Sorry, you need to enable JavaScript to visit this website.

Owner Dispensability: The Key to Transferable Value

Submitted by John Brown on Fri, 06/19/2020 - 11:00am
key

In our last blog post we met Ida and Gary Nella, the owners of a successful machine shop. During a meeting with an M&A advisor, they learned that their company—one that generated $500,000 in cash flow—had little value to an outside buyer. Because the couple was, in effect, the business, they needed to develop a reliable management team to continue the growth of the business. That team would be charged with improving operating systems and diversifying the company’s customer base. 

The Nellas offered positions to two skilled managers who wanted employment agreements to document their responsibilities, salary, and bonus arrangements. The story starts with the Nellas at their first meeting with Lisa Thomas, an attorney.

“As I told you on the phone,” Gary Nella started. “We want simple employment agreements for two new employees. The bonus we agreed on is straightforward: each will receive a bonus equal to 20% of the increase in cash flow over the previous year. How much will this cost?”

Ida Nella jumped in, “We think that if cash flow increases, it will make it possible for us to sell the business five years from now for all the money we will need.” 

Fortunately, the attorney that the Nellas selected was experienced in employment law. When he asked about the new employees’ responsibilities, he discovered that, in addition to managing the company, they were expected to: 1) create and maintain up-to-date operating systems to smooth the workflow in the machine shop; and 2) broaden the customer base. The Nellas wanted these employees to assume responsibility for the customer relationships that Ida and Gary had personally developed over the years. 

“Your M&A advisor gave you some great suggestions on how to become dispensable,” Lisa agreed. 

She could see that the Nellas were a bit taken aback so she continued, “Good operating systems, a diverse customer base, and a successful management team are three critical factors in creating and sustaining transferable business value. Businesses with transferable value are those whose owners are dispensable; meaning that owners can sell or transfer ownership with minimal disruption to cash flow, even after the original owners leave.” 

Gary replied, “I never thought of becoming dispensable, but I suppose that’s what we want. The question is: how do these employment agreements get us there?” 

Lisa explained, “We want to motivate these managers to not only grow cash flow and make it valuable to buyers, but also stay with the company during and after you transfer it to new owners. That’s why I recommend that you create incentive plans with vesting schedules and Non-Solicitation Agreements for both key employees.  Are you okay with that?" she concluded.

Gary and Ida looked at each other, nodded and asked in unison, “How much will that cost?"

When Lisa told the Nellas what they could expect to pay, Gary thanked her for her time and promised to contact her in the future.

As the Nellas settled into their car, they agreed that they could save some of their hard-earned cash flow by putting together a perfectly adequate, and much simpler, employment agreement using online document preparation software.

In our next post, we check in with the Nellas to see how the clear exit path they envisioned when they left the M&A advisor’s office took a few unpleasant twists after they left their attorney’s office. 

Takeaways

  • A business lacks transferable business value until employees (not just the owners) become responsible for successfully growing cash flow, managing, and improving systems, and installing robust value drivers. 
  • Advisors:  It is as important to prepare owners for the costs of preparing a business for ownership transfer as it is to prepare them for the costs of not doing so.


 Tags:

Ready to differentiate yourself?

Schedule a meeting to discuss planning solutions