We continue our discussion of The BEI’s Seven Step Exit Planning ProcessTM with this article for those who want to explore a transfer to insiders.
We kicked off this series with a comparison of Exit Planning and succession planning and followed that with setting the owner’s goals, the critical importance of defining cash flow, protecting business value and the important issues in a sale to a third party.
When owners tell you that they are considering transferring their companies to insiders (co-owner(s), or one or more key employees) where do you begin? We suggest that you first make a preliminary assessment of whether this path makes sense before you assess the intended successors and an owner’s expectations.
1. Will This Exit Path Meet The Owner’s Goals?
We all meet owners ready to head down an exit path (sale to a third party, a transfer to family members or an insider transfer) before they do the work involved in Steps One and Two of the Exit Planning Process. It makes no sense to embark on a path without establishing exit goals, determining business value, cash flow, and knowing the size of the gap between an owner’s current and needed-at-exit resources. Without this information, no one can determine whether a transfer to insiders makes sense.
2. Will The Owner Exchange Time for Risk?
If an owner says he or she wants to exit and transfer ownership immediately, a transfer to children or employees is fraught with risk. These successor/insiders can rarely obtain financing to buy a company. The consequence is that your client ends up carrying a long-term promissory note from the buyers. As an advisor, you must make owners aware of the risks and likelihood of not getting paid using this (non-) strategy. It is also necessary to show them better alternatives.
We suggest that you describe and illustrate the benefits of implementing a gradual transfer of ownership that occurs only if the business performs as expected. The benefits to sellers of pushing back a departure date include: 1) continued receipt of cash distributions (usually S distributions) from their businesses, 2) increasing the likelihood of receiving payment, and 3) time to evaluate whether members of the KEG are good candidates for ownership. Transferring increments of ownership over several years and requiring the KEG to meet an ever-increasing performance standard (such as annual increases in company cash flow), is a primary strategy we use.
3. How Much Risk Can An Owner Stomach?
Transfers to insiders are not at all difficult if owners don’t mind depending on key employees, children or other quasi-paupers to successfully run their businesses and pay them in full. Successful transfers, however, are more difficult because they require: 1) proper planning to minimize owner risk, 2) a company that can run without its owner, and 3) an advisor who knows how to structure the transfer.
4. Has The Owner Made Any Promises?
As the advisor, you must know whether an owner has made any promises of ownership (no matter how vague) to one or more employees. If so, you will have to handle those promises as you design the transfer of ownership.
5. How Old Are The Intended Successors?
As you look at an owner’s intended successor, are any are older than 50? If so, few would-be owners want to spend years acquiring stock only to sell it at retirement (probably via a long-term installment note) at a value not substantially greater than the one they paid. If you know that successors are “mature,” you may want to consider a phantom stock or stock appreciation rights plan.
In our next article, we will discuss the five owner assumptions that you will need to probe.
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