Navigating Business Transfers to Insiders Lacking Financial Resources

Fri, 06/03/2022 - 11:36

Written by: mernzen

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.  

The Top 9 Ways to Increase Business Value

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:  

Time:  

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.  

Benchmarks:  

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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Navigating Business Transfers to Insiders Lacking Financial Resources

Who Should Take Over the Family Business? Key Factors to Consider

Mon, 12/20/2021 - 08:00

Written by: JMongaras

Business owners often dream of working side by side with their children in their family business. Unfortunately, this idea is often plagued with unexpected challenges: what if the child doesn't want to run the business? What if they're happy to, but lack the skills?  

Many times, internal family stresses often spill into the business and vice versa. All these challenges affect the succession planning process, which is often delicate and time-consuming. When clients turn to you for advice about their exit strategy, here are some crucial points to consider.  

Key Challenges of Succession Planning In a Family Business  

Three common scenarios that can disrupt family businesses during Exit Planning.  

Heirs Lack Relevant Leadership or Knowledge  

Problems arise if the children don’t have the necessary skills to take over the family business successfully. Most often, children pursue other unrelated careers that don’t transfer easily. For example, if the kids studied medicine or law, it’s tough to leave those careers to run the family restaurant or accounting firm.  

Heirs Prefer Not To Work with Their Parents  

It seems obvious, but this needs saying: parents and children are separate individuals. Sometimes the next generation has absolutely no desire to follow in their parents’ footsteps.  

Others may agree to run the family business but feel trapped in their duties. It ultimately harms the company and adds unnecessary stress to the family.  

Parents Prefer Not To Work with Their Children  

Parents may feel resentful of their child’s success in one branch of the business. They may dislike the direction in which the child is driving the company. Parents might believe that family wealth leads to laziness, and therefore stifle their children’s efforts in the family business. They may simply underestimate their children’s abilities.  

All these are reasons why parents may opt not to involve their kids in the company, even if they are willing and able.  

How to Overcome Exit Planning Challenges   

If there’s no clear way for the children to participate in the family business, there are several options you can take to ensure the long-term success of your client’s business.  

Speak Honestly About the Family Business  

Be open with your client about the realities of family business succession. In many cases, the client failed to gauge their kids’ interest in the family business. It’s always best to have this conversation early in the Exit Planning Process before you take your client down a path that isn’t right for them and their family.  

If the children express interest in another line of work apart from the family business, guide your client to alternative avenues for succession.  

Discuss the Alternatives Available for the Business  

The kids could own but not run the business or serve as board members. Your client can also sell the company to someone outside the family, usually a key employee or third party. All these options need a clear transition strategy with the help of an Exit Planning Advisor.  

Give yourself plenty of time to work on a transition plan since succession doesn’t happen overnight. Remind your client that they are also responsible for their employees, not just for their children in the business. The impact on all parties should be considered in the Exit Planning Process.  

Accept that the Child May Not Be the Best Fit for the Business  

Sometimes, parents may have to fire their children to protect the business. This is a tough decision, and it can have lasting consequences for both the family and the company. However, if their leadership style isn’t working out, and there’s proof of this in the declining bottom line or high turnover rates, the child can be justifiably relieved of their role in the family business. By letting the child run the business before giving up complete control, business owners can see if their wishes for family succession can come to fruition.  

Get a Concrete Valuation of the Business 

Exit Planning should always begin with a solid idea of how much a family business is worth. This, in turn, affects how your client plans their estate, regardless of the children’s participation or lack thereof in the family business.  

Conclusion: Put the Family First 

Choosing a family member to take over a business is always a big decision, but ultimately, there are two things to keep in mind. First, there are viable alternatives if there is no suitable heir to a family business. Secondly, your client will want to continue having a productive life with their family outside of and after the company. So even if there are challenges in choosing a successor, the owner's Exit Plans should always consider maintaining family harmony. With these tips in mind, you can make the best possible recommendations for the long-term success of your client’s family business.  

