Why Is It so Difficult to Successfully Transfer a Business to Insiders?

Last week we looked at the benefits of, or "good news" about, transfers to insiders. This week we'll check out the bad news (or challenges) that we face when designing Exit Plans for our clients who want to transfer their businesses to their key employees.

1. Employees Prepared to Put Skin in the Game. Asking key employees if they are willing to personally guarantee not only the loans necessary purchase shares of ownership and fund ongoing business needs is key to a transfer to insiders. If the answer is no, the buck stops here.

BEI Member Greg Banner approaches the issue of employee willingness this way.

When an owner of a business tells me that he is going to transfer the business to a key employee, the first thing I ask is, "Have you expressed this desire to that key employee?" At least half of the time the answer is no. Owners commonly assume that their key employees want to take over the business at some point in time.

I once was asked to sit in on a meeting with an owner and key employee when the owner asked the employee that question. The employee's response was something like, "Why would I want to go through and deal with all the headaches you have all the time? I am a simple guy who is happy getting my paycheck and going home at the end of the day without any of that responsibility."

This employee's response is not at all atypical. It is important for you to verify the key employees' willingness to buy a company before traveling down this exit path. Most importantly, if employees are not willing to personally guarantee loans, owners can't pursue this type of exit path without increasing the risk of not getting paid.

One of the most effective transfer plans requires key employees to obtain bank financing to purchase an owner's remaining ownership after they have gained sufficient experience and have substantial ownership. Banks will require personal guarantees from these key employees. Only at this point (when owners have received the balance of their "purchase price" via bank financing) does control of the company transfer to the new owners.

Before losing control, owners should insist that all debt, leases and bonds that they've signed and guaranteed personally be transferred to key employees.

Again, if early in the planning process you discover that key employees are unwilling to put their names on the dotted line, it is foolhardy to recommend this exit path.

2. Getting Paid. Closely related to the willingness of employees to secure debt, is the risk of not getting paid. This challenge (unlike the first) can be overcome with planning well in advance of the owner's exit date. Key employees typically have little or no money, may be untested in ownership and unproven in ambition. To succeed, good plan design allots adequate time to address all of these concerns.

3. The Business is not Ready to Run Without the Owner. Usually, owners begin the transfer process before the future owners are fully able to run the business without the original owner's leadership, expertise and guidance. Businesses must be weaned from dependence on their owners and owners need to be weaned from finding their life's meaning in running their companies.

4. The Owner is Ready to Exit. The best transfer designs (those operating under the three guiding principles: minimizing risk, maximizing value and maintaining control until owners receive the cash to achieve financial independence) take time. Think years: five to ten years, on average, from the time owners start to transfer ownership to key employees until they are completely cashed out. Hence, it is imperative that you help the owner initiate a transfer plan before the owner is ready to exit . Most owners need to stay involved with their businesses for some time before the future owners are prepared to take the reins.

5. New Ownership is Untested. Are key employees capable of one day replacing the owner?

6. Cash Flow / Growth is Inconsistent. If the company has a history of inconsistent cash flow, it may not be a good candidate for a transfer to an insider—or any transfer for that matter. Cash flow is an issue that must be addressed and resolved in that part of the Exit Planning process devoted to growing transferable value. The design of a transfer to insiders can require maintaining consistent cash flow as part of the performance standard that must be met in order for the KEG to be able to acquire ownership.

7. I'm Using My Own Money to Buy Myself Out! Owners suspect that a transfer to employees is just a way of using their own money to buy themselves out. They are correct, but only if the transfer is not properly planned.