Today we continue our discussion of BEI’s Seven Step Exit Planning ProcessTM with this article discussing successor and owner expectations in an insider transfer.
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, important issues in a sale to a third party and assessments you must make in an insider transfer.
As you may recall, our previous article discussed the first five assessments you must make when one of your clients tells you that they are thinking about selling their business to insiders. They were:
- Will This Exit Path Meet The Owner’s Goals?
- Will The Owner Exchange Time for Risk?
- How Much Risk Can An Owner Stomach?
- Has the Owner Any Made Promises?
- How Old Are The Intended Successors?
Once you answer all of these questions, you can move on to important questions about the successors and owner and then to your role in explaining the issue of minimum value.
Questions About Successors
1. Are Successors Capable of Being Owners?
Do successors have the ability to run the business without the owner? If an owner assures you that they do, ask how she knows that. For how long has the owner ever left the employees in charge and in what shape was the business when she returned?
Good, even great, key employees do not necessarily equal good or even passable, successor owners.
2. If Capable, Do Successors Want To Be Owners?
Does your client know or assume that a co-owner or key employee wants to be owners? Many motivated, loyal employees are quite content to be employees. They don’t want to take on the stress, hours, sleepless nights, and level of risk that ownership entails. To succeed as owners, successors must possess the same spark that motivated the owner each day to make something of the business–no matter the risk or personal cost.
3. Do The Successors Understand The Risk Involved In Ownership?
Many employees are both capable and willing to become owners—until they learn that they will have to put their own skin in the game. Depending on the structure of the buy-in, their personal funds (or loans) will pay for initial ownership interest and fund ongoing business operations.
The requirement for employees to put skin in the game can be a deal breaker so you must raise the issue early in the process.
What Do Owners Expect?
Some owners want a strong link between the privilege of purchasing the company’s stock “at a bargain price” with the risk that successors bear. They believe that KEG members only become true owners when they bear risk—especially when there is a slowdown in cash flow. In that case, you must ask how much risk they want their successors to assume. Are they willing to look exclusively to the future cash flow of the company to provide successors a means to pay them or will they require their successors to rely on other assets?
You might suggest that:
1. The owner requires members of the KEG use their money for the down payment for initial stock purchase, or that each key employee use personal collateral (such as a residence) as security for any installment note.
2. The owner requires buyers to obtain a bank loan for the entire initial purchase (with or without the company’s guarantee).
The Conversation About Minimum Value
We’ve already mentioned that you are the best person to communicate to your client’s successors that they will have to use personal assets to fund their buy in and possibly ongoing business operations.
You are also the person best suited to explain to all parties the need to place a minimum value on the company.
While you may understand the role, a low enterprise value plays in this type of transfer, I can almost guarantee that your clients do not. Even among those who do, there are many who find the idea of a low value emotionally unpalatable. To them, a low value gives away part of the business.
You must persuasively and accurately communicate that selling a company to an insider for the lowest enterprise value permitted by a qualified appraiser is the best way for owners to maximize the money they receive. By using a low value for the initial purchases of ownership, more of the company’s cash flow remains to be paid directly to the owner who pays a tax on it. Less cash flow needs to be diverted from the company and paid to the buying insider (who is taxed on it) before paying the net amount to the seller who is taxed on the gain. Using a low defensible value, properly designed, reduces the amount of cash flow the company needs to create to pay the owner the same amount of money, after tax.
In this article and the one that preceded it, we’ve covered the four tasks you must undertake when you learn an owner/client has chosen this type of transfer:
- Assess the prospects for success
- Assess the intended successors
- Extract the owner’s expectations
- Explain the role of minimum value.
Of course, there are many more once owners realize that there are many plan designs and many decisions to be made as they move forward in their Exit Planning.
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