Facilitating the transition of a business to the next generation can be an emotional and daunting task. Even when you’ve determined the best structure and mechanism by which to transfer the business, oftentimes funding the transition can present challenges. It can become even more of a financial worry the larger a firm becomes… even with seller financing. Just imagine how a potential next gen owner might feel about having to come up with the funds for a $2mm (or greater) buy-in!
Luckily, there are some specific programs that can help lessen the financial burden for the next gen. Sometimes owners will think they can “gift” equity to their next gen in exchange for their sweat equity. We caution that you work with an accountant when contemplating this, to make certain you take any tax consequences into consideration. Similarly, you could grant equity (under a 3-5 year vesting program) for your next gen owner. But that usually doesn’t make enough of a dent in the financial obligation that your key executive(s) is facing – as grant equity percentages are generally 5% or less.
Another option to consider is a cash rolling vesting plan. This is a performance-based plan that promises key employees a cash bonus in the future.
For example: Under this plan, an annual pool of dollars is structured so each participant is awarded an incentive based upon attainment of firm or individual goals. Typically, the goals are tied to the firm’s gross revenue, net income before executive salaries, or the compensation of the executive. Each year this award is credited to an interest-bearing account. A certain number of years [usually three (3) or five (5)] after the allocation is made, the account “vests”. When each allocation is fully vested, the participant is entitled to all “vested” amounts and can “cash them out” …. and use the funds to buy tranches of equity!
Let’s say a firm generated $1,000,000 of profit before owner’s compensation in 2019. The profit covers the salaries, bonuses, and benefits of the existing key management. If the firm generates $1,500,000 of profit in 2020 before owner’s compensation, then $500,000 will be considered “overage”. You can then share a percentage of this overage with the key management team in the individual percentages you deem appropriate. When fully vested, the key management participants can take the bonus as cash or choose to purchase units in the firm, if available. You also reserve the right to add or remove participants as appropriate. Under this plan, you are not affecting current compensation of the management team and those executives who choose to buy units truly want to be owners. Also, since the contributions are based on firm profits, management has an incentive to increase profits over the long term. The contributions can also be based on the profits generated by individual cost centers.
In addition, in order to mimic ownership in the company, a triggering event for the plan could be added in order to pay an equity type benefit should there be a third-party sale (before, or in lieu of, an internal transition). In this event, the plan would reward the executive with a percentage of the value of the company much like a Member would receive upon such an event. Typically, we recommend that the executive benefit be a fixed percentage of the proceeds of the transaction in excess of some floor. The executive benefit should then be based on a fixed percentage of the company subject to the attainment of defined performance objectives set. Any amounts due to the executive upon the triggering event will be offset against any amounts previously paid under the Rolling Vesting Plan.
From a tax standpoint, the executive is taxed on the compensation when it is actually or “constructively” received by him or her; the employer is entitled to a tax deduction when the compensation is taxed to the employee.
This plan is popular because it also serves as a vetting device for the true intentions of your next gen. If they choose to buy a new car (rather than equity) with their first fully-vested “cash out” amount, you’ve perhaps determined that they might not be of an owner mindset. But if they do decide to utilize this leg-up opportunity to buy equity, you’ve provided a nice mechanism to fairly help them achieve your mutual goals.
