Becoming a Partner with Firm 2

[DoEngineering]

I have the opportunity to purchase ownership/stock at my current firm. Some information about the firm:
-The firm is categorized as an S-Corp currently with only one shareholder (the owner).
-The owner will be looking to sell/retire in 5-8 years. A 3rd party buyer is the most likely scenario.
-I have been given the opportunity to purchase an option for a 5% stake in the company. The option price is based on the discounted value of the firm valuation.
-Once I exercise the option I would receive distributions to shareholders based on our revenue at the end of the year. Based on my math, the distributions I receive would pay for the stake I purchased in 3-4 years.

I have been trying to find a financial advisor that is familiar with this, but haven't had much luck. I feel like I need someone who is familiar with buy-sell agreements in the professional design services industry. If there are any recommendations, please feel free to share.

My main question is what would be my best way to maximize profit for this transaction? I will have the opportunity to purchase options to buy 5% of the company for the next several years. As I mentioned, the owner will likely be retiring in about 8 years by bringing in a 3rd party buyer. If I just hold the options and never exercise them, would the 3rd party buyer have to buy my options? Could I exercise my options and then immediately sell them to the 3rd party, so I just net the difference in the discounted price and the purchase price?

It is my understanding that I would have to pay taxes when I exercise my options on the difference in price between the discounted value and fair market value (income taxes). If I have to pay taxes when I exercise the option, do I not have to pay taxes when/if I sell my shares on the difference between my purchase price and the sales price? Would it instead be the FMV price vs the purchase price? It seems odd that I would have to pay taxes twice, so I am wondering if I am understanding this correctly?

Any other insights into this if someone has had a similar agreement or situation, would be appreciated.

 

[SWComposites]

One of the first things is to figure out if the firm validation is realistic. Often it is not for single owner firms. See many other threads in this forum.

 

[IRstuff]

It seems odd that I would have to pay taxes twice, so I am wondering if I am understanding this correctly?

You pay taxes on the capital gain, either long-term or short term. It's no different than if you were compensated in cash and immediately bought stock in the company.

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[LittleInch]

I'm not quite following you here as there are a number of ways to interpret what you're saying.
"purchase an option for a 5% stake in the company. "
An option is exactly that - optional. You are normally "given" these, you don't pay for them?

When you "Exercise" your option you pay money. Who to?
Are you buying 5% off the current owner or is the share capital increasing by 5 percent each time so the money goes into the company? Or the Owner?

So lets say there are 1000 shares all belonging to the owner.
Are you buying 50 of those so you then have 50 and the owner now 950 or does he still have 1000 and you now have 50?
MOST IMPORTANT - Are all the shares the same and have the same rights? You don't want to be buying "B" shares and the owner keeps his "A" shares....

Payback in dividends over 4 years for shares sounds too good to be true. Either you're getting a special dividend or the value of the company being given to you is very low.

I had something similar and in the raft of paperwork the where specific provisions about when the options could be exercised or what happened if the company was sold or otherwise the other shares changed hands. In most instances there is an allowance / time for those shares to be purchased BEFORE the sale of the company and the buying company is aware of that. As said it depends who is selling the shares - the company with more shares created or are you buying the current owners shares? But if you're expecting a quick profit then you can borrow that money in the expectation of paying it back plus profit pretty quickly.

"I will have the opportunity to purchase options to buy 5% of the company for the next several years." What does this mean? Are you steadily buying 5% of the company every year ? or your option lasts for years before you need to exercise it? Also it's this phrase "purchase options" which isn't clear.

Tax issues you need to look it up and ask an accountant. Different places allow certain amounts of tax free incentives, but tax is a murky business other than you having to pay more than you you normally want to.... or you need to hold the shares for a certain time before selling.

But the biggest issue is whether the shares actually have any real value. Small consultancies are in reality worth very little - see many posts here on that subject.

But if you think it will be paid for by dividends which otherwise you wouldn't get then maybe its a no pain idea.

