that is what happens if one of the participants has an accident or sickness and lives. Living benefits are critical to the equation as the chances are far greater of an accident or sickness versus one dying.
Wise Financial Group Inc. can assist in the process of formulating a Business Exit Strategy and can be reached toll free 1-877-779-4731 or please email info@companybenefits.ca.