Tanner Montague came to town from Seattle having never owned his own music venue before. He’s a musician himself, so he has a pretty good sense of good music, but he also wandered into a crowded music scene filled with concert venues large and small.But the owner of Green Room thinks he found a void in the market. It’s lacking, he says, in places serving between 200 and 500 people, a sweet spot he thinks could be a draw for both some national acts not quite big enough yet for arena gigs and local acts looking for a launching pad.“I felt that size would do well in the city to offer more options,” he says. “My goal was to A, bring another option for national acts but then, B, have a great spot for local bands to start.”Right or wrong, something seems to be working, he says. He’s got a full calendar of concerts booked out several months. How did he, as a newcomer to the market in an industry filled with competition, get the attention of the local concertgoer?
1, Sellers need to retain power over some decisions in a transition to younger family members to ensure they’re protecting their ability to get paid.
2, Even within family, the interests of buyer and seller will be averse to each other during the transaction. Each side should retain their own attorney to protect their interests.
3, Even if the company is being gifted or sold at a discount, parties must establish a company value for tax purposes.
4, Gifting of ownership interests are a common transition mechanism for sellers, often in conjunction with a partial sale. Set a specific plan for the timing of gifts to provide certainty to buyers.
Ins and outs of family business succession planning
The transition of a family business to a younger generation is an exciting, but nerve-wracking time for both sides of the deal. The older generation (sellers) is spending more and more time away from the day-to-day operations of the company and enjoying the fruits of their labor but is also confronted with the fact that failing to create and implement an exit plan can lead to the company’s demise. And, in many cases, the younger generation (buyers) has been participating in running the company and developing their own visions for a new era for the company.
Once the parties have agreed in principle on the timing of the transition and to some broad deal terms, an attorney is needed, not just to draft up relevant purchase agreements and promissory notes, but also to come up with creative solutions that give the sellers a modicum of control until they are paid off.
Legal representation
When attorneys are retained to draft the documents for the succession plan there are technically at least three parties involved: 1) the company, 2) the seller and 3) the buyer. There may be more if there are multiple sellers and/or buyers.
The company and the sellers are often times synonymous with each other, but the interests of the sellers and buyers will be in competition to each other as the details of the transaction are drafted, even when both sides are family. It is important for each party in the transaction to consider having their own attorney to protect their unique interests in the transaction.
Purchase/sale of the business
• Valuation
Before any aspects of a succession plan can be implemented the value of the company must be established for tax purposes. The sellers can certainly sell their ownership interests at a discount, or even gift them, but a baseline value of the company needs to be established for tax purposes under all of these circumstances. If the sellers intend to sell the ownership interests at a discount it would be beneficial to have the valuation also provide the range of value based on such discounts. The valuation used for the succession plan should be less than 12-months old so that it reflects the current value of the company.
• Purchase/sale of ownership interest
Once the valuation is established the parties will need tax advice as to whether the seller’s ownership interests should be purchased by the buyer or redeemed by the company. There are certain scenarios that justify the sale of the ownership interests based on two transactions (direct purchase and company redemption) but that structure would be based on a tax adviser’s recommendation. The documents associated with these two versions of the sale/purchase are very similar in construction but the distinction is in the tax implications of each option.
Many companies do not do a good job of keeping track of ownership changes over time and understanding the current ownership structure is key to developing the transition model. The purchase/sale document is a good place for a reset, to make sure to clearly articulate the ownership structure prior to the transaction and to articulate the ownership structure after the transaction has taken place.
The terms of the purchase agreement need to contain several key elements. These include:
The purchase price and payment terms, including terms of a promissory note (term and interest rate) and pledge agreement
Additional consideration: participation in company benefit plans, retention of company vehicle, reimbursable expenses and other fringe benefits
Post-closing obligations, such as:
Indemnification of buyer by company;
Mutual indemnification in the case of material misrepresentations;
Commitment to seek release of seller personal guaranties;
Promissory note and pledge agreement.
Very few succession plans assume full cash payment by the buyer. The parties will need to negotiate the payment terms of a promissory note. They will want to be mindful that the payment schedule works from a company cash flow standpoint. Some note payment terms will provide an acceleration of principal payments based on the company achieving certain financial benchmarks. In addition, the buyers should be required to execute a pledge agreement which allows the sellers the remedy of retaking certain rights in the ownership interest in the case of default on the payment schedule.
Gifting
Gifting of ownership interests is a common transition mechanism for sellers and is often done in conjunction with a partial sale. An effective succession plan will have specifics about the timing of the gifts (annually, every other year, etc.) in order to provide certainty to the buyers. Instead of a lump-sum gift, sellers often choose to gift certain percentages of their ownership over time for tax planning purposes.
Post purchase/sale control
Because the sellers help to finance the buyout, their financial interests are still at risk until any note is paid in full. It is important for the sellers to continue to have a voice, or even veto power, on certain business decisions.
In the context of an LLC Operating Agreement, using a manager-managed version of the LLC can be an effective tool. The buyers can be given control of the day-to-day operations but the sellers would be elected to the board of directors on a permanent basis to control fundamental decisions affecting the company’s viability until the earlier of the payoff of any promissory note, the death/disability of the seller(s) or the resignation of the seller(s). Such decisions which the sellers have veto power over could include the following:
The sale or merger of the company or the addition of new owners;
Changing the salaries of any member or the manager;
Approval of any distributions to any member;
The borrowing in excess of an agreed-upon threshold or the giving of guaranties of the company or the sellers;
Any single transaction, such as a capital expenditures or lease of equipment or real estate in an amount exceeding an agreed-upon threshold.
Surrendering this kind of control may be onerous to the buyers but they need to understand the risk the sellers still carry and their reliance on the continued success of the company. The updating of the company operating agreement or bylaws simply acts to codify the powers that the sellers are going to keep during repayment.
Update to buy-sell terms
As ownership transitions to the buyer(s), the typical buy-sell provisions addressing the death/disability of a member/shareholder may also need to be updated. It is important to consider the buy-sell provisions from the perspective of the seller(s) and the perspective of the buyer(s) and to have the buy-sell terms be consistent with the estate planning intentions of the sellers.
There is no formula to succession planning and it is important to spend time with the clients understanding what their goals are and what their concerns are as the business leadership transitions to the younger generation.
