Many business owners like the idea of selling their company to an employee or group of employees but don’t know how to get it done when those employees don’t have the money or creditworthiness to obtain financing. Depending on the circumstances, a uniquely designed 3–7-year deferred compensation plan could be a good way to structure the sale of the company. 

Ideal Scenarios for Deferred Compensation Plans 

A good situation for this type of arrangement is where the business owner has started to transition duties to a key person or key people and is in a state of mind to be done working in the business in 3 to 7 years. If the business is overly dependent on the owner, this type of plan would likely not be desirable.  

If that situation does exist, the idea of the deferred compensation plan is to reward the key employee(s) with future dollars that can be used to buy stock in the company. The reward is based on metrics set forth at the beginning of the plan and is usually tied to growing the company's value. 

The unique part of these plans is that the key employee(s) only receive the dollars if the owner offers to sell shares to the plan participants or the company sells to a 3rd party. If they quit, die, or are terminated from employment, they do not receive the deferred compensation dollars. 

Benefits and Considerations for Employees 

From the employee(s)’ standpoint, it is desirable because they could earn a significant down payment on the purchase of the company without having to come up with any cash out of their own pocket. Furthermore, if they are key to growing the value of the business, they like the idea that they don’t have to pay for all the value growth they helped to generate.  

 Sometimes, the employee(s) can have concerns about the fact that they could be fired and not get the money they earned, but this is generally offset by the owner of the business explaining to them that the key employee(s) is the owner’s transition (exit) plan. And if, for some reason, the owner changes his mind and decides to sell to a 3rd party, the key employee is still rewarded. 

How to Implement a Deferred Compensation Plan 

Typically, we see these types of deferred compensation plans implemented in businesses that have a value of under $10M. Industry type usually does not matter, but these models work best in businesses that don’t have significant bank debt. Ideally, the plan will generate a bonus paid to the employee, where the after-tax dollars are used to buy stock from the owner. The bonus is a tax deduction to the owner, and employees receive the after-tax cash from the bonus and pay it to the owner for the purchase of company stock. 

The goal is for the key employee(s) to end up having approximately 10% of ownership in the company after the transaction. At that point, the company can approach banks and request SBA financing (without a seller personal guarantee requirement) for the sale of the rest of the stock when the owner is ready to retire. 

How It Works: 

Day 1 – Company Value = $4,000,000 

• Deferred Compensation Plan to Award Key Employees with 50% of the growth in company value over a 5-year period 

Year 5 – Company Value = $6,000,000 

• Deferred Compensation Award = $1,000,000, Net of Tax = $600,000
• 10% of stock purchased for $600,000 (owner received this plus $1M tax deduction = $400k)
• SBA loan for 80% of company value = $4,800,000 to owner
• The owner carries 10% of the value of the $600,000 note with interest only until the banknote is paid off

We have successfully implemented plans in companies in construction, service, retail as well as many others. If you are a small business owner who is interested in potentially selling your company to key employees, the Certified Exit Planners at Lutz offers business transition and exit planning services that can help. Contact us to learn more.