In this post, we will discuss the key expectations both owners and successors have when owners transfer their businesses to insiders. As Exit Planning Advisors, we must remember to ask the following five questions when a business owner approaches us with interest in selling the business to insiders:
- Will this Exit Path meet the business owner’s goals?
- Will the owner exchange time for risk?
- How much risk can the business owner stomach?
- Has the owner any made promises?
- How old are the intended successors?
Once you’ve answered these owner-centric questions, you can move on to the following three successor-centric questions.
Assessing the Successor
- Are the intended successors capable of being owners?
Though business owners may have a specific person or group of people to whom they want to transfer the business, we as Exit Planning Advisors must first question whether their choice of successors would make for strong owners. It is important to directly ask business owners whether they believe their chosen successors would make good owners. If they say yes, we need to ask them why they think so. Additionally, we can ask for evidence of their belief. For instance, you can ask whether the business owner has ever left the business in the successors’ hands for an extended period and, if so, what the state of the business was upon the owner’s return.
- If capable, do the successors want to be business owners?
We must make sure that owners are positive that their preferred successors want to be owners. Some key employees are happy being no more than employees or have no desire to own a business and deal with all of the work, stress, and time that go with it. In order to be a strong business owner, successors must have the same spark and commitment to success that the owners had when they founded the business, no matter the cost.
- Do the successors understand the risks inherent in ownership?
Most employees are both capable and willing to own a business until they realize that they need to invest their own money to become owners. Ownership transfer is not a charity: Successors are expected to put their own skin in the game. Successors will need to use personal funds (or, more likely, loans) to fund the initial ownership interest and, occasionally, ongoing operations. It is critical that owners bring this fact up early in negotiations: Many willing and able successors have balked in the face of putting their own skin in the game.
Business Owners’ Expectations
Some owners expect that their successors will willingly accept the risks inherent to owning a business in return for the privilege of buying the business’ stock at “bargain prices.” Such business owners tend to believe that key-employee group (KEG) members do not become true owners until they bear the brunt of the risk of owning a business, especially during cash flow slowdowns. When working with clients who hold this belief, you should make sure to clarify how must risk the owner-client expects his or her successors to assume. It is important to ask owner-clients whether they expect their successors to rely solely on future cash flow as the means by which to pay them for ownership transfer or on other assets.
The following two suggestions can help your clients determine how to approach this issue:
- Suggest that business owners require KEG members to use their own money as a down payment for the initial stock purchase or that each key employee use personal collateral (e.g., a house) as security for any installment notes they commit to.
- Suggest that business owners require KEG members to obtain a bank loan for the entire amount of the transfer down payment (with or without the business’ guarantee).
The Minimum Value Conversation
As an Exit Planning Advisor, you are the best resource to explain to successors that they will have to use personal assets to initially buy and perhaps fund ongoing business operations. Additionally, you will be the best resource to explain the importance of setting a minimum value for the business to owners and their successors.
Though Exit Planning Advisors understand the role a low enterprise value plays in insider transfers, most business owners do not. Even owners who do understand the role of low enterprise value might not find such a low value emotionally acceptable: They might feel that they are giving a piece of the business away. Thus, you must accurately and persuasively assure business owners that using the lowest allowable enterprise price (as permitted by a qualified appraiser) is the best route for them to receive the maximal amount of money for the business.
Using the lowest allowable value for initial ownership purchases allows more of the business’ cash flow to be paid directly to the owner, who then pays a tax on that amount. Therefore, a smaller amount of cash flow needs to be diverted from the business to be paid to the successor—who is taxed on that amount—before paying the net amount to the seller, who is then taxed on the gain. Using a properly designed low defensible value reduces the amount of cash flow the business needs to create to pay the owner (i.e., seller) the same amount of after-tax money.
When you work with business owners who intend to transfer the business to insiders, always remember to complete the four following tasks when learning more about the owner-client:
- Assess the prospects for success.
- Assess the intended successors.
- Extract the owner’s expectations.
- Explain the role of minimum value.
For more information about transfers to insiders, contact us today.