What Is It?
When the sale of your business involves deferred payments, such as from an installment note or a supplemental pension plan funded from future business earnings, you may be dependent on the buyer's success for your money. You want to be sure that the buyer is committed to the business, will hang tough through the difficult early years, and will use the business's funds appropriately. Personal guarantees, salary caps, and dividend limitations are mechanisms you can use to help achieve these ends.
Personal Guarantees, Salary Caps, and Dividend Limitations
Personal guarantees, salary caps, and dividend limitations are all available for your use depending on the objective you're trying to achieve.
You can request the buyer to sign a personal guarantee, securing the sale with personal assets such as a house or car. By forcing the buyer to put his or her own assets on the line, a secured personal guarantee requires the buyer to buy in to the business and may motivate him or her to hang tough through the difficult early years. If the buyer is reluctant to do this, perhaps he or she is not as committed to, or as confident in, the success of the business as he or she should be.
You can require the buyer to cap salaries and restrict bonuses and other perks for the first several years or possibly longer with adjustments for a small company. These restrictions can apply to the buyer, the buyer's family, and possibly senior management.
By restricting the funds that can be used for personal compensation, you help ensure that needed funds remain in the business to maintain it and to advance its growth and development. The first several years are likely to be the toughest for the new owner, so you want to be sure he or she retains sufficient funds to build the business and doesn't siphon them off for personal use. However, salary caps may make it more difficult for the company to attract and retain quality employees.
You can require that dividends be limited to the amount needed to cover income taxes until all debt obligations (yours included) are fulfilled. By limiting the funds that the business can distribute as dividends, you help ensure that cash is retained to maintain, grow, and develop the business. This approach is more useful for an S corporation, which is more likely to distribute dividends.
However, such a limitation may cause a tax hardship for the owners in the S corporation, since taxes will still be due, but dividends will not be distributed to meet that burden. If the company is a family business structured as a C corporation, it's unlikely that dividends are paid.
When Can It Be Used?
You can use personal guarantees, salary caps, and dividend limitations when the sale of your business involves deferred payments (such as from an installment note or a supplemental pension plan funded from future business earnings) and you want to ensure the buyer's commitment to the long-term success of the business.
Personal guarantees, salary caps, and dividend limitations require the buyer to make a personal investment in the long-term success of the business. In other words, it requires him or her to buy into the business. You can use these requirements to weed out reluctant buyers who aren't prepared to make the sacrifices necessary to succeed.
How to Do It
- Require the buyer to sign a personal guarantee, using personal assets as collateral
- Structure a provision into the sales contract capping salaries of the buyer, the buyer's family, and possibly senior management, and restricting bonuses and perks
- Structure a provision into the sales contract limiting the distribution of dividends
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