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Eight Questions to Ask Your Client Before Their Child Takes Over the Business

Fri, 12/10/2021 - 08:00

Written by: JMongaras

Someday, perhaps soon, your client will want to step down as the leader of the family business. If they are like many parents who lead a family business, they have probably always dreamed that one of their children would pick up the reins when they didn’t want to lead anymore.  

Unfortunately, succession in a family business is not always as simple as these clients would hope. Taking the time to gather information from your client early in the Exit Planning Process will save your time and their money in the long run. Therefore, before your client hands the family business off to a child, there are eight questions that you should ask your client, to make sure they are ready to pass on their business to their child. 

Is running a business the right choice for your next generation? 

This first question is so important. Ask your client to reflect critically on their time in the business. Was it a happy part of their life? Is this type of work what they want to encourage their children to pursue? If your answer is yes, it’s time to have an open conversation with the next generation about running the family business. 

What has this person the chosen successor said about running the family business before? 

In their conversations with their child about the family business, what has the child said throughout their life about running the family business? If the child had always been disinterested and has suddenly changed their mind, explore that decision with them.  

Make sure that the child does not feel obligated to take on this responsibility because this will only lead to more conflict in the long run. 

Is Owner the right role? 

As they talk to their child about the business, ask your client to figure out where the child would best fit into the business. Don’t assume that they will want to lead the business before talking to them about all their options. Many people want to take a back seat role, so they can focus more on their own family.  

Are there other relatives who are more interested? 

If the child is not interested in taking over as an owner, or is not interested in the business at all, that does not necessarily mean that your client must sell to a third party. Many nieces and nephews are fantastic at running the family business could also be a good candidate to take over the family business, and that power transition can be quite comfortable for some families. Don’t be afraid to think creatively about succession planning if your client insists on keeping the business within the family. 

Does this person understand the values the business was founded on? 

Often, conflicts within family businesses come when different generations have different ideas of what the business should value. For example, perhaps the older generation was more focused on the bottom line, and the younger generation is more interested in communication and customer engagement. Before your client passes on the family business, make sure they have a conversation with their child about the values that the business was founded on. If it’s important to keep those things values intact with the next owner, a different exit path may need to be explored. 

If you set aside your view of what the business should be, could you see a way the business could grow under this person? 

The new generation having a different view of how a business will succeed is not always a bad thing. Often, when there is a disconnect between generational values in a family business, it is because the younger generation has a better sense of what people need from the business today or have ideas for innovation that their parents just couldn’t see may not have ever thought of.  

This is often difficult for a patriarch or matriarch to handle because they want to believe that the business will stay the same in their child’s hands. However, it is important to ask your client, “what could your child bring to this business if you got out of the way?” 

How well will you work together during the transition? 

Even if the generations agree on the values and direction of the business, the transition can still be difficult. We all know that the best leadership transitions are gradual, so with that in mind, how well can your client work with their child during the transition? 

Will your business relationship jeopardize your personal relationship? 

Running a business together and transitioning power from one generation to the next can often put a strain on personal relationships. Therefore, for this transition to be successful, both your client and their child need to be able to set aside their personal relationship during business hours and set aside business conversations at family gatherings. If they feel that they can do that, you are on the right track. 

As you create an Exit Plan for your client, there are many things that you need to talk to your client about, but by far the most important thing you should remind your client of is: how their child feels about the business is not how they feel about their parent. If the child is interested in running the business, a parent can create a transition plan that works for everyone, and if they aren’t, that is alright too. 

If you are interested in learning more about how to manage your clients’ Exit Plans and a process to ensure all their goals are met, check out our upcoming Exit Planning Boot Camp

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Sales to Co-Owners or Key Employees: The Disadvantages 

Fri, 01/29/2021 - 08:00

Written by: eswanson

In the previous article, we examined the main reasons owners choose to exit their companies via a sale to insiders. Today we look at the other side of the coin: the disadvantages. 

