Navigating Business Transfers to Insiders Lacking Financial Resources
One of the most popular business transition strategies is the sale to key employees. The reason for the interest in this exit path is because if this plan is structured properly, with the assistance of an Exit Planning Advisor, business owners can achieve several of their values-based goals more efficiently. There are a variety of goals that insider transfers generally foster including financial security, time to train employees, time to consider their personal post-exit goals, and the peace of mind that the culture, legacy, and mission of the business will be passed on.
However, all the potential benefits of this type of transfer do not matter if the chosen successor doesn’t have the financial resources, or access to resources, to buy. It is likely that key employees may not have the ability to obtain the financing they need for the purchase or that they are hesitant to risk their personal assets to fund both their buy-in and ongoing business operations.
This leaves the owner at a crossroads: abandon their desired exit path and explore alternatives or structure a deal in a way that the chosen successor builds up their resources over time.
As an Exit Planning Advisor, you will have the unique positioning to make the necessary recommendations to business owners. You’ll have the ability to suggest what steps need to be taken to secure finances and improve cash flow if they are set on an insider transfer for their exit path.
Finding Financial Resources – How Cash Flow Supports the Sale Price to Insiders
The secret to success for an insider who is otherwise a strong candidate for a successor is cash flow.
If the owner is set on this exit path, they risk receiving little or no cash up front as the insider typically has limited borrowing potential. Therefore, the buyer’s initial source of funding comes from future earnings of the business once the transfer process begins. If the cash flow is inconsistent or does not meet the projected targets, the transfer may take longer than planned, or may not work at all.
Challenge of Cash Flow
The time factor comes into play because every dollar of cash flow that is created through operations will be taxed at ordinary rates because it will either be reported as company income or paid to the key employee. Then, the key employee will only have an after-tax amount to pay to the owner, who will then likely owe capital gains tax for the ownership interest. This means that every dollar making its way to the owner during the transfer process is taxed twice, which is why it often takes so long for the owner to reach financial targets with this exit path.
Improving Cash Flow
As an Exit Planning Advisor, you can suggest planning strategies that may work better and improve the overall Exit Plan designed for the insider transfer. This could include:
Revisiting company business value to get an accurate valuation,
Highlighting steps that could be taken to increase business value over time,
Adding different types of payments made to the owner,
Transitioning ownership over time versus all at once.
Through analysis and strategic thinking, Exit Planning Advisors can help produce ways to use company cash flow more efficiently while keeping an eye on the overall exit goals.
Cash Flow Advantage
While financing with company earnings may seem less than ideal at first, if an owner is set on this transfer path, there are ways in which improving cash flow over the transition period could work to their advantage. If the payout methods are structured correctly, this path could yield more income over time than a sale to a third party or Employee Stock Ownership Plan (ESOP). During the multi-year transition period, the continuous distribution of free cash flow to an owner in the form of salary, distributions, and perks can be a source of asset accumulation. When the owner cashes out, they would receive not only the initial business value, but the proceeds from the growth in value too.
Considering the timeline and cash flow needs required in this type of transfer, as well as the financial obstacles of the key employee, it is important to structure the sale in a way that keeps the owner’s needs at the forefront.
How the Exit Planning Advisor Frames the Sale
Owners often underestimate what it takes to properly conduct the complex transfer of ownership to insiders. The structure and design of the sale is of utmost importance, especially when transferring to someone with limited financial resources. It is advised that owners stay in control of the business until they receive full value. Advisors should consider the following design tips:
The insider transfer exit path takes longer if the owner wishes to maintain control until they are fully paid. This can be a hurdle to owners who desire to exit immediately or in a brief timespan because the buyout period takes longer than it would if sold to a third party, for example. However, even if a business was sold to a cash buyer, an immediate exit won’t result in financial security for the owner in a short amount of time.
Businesses and owners need time – often years – to build value; take owner distributions from ever-increasing cash flow and invest them outside the business; and develop the capabilities of the management team and the business.
The Exit Plan can be designed so that owners sell incremental percentages of ownership based on whether key employees achieve their annual benchmarks. For example, an owner might sell 5% of their ownership to a key employee each year only as it achieves ever-increasing cash flow benchmarks. When benchmarks are designed and the key employee can achieve them, the owner is more likely to meet their goal of financial security. BEI provides the tools and resources to help advisors simplify this planning.
Option for retained ownership:
It is important to structure the deal to suit the owner’s financial needs and give them the option to sell to a third party at any point along the transfer continuum. Additionally, many owners choose to retain some ownership (5 – 20%) and/or remain involved with their companies as needed or desired. Retained ownership benefits several types of owners: those who want to remain involved if future growth occurs; owners who simply like being owners; or owners who want to contribute to continuously growing the business they started.
The Bottom Line
A sale of ownership to insiders can be fraught with risk if the overall picture, from company performance to individual tax consequences, is not considered. Comprehensive Exit Planning can take time or may require several perspectives, but the benefits can outweigh the costs for many owners, even if their desired successor doesn’t have the financial resources during the initial stage.
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