Management buy-outs keep the business independent and insure that it will continue operating. A management buy-out can take a variety of forms; the most common include buy-sell agreements and stock options.
First, equity owners must be identified and a stock price determined.
The sale price is negotiable, especially when the sale is among colleagues. Sometimes owners create continuing compensation agreements. These commit the company to pay the former owner for a specified number of years. This obligation reduces future earnings and can reduce the value of the company, making the sale easier.
Employee Stock Ownership Plans (ESOPs) can be used to finance part of the stock purchased. The effect is to reduce the total cost of the stock purchase, while retaining closely held control among the primary shareholders.
Since the loan to purchase stock is made through the ESOP, a qualified retirement plan, the principal payments are a pre-tax expense. Thus, the company can purchase stock from the retiring owner dollar for dollar.
In addition, the selling shareholder can receive a major tax break as well. The owner can defer payment of capital gains taxes if all of the following conditions are met:
The taxpayer has owned the stock for more than three years
The taxpayer chooses to reinvest in a portfolio of domestic operating companies
The ESOP owns at least 30% of the outstanding shares
The capital gains tax will come due when the replacement investments are sold, but can be avoided completely if the replacement investments pass into the estate of the selling shareholder.
In the right situation, a sale of some or all of a business to an ESOP can give everyone involved significant tax breaks. ESOPs can make a management buy-out easier for the company and beneficial to the selling shareholder. Further, it will continue the business as an operating entity, controlled by chosen management and may have a positive impact on employee motivation.