Owner’s Financial Security 

Owners may receive little or no cash up front. The buyer’s source of funding, at least initially, comes from the future earnings of the business after the transfer begins. If business cash flow is inconsistent or does not grow as projected, this transfer may not work or take longer than planned. 

The Time Factor 

It takes owners longer to exit using this path than other paths if they want to maintain control until they are fully paid (which we strongly suggest). This is a huge hurdle when an owner needs to exit immediately. It usually takes longer to get paid than it does when they sell to a third party. As is true in a transfer to children, a longer buyout period exposes the owner to a longer period of general business risk. 

The Time Margin 

Owners run the risk of spending more time than they may wish on developing the ownership and management skills of incoming owners. If there are multiple incoming owners, any squabbles or conflict will likely require the owner’s time and involvement.

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Tax Consequences 

Without proper planning, the tax consequences of this type of transfer are significant. Paying unnecessary taxes also negatively impacts the company’s cash flow. 

Achieves Owner’s Values-Based Goals 

There are normally no disadvantages to an owner related to attaining values-based goals unless the successors want to take the business in a different direction. 

Successor 

Key employees, unlike co-owners, are often employees because they don’t have an owner mindset. 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 as guarantees to secure the financing necessary to purchase ownership.   

Benefit to the Advisors  

The benefits to advisors in discussing possible disadvantages in this and the other exit paths is straightforward: it aligns your interests with the owner’s. That’s why we call our version of Exit Planning “owner-centric planning.” This will in turn create a strong relationship with your business owner clients when they can trust you and you can share the same goals.  

As we noted in the prior article, there are several benefits to advisors who help their clients transfer their businesses to insiders, but we must be able explain the disadvantages of this exit path as well. Only then can our clients make an informed choice of the exit path that best meets their goals. 

Follow us on LinkedIn, Facebook, and Twitter to stay up to date on all current Exit Planning news and trends. 

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Transferring the Family Jewel to Children: The Disadvantages

Fri, 01/15/2021 - 08:00

Written by: eswanson

In our previous article, we listed the numerous benefits to owners (and their families) who transfer their businesses to their children. In this article we ask, how can an exit path that has so many advantages crash so often and so spectacularly into the brick wall of reality? The following reasons come immediately to mind.

Financial Security

Basing a business transfer on family ties, especially ties to someone who can’t or won’t run the business properly can threaten not only the owner’s financial security but the very existence of the business. Family dynamics can cause owners to transfer voting control to children before they achieve financial independence and before their children are prepared to run the company successfully.

The Time Factor

Getting paid full value for a company generally takes more time in a transfer to children than it does through a sale to a third party or a sale to an Employee Stock Ownership Plan (ESOP). The longer the buyout period, the longer the parent-owner’s financial security is exposed to general business risk. Another recession, pandemic, or a new and stronger competitor entering the marketplace puts the owner’s (and their family’s) financial security at risk.

The Time Margin

If children can’t run the business without the parent-owner remaining at the helm or are squabbling with one another (or the owner) in the business, the owner’s time margin (the period of time owners have to prepare themselves, their businesses, and their children) may disappear.

Tax Consequences

Without careful tax planning, owners and children can pay far more in taxes than necessary.

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Value-Based Goals

  • Family harmony - If children don’t get along well with each other when they aren’t working together, how will they likely behave when they are? These children generally act like children—not owners—when making business decisions. 
  • Family discord - Transferring ownership of the family jewel—the family business—to children often exacerbates existing family friction, discord, and perception of unequal treatment among siblings, between parents and children, and between owner and spouse. Have we left anyone out? Oh yes: you need to consider friction among sons- and daughters-in-law who we refer to as “The Gatekeepers to Your Grandchildren.”
  • Blood is thicker than water, in so many ways - Communication among family members is emotionally loaded in a way that it is not between unrelated third parties. If not managed early, correctly, and continuously, it can create or add fuel to the family discord described above.

