Dealer Exit Strategy: ESOPs and transferring ownership to your family (Part 3)

Updated Jul 24, 2019

Construction Professional

As we’ve examined in our first two parts of this series, dealer exit plans need to be carefully thought out. Here’s what you need to look at when considering ESOPs and transferring ownership to a family member.

Considerations for Creating an ESOP

At the risk of being redundant, check with your manufacturer before you spend time or money pursuing an Employee Stock Option Plan – some OEMs embrace them, some don’t. Know where yours stand.

Dealer consultants Garry Bartecki and Lance Formwalt are both advocates of ESOPs, provided the dealer meets the qualifications. It’s a heavily regulated program by the Department of Labor and the IRS, because, essentially, the ESOP turns your company into an employee benefit, like a 401(k). The process is formalized and can be more expensive than a transaction because it requires the formation of a benefit plan and often the negotiation of a bank loan. However, the owner gets to essentially create his own buyer and receive positive tax advantages, while retaining a bigger share of the sale price. It’ll take several months to put together, and family members who work in the business can continue to do so.

“You can keep your company, and you can get out from all of your personal guarantees,” says Bartecki. “You can avoid paying future income taxes and you can still get another bite at the apple if the ESOP is sold; you will have warrants; you will have stock appreciation rights; you’ll have your regular salary and bonus compensation program. Plus, you’ll have probably 50 or 60 percent of the company in your bank account – as cash. With no obligations on it. So that’s not bad.

“But, you’ve got to qualify,” he adds. “You’ve got to have the cash flow. And you’ve got to do your homework.”

It’s not a simple process, but doable, says Bartecki, if you have a sound, profitable company with an EBITDA in the industry’s upper quartile. The bank or other liabilities have to be paid off, although typically bank debt is transferred to the new ESOP bank. You can pay capital gains tax on the proceeds received, or you may have the option to defer the tax – as an ESOP, the company no longer pays any income tax. “Run your numbers to compare what is at stake between ESOP and an asset sale,” he says.

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Kid on Construction SiteConsiderations for Transferring Ownership to Family

Statistics do not bode well for family business succession. Numerous studies have demonstrated that two-thirds of businesses aiming to transfer ownership from first to second generation will fail.The same percentage also fail in the attempt from second generation to third, according to Dana Telford, principal consultant at The Family Business Consulting Group. Failure, he says, may not mean the business dissolves, but the goal of keeping it in the family fails. It’s not until the third and fourth generations and beyond that the odds improve – double, in fact.

From a human/relational perspective, you, the owner, walk a paradoxical line that doesn’t occur so much in the other exit strategies: On the one hand, you desire a family business legacy; on the other, you desire peace and harmony in the family. It’s tricky to do both.

“You can’t go far in this business without hearing a tragic story of sibling love and partnership that turned into war, litigation and bankruptcy,” says Telford.

Which is why getting it right is so crucial.

Families are the closest, most permanent relationships that we have. “If something goes wrong in a transition, it’s not easy to shake off,” Telford explains. “It’s so important that it’s handled carefully.”

From an owner’s perspective, two simple practices will go a long way toward keeping relationships intact – transparency and inclusion. Both will act as a salve to your kids, their spouses, and your siblings whenever the sore subject of fairness flares up.

As a dealer principal, the idea of transparency may scare you more than anything – if so, consider bringing in a consultant and let them say the truths that have to be said.

Telford says there are two parts of a strong foundation for conducting even the most basic transition conversations.

1) They must set a code of conduct. This has to do with how they will treat each other. The words they will and won’t use. It has to do with respect, listening without interrupting, not taking things personally but taking personal responsibility, and acting like grown-ups with the people you grew up with. When conversations about skills, weaknesses, money and control have to happen, there’s a language they’ll be prepared to use.

“It gives them the chance,” says Telford, “to handle it professionally and not like little kids in the back of the station wagon fighting over who gets the front seat.”

2) They must all agree and adhere to a set of guiding principles and core values. This might be integrity, honesty, kindness, service. By agreeing, family members commit to living by the values – and also subject themselves to accountability and confrontation if their behavior doesn’t conform.

Even when the family learns the ground rules for communicating with one another, the 800-pound gorilla in the room remains for you, the owner: Who is going to control this business when I’m out of it?

Telford prefers to think of the decision not so much in terms of a primate, but a very special waterfowl, instead.

“Along the way of doing business, you’ve created a golden goose,” he says. “And the golden goose is valuable because it lays golden eggs.

“So, who should take care of the golden goose in the next generation? Should it be the oldest male? Should it be the one who got the highest degree of education? Should it be the one who yells the loudest or is a bully to the other ones? No, it should be the one who knows how to take care of the goose, because the golden eggs are what everybody’s really interested in.”

“Sometimes,” Telford continues, “there’s no one in the sibling group or the cousin group who can care for the goose as well as an outsider. So, who should run the business? Well, it should be the person who can run the business better than anybody else.”

If your final answer to that merit-based mystery turns out to be one of your kids, Telford has a few parting recommendations:

  • Make them go out and conquer something. Make them leave the nest – and we’re not talking about college. Leave, work, and return with war stories of victory and valor, Telford says. Maybe that’s two years on a fishing boat in the North Sea, or maybe it’s working at another dealership in your OEM network. But get them out into the real world of authentic employment and let them discover what they are capable of.
  • Make sure they want it.Their transition into the business must be voluntary. “That’s going to take away so many of your problems,” says Telford. Make it okay for them to say, “I don’t want to be an owner; I still love you and I want you in mylife, but I don’t want to own stuff with you, and I don’t want to work with you.”
  • Consider establishing a family council.Start it with the help of a third party initially with the goal of being independent with family members after a few years. This is like a board for the family – meeting two or three times per year, it creates a regular platform for discussing priorities, concerns, plans, money, the next generation and more. Again, be inclusive – that means in-laws/spouses, too.

Editor’s Note: This is the final segment of a three-part series on dealer exit strategies. You can download a white paper that contains all three parts of the story here.