Are you planning your succession and thinking about passing the torch to one of your employees? What are the financing options?
It can sometimes be difficult to find a buyer for your business, but the hidden gem could be right within your organization, among your employees. They have the advantage of being familiar with the organization’s culture and being involved in its daily operation. Several factors must be considered when choosing a buyer and this decision must be carefully thought out, just as the transfer must be well prepared. One of the most common obstacles to a transfer is the potential buyer’s ability to finance the purchase.
When the buyer’s financial resources are insufficient to finance a business purchase, there are several interesting options to consider that can compensate for or complement traditional institutional financing, namely:
- Stock option plan;
- Estate freeze;
- Low-interest loan;
- Share-based bonus;
- Employee trust.
Stock option plan
This is a written agreement between an employer and an employee to allow the employee to become a shareholder and thus receive a portion of the company’s profits. One of the advantages is that it increases the employee’s sense of attachment and involvement in the organization.
The agreement is drafted by the employer and details the conditions which the employee in question must satisfy in order to acquire share capital, including the share price the employee will pay (equivalent to or less than the market value).
A stock option plan helps to foster employee loyalty and may also provide significant tax savings. In certain circumstances, the employee could benefit from a 50% deduction for federal purposes and 25% or 50% for Quebec purposes, as applicable. Additionally, the employee can defer the benefit provided by the organization.
With an estate freeze, an employee can subscribe to the company’s participating shares with a minimum outlay.
Immediately before the employee subscribes to the shares, the value of the corporation’s participating shares is “frozen” at its fair market value (FMV) or, if preferred, transferred to a new class of preferred shares.
Accordingly, the corporation will issue new participating shares to the employee at a value that corresponds to the subscription price, at a lower price.
For example, an entrepreneur holding participating shares in the business with a cost price of $1 million and a current FMV of $5 million could transfer the value of the participating shares, i.e., $5 million, to non-participating preferred shares that will retain their $5 million value.
In exchange, the entrepreneur could issue new participating shares at a minimal cost to the employee wishing to become a shareholder.
Not only is the buyer obtaining shares at a lower cost, but he or she will benefit from any appreciation in their value over time. A comprehensive plan on how to purchase or redeem the preferred shares issued to the departing shareholder must be put in place.
This will allow an employee to participate in the future profits of the corporation and thus accumulate financial capital more quickly to eventually purchase the securities of an outgoing shareholder.
When properly carried out, a business transfer takes place over several years. It is therefore important to ensure the potential buyers’ interest and reliability. In general, it is recommended that employees who wish to succeed the seller make a minimal investment. A monetary commitment on their part will guarantee their retention and involvement in the transfer’s and organization’s success.
The company can provide a low-interest loan to an interested employee. Naturally, this loan would include a commitment with reasonable repayment terms, which would strengthen the employee-employer bond. Accepting a loan agreement demonstrates the potential buyer’s motivation and commitment.
It is also possible to offer the acquiring employee a share-based rather than a cash-based bonus. This approach, which has the same tax advantages as a stock option plan, is easier to implement because, instead of targeting a category of employees, it can be customized to a specific employee.
A trust may be created to hold shares to the benefit of the employees. In this case, the trust’s administrators are usually the business’s current managers. The employer thus retains management of the rights associated with the shares issued (the employee is not directly involved). Even if the shares are not personally owned by the employee, the latter benefits from all the tax advantages attributable to a shareholder who directly owns the shares.
In all of the cases presented above, it is important to review the shareholder agreement to take the arrival of these new shareholders into consideration.
In order to properly assess the impact of these different options on your personal situation, it is preferable to call on a tax specialist who is familiar with the laws and all the tax implications resulting from these choices and who will be able to guide you and suggest the best solution for your situation.
As a supplement to this article, we invite you to listen to Episode 6 of our Propulsion podcasts “J’aimerais intéresser mon directeur général à l’actionnariat” (in French only).