But also look at what happens if for whatever reason you need to sell your shares. You never know what is going to happen or if you leave the company what happens? What happens if the owner dies? what happens if he just folds the company if no one wants to buy it? What happens if he decides to soldier on?
What happens if you die?
Who would buy the shares back and at what value?
Or are they iliquid non tradeable shares basically worth nothing if there is no buyer or agreed purchase of shares built into the agreement.

Succession planning for small companies is fraught with danger, but also a chink of opportunity. If you can get ti paid for using money you wouldn't otherwise see, then maybe worth the risk.

Putting your own money / capital in - Very risky IMHO and I've been there. Only just got out in time ( I got back what I'd put in) but others who bought shares lost it all when the owners decided to liquidate the company and the others as minority shareholders and with "B" shares couldn't do anything about it.

We all got a bit fixed on the end prize of the owners selling up in 5-10 years and lost sight that we might lose it all...

Remember - More details = better answers
Also: If you get a response it's polite to respond to it.

 

[jorton]

This does sound weird. As LittleInch said, options are typically given. You'll often see startups use them to obtain and keep talent without having to spend cash. If you "buy" an option, then it seems the current owner is just raising cash, and you are betting on a higher future value than present value. Does the owner keep the cash from your option purchase if you never exercise the option? Have you seen the books? Can you look at past years revenue, profitability, dividends, and current backlog to project out what future dividends may be given a range of projected revenues? Why do you think the owner is making this offer? It doesn't sound like this is his exit plan if he is planning a complete sale in a few years. Is he trying to retain you without spending cash today? Than giving you an option would make sense. Or is he trying to raise cash internally? That would make me concerned.

I passed on an option to buy into an S-Corp a few years back. I ran a few different financial scenarios, and I determined that with the growing S-corp I would be paper rich but cash poor for 10+ years. The paper rich part is only if I were allowed to continue to keep buying in at a level that would provide a nice retirement fund when (if) I finally got out. However, there was no guarantee that I would ever get to buy in after my initial purchase, so a buy-in was actually a form of capturing talent. Of course there were also valuation issues. The company is only worth what it is worth today, and there is no guarantee that it will be worth that in the future, especially when the previous owners move on. It really was a bad business deal for me. Then I started realizing that the other owners would not be people of my choosing and that they seemed to think the bad valuation and terms were a good business deal - they were not the business partners I wanted to sink every extra penny into.

 

[CWB1]

Agreed with SWC. I would start by ensuring the valuation was calculated properly by a certified valuation analyst and isn't just a random multiple (N * cashflow). The owner should be able to provide a 20+ page report prepared by the analyst listing the company's tangible and intangible assets, multiple ways the valuation was calculated, and a rationalization for discrepancies between valuation approaches. It should also reference property appraisals and other necessary supporting docs. If the owner is actively leading a small office themself be aware that there really won't be any intangible value other than patents/IP because ownership changes will have a major impact on brand value, customer trust, etc. In many instances consultancies are tiny rented or home offices and their only real assets are used office equipment with little residual value, they're effectively worthless to buyers. I would suggest reviewing qualified vs unqualified gains with your CPA bc yes, in some circumstances you might have a taxable gain if purchasing a business below FMV. I would also recommend reviewing any purchase agreements with an attorney to understand whether/not a buy-option offered is binding during a sale, I would wager its not bc there's no free lunch - usually you can't sell what you dont really own. And no, there's no guarantee that a buyer will buy your portion of the company or even retain you on staff after buying out the majority owner.

 

[DoEngineering]

@IRSTUFF:
My main question is what is my gain based off of. If for example - the firm had a FMV of $10/share. I buy discounted shares at $5/share. I am taxed for the difference in the FMV vs discounted price as income. If I later sell my shares for $11/share, would my capital gain be $11/share - $10/share = $1/share? Or would it be $11/share - $5/share = $6/share? If I am following your example of receiving cash, it seems like the capital gain would be based on the FMV not the discounted price. If I sell the shares at $9/share, would I be able to claim that as a loss?

@LittleInch:
An option is exactly that - optional. You are normally "given" these, you don't pay for them?

