This article continues our series describing the advantages and disadvantages of the five primary Exit Paths that business owners might choose. In our last article, we showed you the primary advantages of a transfer to management for business owners. Today, we’ll show you the challenges of that Exit Path. As always, our goal is to introduce important issues so that business owners, Exit Planning Advisors, and Advisor Teams can communicate and strategize on the same terms.
As with all good things, business owners who want to transfer their businesses to key employees or management face obstacles in pursuing this Exit Path. In fact, unless business owners have help from an Exit Planning Advisor, many of the same advantages of a transfer to key employees or management can quickly devolve into disadvantages. Likewise, if advisors to business owners fail to foresee the challenges of this Exit Path, it can lead to a delayed or failed business exit altogether.
When discussing the challenges in an ownership transfer to key employees or management, it’s important to recall the three fundamental goals of all BEI Exit Plan designs:
- Maximize the amount of money the business owner receives.
- Keep the business owner in control until he or she receives all monies.
- Minimize the business owner’s risk.
In this context, what are some of the challenges in transferring a business to key employees or management? How can business owners and their advisors identify and address them?
Challenges of a Transfer to Key Employees or Management
The challenges relevant to a transfer to key employees or management usually fall within the same realms as the advantages. Because the advantages and challenges inherent to a transfer to key employees or management fall under similar categories, it’s critical for business owners and their advisors to spot the patterns and procure the tools to turn challenges into advantages. Let’s look at what those challenges are. (Please note that this list contains the most common challenges, and is not comprehensive.)
Challenge 1: Financial Security
Though financial security is often a big reason business owners choose to transfer ownership to key employees or management, the road to financial security in this type of transfer is often long and occasionally risky. There are three reasons for this:
- Business owners may receive little or no cash up front. Typically, key employees or managers don’t have the cash to buy the business outright, meaning business owners receive a protracted payment over years.
- Future cash flow dictates payment. At least initially, the buyer’s source of funding comes from the future cash flow of the business, after the transfer begins. This makes identifying capable successors critical to financial security for business owners.
- Poor performance can extend exit timelines. If business cash flow is inconsistent or does not grow as projected, this transfer may not work, or can take longer than planned.
Challenge 2: The Time Factor
In transfers to key employees or management, time management is critical. Again, when transferring to key employees or management, business owners receive little to no cash up front, buyers rely on future cash flow to make payments, and everyone is bound by the company’s future success. The reliance on future cash flow to fund an exit is typically the greatest risk business owners face when transferring ownership to insiders.
On top of that, the essence of time can be a challenge for business owners. If owners want to maintain control until they are fully paid (a fundamental tenet of BEI plan design), this Path usually takes more time to travel than other Paths. A longer buyout period exposes business owners to a longer period of general business risk.
Challenge 3: The Time Margin
Recall that according to Jeff Spadafora, the time margin is the time owners spend developing interests outside of the business. Capitalizing on the time margin is critical, because it helps business owners plan for what they’ll do in their post-exit lives.
When transferring to key employees or management, business owners may run the risk of spending more time on developing their successors’ ownership and management skills than their own post-exit plans. Additionally, if there are multiple successors, their squabbles and conflicts will likely require even more owner time and involvement. This can lead owners to getting sucked back into the business they’re trying to exit, wasting their own time and money, along with their advisors’ time and effort.
Challenge 4: Tax Consequences
Without proper planning, the tax consequences of a transfer to key employees or management are significant. For instance, without proper planning, owners can end up paying unnecessary taxes, which negatively impacts the company’s cash flow. Because future cash flow dictates payment, the tax consequences of a transfer to key employees or management can have massive impacts on the owner’s sale price, exit date, and overall exit success.
Challenge 5: Values-Based Goals
Normally, business owners face no challenges related to attaining values-based goals in a transfer to key employees or management, unless successors want to take the business in a different direction. Nonetheless, it’s important to reiterate that many business owners don’t realize that they have values-based goals until it’s too late. Thus, it’s important for advisors to get the tools and ideas necessary to help owners realize and identify their values-based goals.
Challenge 6: Successor
Business owners sometimes assume that key employees or managers would make great owners because they do their jobs so well. However, key employees, unlike co-owners, are often employees because they don’t have an owner mind-set: They’re not entrepreneurs, they don’t respond well to the challenges and pressures of ownership, and they don’t want to risk their personal collateral and guarantees to secure the financing necessary to purchase an ownership interest. Thus, it’s crucial that business owners know how to identify successors who have an ownership mind-set. It’s equally crucial for advisors to capably identify and explain an ownership mind-set to owners.
Addressing the Challenges of Insider Transfers
Though these challenges can be difficult, there is a way for advisors to help business owners through them.
The key requisite in a transfer to key employees or management is time: usually three to eight years and often more. Fortunately, BEI has developed a variety of bespoke designs and tools to facilitate ownership transfers to management, timely and effectively. Over 40% of all written Exit Plans created by BEI Members are transfers to key employees or management, even though only 30% of owners are initially interested in that Exit Path!
If a business owner waits to begin planning until he or she is ready to exit, a transfer to key employees or management is at best perilous. Because most owners would like to exit within five years, advisors must clearly present the advantages and disadvantages of this Exit Path immediately.
In our next two articles, we’ll discuss the advantages of a third-party sale as well as the disadvantages of a third-party sale, which is the Exit Path that many business owners initially find themselves attracted to.