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3 Risks of Transferring Business Ownership to Insiders

Submitted by John Brown on Mon, 10/27/2014 - 1:24pm
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When your clients start to implement their Exit Plans, they need to consider who will succeed them. Owners can sell to a third party, transfer to an insider (key employees), or transfer to a child. Today, let’s focus on a transfer to an insider. The transfer of ownership to an insider can be difficult and risky, but it can be done.

3 reasons why transferring business ownership to an insider is risky:

  1. Insiders have no money.
  2. Successors’ management/ownership skills and commitment to ownership may be untested.
  3. Owners lose control of the business if they complete the transfer before cashing out.

Creating a plan that helps minimize risk gives owners the best chance to reap all of the benefits of their transfers. Let's look at some potential ways to address each of these issues.

1. Insiders (i.e., key employees) have no money. Therefore, it is too risky to sell to them. This is true if owners don’t design a transfer strategy that puts money in the key employees’ pockets as they increase business value. Cash flow must be steadily and effectively built through the installation of Value Drivers and careful planning to minimize taxation, years in advance of the transfer.

Additionally, cash flow can be taxed twice unless owners carefully plan to avoid it. This double tax (sometimes totaling more than 50%) can spell disaster for many internal transfers. Through effective tax planning, much of this tax burden can be legally avoided.

Finally, owners and their advisors (including a certified business appraiser) should use a modest but defensible valuation for the company. When a reduced value is used for the purchase price, the size of the tax bite is correspondingly reduced. The difference between what owners will receive from selling their businesses at a lower price and what owners want to receive after they leave their businesses is “made good” through several different techniques that extract cash from their companies after they exit.

2. Successor’s management/ownership skills are untested. If that’s the case, owners and their advisors must create a written plan to systematically transition management and ownership responsibilities to the chosen successor, beginning today. The transition period during which assumptions and the successors’ skills can be tested usually takes several years to complete.

3. Business owners lose control before being cashed out. This is only true if owners and their advisors fail to implement a transfer strategy designed to cash owners out before they lose control. In successful insider-transfer plans, owners keep control, in part through a well-designed and incremental sale of the company, and are cashed out based on improving company cash flow.

The keys to reducing the risks of an insider transfer are:

  1. Planning the transfer well in advance of the desired exit date. Executing an insider transfer takes longer than executing a sale to a third party.
  2. Implementing value-building activities, which are just as important to an insider transfer as they are to a sale to a third party, if not more.
  3. Making the plan tax sensitive.
  4. Writing the plan down, which keeps advisors accountable for achieving the owners' stated goals.

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