Brownie was a typical hard-working owner. When the time came for him to retire, he realized that his only son had no taste for the food business. That left one possible buyer: Bill, his key employee of twenty years. So Brownie asked his attorney to “draw up the papers.” Bill bought the business for a small down payment and a large promissory note.
Bill made a few payments, fell behind, promised to catch up, and then stopped paying. By the time Brownie got his company back, there was little left to take back.
Exit stories don’t have to end this way. The transfer to insider process (a sale to key employees or children) that we use has three guiding principles:
- Maintain owner control
- Minimize owner risk
- Maximize owner’s receipt of value
The owner maintains control of the business until he or she receives maximum value, defined as the cash needed or desired for financial independence. In maintaining control, we minimize the risk to the owner (of not achieving financial independence) and to the business (of failing to succeed).
Many owners often don’t even consider transferring a business to their key employees because employees rarely have money and/or can’t run the business. Instead, they look at selling to an outside party (who has cash) as the only practical exit path. They assume that any other path is too risky.
Others think of transferring to insiders as the exit path of last resort. Only when they learn that their companies aren’t valuable enough or aren’t attractive to third parties or that their kids don’t want the business, do they default to, “I guess I’ll sell to my key employees.”
When owners pick a transfer to insiders as their default option, the transfer usually fails because the business lacks essential value drivers; it has little transferable value. It has little transferable value because the owner is still indispensable to the business. Even if key employees had capital, they can’t run the business without the owner. (See: To Grow Value and Exit Successfully Owners Need to Change Their Role)
The typical (and doomed to fail) transfer to insider plan design mirrors Brownie’s: a long-term note with little money down. The buyers default because the business doesn’t produce enough cash flow to support both operating expenses and a note payment.
Our experience and the experience of BEI Members is the polar opposite of the typical inside sale scenario. We find that the transfer to insiders is the exit path most traveled, successfully, by business owners today.
So what do these owners and their advisors know about designing a successful transfer that you don’t? Let’s meet Francis, an owner that we will use, in the next several articles, to illustrate the benefits and challenges of this type of transfer, as well as the elements of a successful design plan.
Desired Exit Date: Six to seven years from today
Desired Successor: His three key employees
Needed from the Sale of Business for Financial Independence: $2.5M (after tax)
Current Value of Business: $1,000,000 (pre-tax)
Business Value Necessary to Net $2.5M: $3,300,000 (pre-tax)
When Francis first met with his Exit-Planning advisor, they started working to increase the transferable value of the company by creating an incentive for the key employee group (KEG) to grow the cash flow of the company. If the company attained specific cash flow growth each year, members of the KEG were rewarded with the opportunity to acquire ownership.
The transfer plan design provided the KEG with the ability to acquire the company, and Francis knew, based on the plan design, that if the KEG reached their performance goals to acquire ownership, he would realize his exit goals.
During the seven-year buy-out period, Francis’s after-tax proceeds totaled $2.5 million, he maintained full control of the company and continued to draw his full salary, even though he worked fewer and fewer hours. With less time devoted to the business, Francis was able to explore activities he thought he might pursue after he sold the business.
How did Francis do it? That’s the topic we begin to tackle in next week’s article.
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