Sorry - I should be more clear. I am purchasing an option to lock in the discounted price of the company based on the most recent valuation. The company will be re-evaluated each year. The option I purchase would basically be a down payment on the stock I could purchase at a later date. For example, if the FMV of the stock is valued at $10/share, I purchase an option to buy 100 shares at $5/share for $5. I could then exercise the option to purchase the remaining shares for $495. The intent is to put in a deposit on the stock purchase and then use bonuses to buy stock over a period of time. That way I would not need to contribute any of my own capital out of my salary.​

When you "Exercise" your option you pay money. Who to? Are you buying 5% off the current owner or is the share capital increasing by 5 percent each time so the money goes into the company? Or the Owner?

My money would go to the owner and I am buying a percentage of the company from him. The capital would not go into the company.​

So lets say there are 1000 shares all belonging to the owner.
Are you buying 50 of those so you then have 50 and the owner now 950 or does he still have 1000 and you now have 50?
MOST IMPORTANT - Are all the shares the same and have the same rights? You don't want to be buying "B" shares and the owner keeps his "A" shares....

The number of shares do not change and all stock has the same rights.​

Payback in dividends over 4 years for shares sounds too good to be true. Either you're getting a special dividend or the value of the company being given to you is very low.

The shares I will be purchasing are at a discount (1/2 the FMV). The intent of the program is to retain key personnel and offer the opportunity for ownership.​

"I will have the opportunity to purchase options to buy 5% of the company for the next several years." What does this mean? Are you steadily buying 5% of the company every year ? or your option lasts for years before you need to exercise it? Also it's this phrase "purchase options" which isn't clear.

I have to get more detail, but the agreement says new partners will have the opportunity to purchase options each year and the options are for 5% of the company. I need to determine if I am able to buy another option for 5% of the company even if I have not completely exercised my previous option.​

But also look at what happens if for whatever reason you need to sell your shares. You never know what is going to happen or if you leave the company what happens? What happens if the owner dies? what happens if he just folds the company if no one wants to buy it? What happens if he decides to soldier on?
What happens if you die?
Who would buy the shares back and at what value?
Or are they iliquid non tradeable shares basically worth nothing if there is no buyer or agreed purchase of shares built into the agreement.

These are all very good questions I need to review with the owner.​

Thanks for your response/information.

 

[LittleInch]

Aaah, the smoke clears a bit.

So by the sound of it you are paying 0.5% of the option share value for basically a promise to sell you a share of the owners shares at some unspecified point in the future at an agreed price today? Is there a time limit on these options or are they unlimited duration? But even 0.5% is good work if you can get it....

"The intent is to put in a deposit on the stock purchase and then use bonuses to buy stock over a period of time. That way I would not need to contribute any of my own capital out of my salary." That's a bit ( a lot) different to buying the shares and then getting dividends you wouldn't have got otherwise to pay for them.

Bonuses which you would get whether you buy shares or not is your money going into the pocket of the owner is in essence your capital. Don't be fooled by this. But if the dividends once you actually buy the shares are good enough to pay for the shares in 5 years then go for it. Again, good work if he can get 5 people to pay 5% so he gets 25% of some mythical valuation up front without even selling the company to anyone else. Can he get 20 people to buy the whole thing off him? Is there any limit on how much of his own shareholding he is going to sell? If you're not careful you and others will end up with 50-60% of the shares and then the owner can just hand over the keys and retire....

You really really really need to see the real accounts for the last 5 years and projections for the future and how any sale is going to be handled.

In terms of capital gains each tax system is different. Where I am you are allowed a certain limit of options each year which are essentially not subject to capital gains or income tax, but it's not a big number ( a few thousand a year agreed with the taxman). After that the gain is the gain, i.e. what's the difference between what you paid for it and what you sold it at. So in your example at $11/share its taxed at xx% of $6 a share. At $9 it's taxed based on $4 a share. If you sold it at $4 tough luck, no tax system on Earth covers losses on stock markets for individuals at least.... That's why the discount works because even if the value falls a bit from what you were expecting, you still make money, even after paying tax on the PROFIT. The share value has to go down 50% for you to start loosing money and that's ONLY if you actually take up the option. Although I know a few people recently working for an oil company with HUGE option amounts accumulated over time, plus some shares, but then the market price fell about 85% so all their dreams went up in smoke....




