“If your long-term goal is to give the business to the children, then the loan option is attractive since the family can simply tap into cash flow and repay the loan over time,” Isdale says. The downside is that some banks may be reluctant to lend if the primary purpose of the loan is to put cash in the founder’s pocket, not to invest in the business. In most cases, they will demand a higher interest rate than on loans that finance a business opportunity.
If the goal is to eventually pass the mantle to children, Susan Mucciarone, regional managing director of Calibre, the family office arm of Wachovia Bank in Philadelphia, says owners can integrate a recapitalization into their overall estate plan. For example, the owner might find it advantageous to lend a trust the money to buy a minority or nonvoting stake in the company, which the trust would hold for the benefit of his or her children. The trust uses cash from the company’s earnings to service the loan.
This strategy gives the current owner some financial flexibility and the ability to diversify assets, while keeping the company firmly in the family’s control. Again, the current low interest rate environment benefits these transactions. (The federal government sets the minimum interest rates for such arrangements.) However, with this strategy, the payout is spread over the life of the loan, and may not suit entrepreneurs who want an immediate lump sum.
For those who want that lump sum, Troy Smith, a financial planner at Navigon Financial Group in Durham, N.C., recommends setting up an ESOP, an increasingly popular liquidity option that makes employees of a company stockholders in the business. According to the ESOP Association in Washington, there are approximately 10,000 ESOPs in the United States, and 90 percent of those are in privately held companies. “It’s a fantastic way for a closely held company to create liquidity for shareholders,” he says.
In these transactions, an owner sells shares in the company to an ESOP, which finances the purchase with proceeds from a bank loan. The owner receives a lump sum payment and can actually defer capital gains taxes on that payout by buying qualified assets that diversify his portfolio. The corporation can deduct the loan payments the ESOP makes to the bank. Meanwhile, the owner retains control of the company. The trick with an ESOP, Smith explains, is ensuring the appraisal of the value of the stock prior to the sale is incontestable. If the ESOP trustee later claims to have paid too much for the stock, the entrepreneur could find himself and his company financially liable. Also, because the shares sold to the ESOP are themselves illiquid (they are not traded on an exchange) and often nonvoting, they are worth less than traded, voting shares would be, so the payout that the owner receives is often smaller than that which he would have received if he took the company public.
Another problem with ESOPs is their expense; they typically cost a minimum of $100,000 to set up and then $20,000 a year to maintain. Other liquidity transactions typically have a one-time cost of $10,000 to $40,000.
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