A major failing in private business is a conspicuous lack of management succession and ownership transfer (MSOT) planning. In the world of private business, as opposed to publicly held businesses, management and ownership are treated as a birthright or as an extension of one's own personality and identity. To even suggest a transfer of management and ownership can be considered treasonous. This lack of planning often causes the downfall of second generation businesses. Either the business isn't passed to the second generation of management and ownership, or successor management, being poorly trained, ill-equipped, and chosen in an emergency situation as a result of the death of the major shareholder, limps along for a while before becoming another business failure statistic.
An ESOP, however, can be a positive force and a catalyst for bringing about change in the mindset of the business owner. Bankers, advisers, or second-tier management usually are pushing the planning issue so they can protect their positions and secure their futures. The planning process, therefore, becomes an unnatural and somewhat unpleasant process to the major shareholder, who feels as though he or she is being pushed out, although politely and with good intentions. This type of planning comes across as benefiting everyone but the owner.
Planning Encouraged – The business owner who already has made the decision to use an ESOP to accomplish his or her personal goals must start the process. Usually those goals have a great deal to do with liquefying his or her investment in the company. It is not unusual for a business owner to have nearly all of his or her wealth tied up in the company and sooner or later to become acutely interested in how that investment can be converted into cash and protected from current taxation.
ESOP buyouts generally are structured so that the company borrows the funds necessary to buy out the major shareholder, then makes a loan to the ESOP under essentially the same terms and conditions. Next, the ESOP purchases corporate securities from the major shareholder.
The very process of carrying out a buyout using an ESOP triggers the planning process for two reasons. First, the company must be profitable enough to repay the loan. A profitable company is a well-run company with capable management at the helm. Thus, the exiting shareholder must plan for management succession as well as ownership transfer.
Second, collateral is involved. It would be rare for any lender to extend credit to a business in the amount of the company's fair market value. Such a loan probably would exceed net worth and produce a debt-to-worth ratio that would be unacceptable to any analyst. How, then, are ESOP loans made?
The answer is found in the structure of the collateral. Usually ESOP loans are at least partially collateralized by means of the exiting shareholder pledging some or all of his or her qualified replacement property back to the lender to guarantee the loan. This type of collateral is released on a monthly basis as the loan is repaid.
This collateral structure shows that the exiting shareholder is interested in successor management's ability to repay the loan. The exiting shareholder wants the best people for the job because it is in his or her best interests. Often this executive will remain in control of the company for a specific period of time to ensure the smooth transfer of power and ownership. A properly designed ESOP can provide this control so the founder/president can sell out but not step out.
You can see how a properly designed ESOP can be a positive force in the planning process. The owner views management succession and ownership transfer from a vastly different perspective. The planning is done to benefit the owner and to accomplish his or her goals as opposed to the owner's being pushed into the planning process because of someone else's agenda.
<< Part One | Part Two | Part Three >> | Part Four >> | Part Five >> | Part Six >>