Remember - More details = better answers
Also: If you get a response it's polite to respond to it.

 

[SWComposites]

DoE - you need to discuss the tax implications with a CPA in your state; options are complicated and tax rules differ depending on exactly how the options are structured. Don't rely on a bunch of engineers for tax advice. Also, you need to get a CPA and Attorney to review the company finances, all documents related to the options and purchases, etc. There are likely many many pitfalls that we here can't thing of.

 

[phamENG]

You don't say what branch of engineering you're in or what the business model is. If this is just a design firm/consultancy....you'd probably be better off putting those bonuses away as seed money to start your own firm as soon as the owner retires and you can take advantage of the dust up during the sale to an unknown third party to snatch up as many clients as possible.

That type of business (which is my type of business), has essentially zero value. It's very rare that they hold any intellectual property of value, the reputation is vested in a few people, not in the the name of the firm, and they have almost no appreciable assets. Even if the owner owns the building, it's probably held under a separate LLC and won't be part of the sale...you'll probably find that he signed (or will sign) a long term lease with his property holding LLC to lock the business into that location and a check going into his pocket.

A business like that only really has value if:
1) they develop a unique design or design procedure that can be patented or some other form of IP that can be used with low overhead and high margins and/or sold.
2) they grow and develop a company culture and system that is larger than the owner(s). If you remove any one of the members, there is no disturbance noticeable from the outside. Owner or office manager (or both) gets hit by a bus on a lunch break? No deadlines are missed, no incoming work is lost, and the ship keeps sailing.
3) they have a large body of tangible property - in my world, that might be a geotechnical firm's testing laboratory and drill rigs - that provides real value through tangible assets.

If you don't have any of those three things...it's all play money. The valuation can say they want, but as soon as the owner leaves the clients that were calling him will find somebody else. They may give you a try, but if you don't do things just the way the last owner did, many of them will start shopping around.

My old firm...the owner retired, and sold to a few of the senior engineers. That was about 6 or 7 years ago. I look on LinkedIn now at all the old clients that used to bring big projects....my old firm's name is not the one listed under "Structural Engineer" anymore. They're still in business, but nobody seems to talk much about that firm anymore....

 

[IRstuff]

I am taxed for the difference in the FMV vs discounted price as income.

This answers your question; you've been taxed as if you got cash money compensation which was then invested in the stock. Therefore, any capital gains/losses are against the FMV at that time, since you essentially got a compensation that was taxed and invested into the FMV. The only issue is whether it's a long or short term gain

TTFN (ta ta for now)
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[LittleInch]

The only real question to think about here is

Is the valuation in any way shape or form actually realistic and achievable in a sale to a third party?

Without any firm agreement in place with this unknown third party, the answer is no IMHO. Any money invested is basically at risk of becoming the owners retirement fund / down payment on his boat / holiday home and you'll never see it again.

Everything else is smoke.

The key here I think is this sentence
"The intent of the program is to retain key personnel and offer the opportunity for ownership."

The first part is true and will probably also reduce wage growth on the basis of the size of the carrot being dangled. If you go down this route, expect some pressure then to turn your options into shares with the carrot of dividends.

The second part could easily be a poisoned chalice.....

Like I said before, I know many people working for a decent sized oil company who were busy amassing a huge number of share options for their retirement and then couldn't move because they would lose them all or a lot of them. As it was a publicly traded company, the value was set by the market and after a couple of bad results the stock / share price plummeted 90% from its peak. There was only muted sympathy from other who didn't have the options...., but a little for those who had actually "exercised" the options and were now looking a large losses.

Just go into this with your eyes VERY wide open and talk it through with your family and as many people as you can to get a full picture and alternative views.

Whilst I have no information about him or her, the intent is probably good to offer long standing employees a chance to benefit from a sale of the company in 5 to 8 years time, the fact that the owner is selling his own shares makes it good for him, but maybe not so good for you.

Remember - More details = better answers
Also: If you get a response it's polite to respond to it.