Successor

The designated successor (the child(ren)) may not share the owner/parent’s vision of the business’s future. In addition, the only people happy with the owner’s choice of successor may be the owner and the selected child. The rest of the family may not be happy at all. Don’t be surprised when owners in this situation attempt to shift the blame for their choice to their advisors. The successor (child/ren) does not have the owner’s desire, ambition, or aptitude for running the business. Parents too often overlook behavior from their children that they would find unacceptable in a non-family successor.

It’s important, when representing owners who are considering this exit path, to review these potential disadvantages. Even if properly designed and implemented, transfers to children cannot avoid all of these problems. When owners conclude that the disadvantages or risks of this exit path are too great, you may wish to recommend that they consider alternative paths.

The benefits to advisors in discussing with owners the possible disadvantages inherent to this and other exit paths is straightforward: you align your interests with the owner’s and demonstrate that our version of Exit Planning is truly owner-centric.

If you would like information about the variety of designs and tools that trained Exit Planners employ in successfully transferring businesses to children, please contact a BEI representative

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Behind the Scenes - Family Meeting

Fri, 12/04/2020 - 08:00

Written by: eswanson

BEI is pleased to announce the launch of our new blog series, Behind the Scenes. In this series, we will interview various professionals that work in the area of Exit Planning, whether by supporting advisors in the work that they do or with business owners directly. Our hope is that by sharing the interesting stories and unique challenges that each of us can relate to, advisors can gain insights and learn from the expertise of their peers.  

Clarke Langrall Jr., CEPA, President and CEO of Forecast Strategic Advisors, has worked in the financial services industry for the last 45 years. Clarke is a published author of several books and articles on the topic of the importance of planning for the “ultimate” event—a successful transition by an owner from their business. Clarke is the author of the book The Underwriters Guide to the Federal Civil Service Market as well as numerous articles on owner Exit Planning.

Clarke is a past President and Chairman of the board of Forum 400, the founder of the Science and Technology Council of Maryland, and a founding member of the Baltimore Angel Investor Group.

As an experienced advisor, Clarke credits his success on his focus on the different strategies he uses to facilitate the business owner toward their goals of selling their business on their terms. In the words of John Brown, "How to run your business so you can leave it in style."

BEI: Why did you decide to work with business owners to help them exit?

Clarke: Exit Planning has been my primary focus for the 45 years I have been serving business owners. Early in my career, I primarily gave advice to owners on risk mitigation for themselves and for their businesses. It wasn’t until about 15 years ago that my focus shifted to broader picture planning. These comprehensive Exit Plans highlight every issue my clients might encounter during the entire process and include recommendations to keep them on their desired timeline. By delivering more complete plans, I can suggest the best routes for my clients to take with their transition out of business and ultimately have a successful exit. My team and I have assisted hundreds of owners in monetizing their most strategic financial asset—their business.

BEI: Tell us about an unexpected challenge you have encountered working with business owners. How did it impact you or your practice and how did you overcome the problem?

Clarke: In my experience, unexpected challenges occur often when working with family-owned businesses where the founder of the business has an entirely different view of the business than the next generation of successors do. Far too often during the planning process we discover a lack of communication leads to all parties involved having very different plans for the business and goals for the future. If the communication issue is resolved early, this can be the tipping point of the entire planning process. Communication is key during any ownership transfer but introducing family dynamics makes the situation that much more emotional. We have found the best way around this issue is to hold a family meeting and have an open dialog with all parties as early as possible to ensure everyone’s goals, perspectives, and opinions are heard and aligned. Everyone’s viewpoint needs to be communicated clearly and accounted for to develop a unified path for the future of the business and for the family.

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BEI: How has your involvement with BEI impacted your practice?

Clarke: I attended a BEI Exit Planning Boot Camp with John Brown in the early 2000s. In this training, I realized John’s vision for an entirely new discipline of Exit Planning for business owners. Exit Planning filled a critical void that business owners had never properly addressed for 100+ years. John was the agent of change that brought to light the importance of planning for an ownership transfer years in advance. The Exit Planning industry has changed immensely just in the last 20 years. Previously no one could describe “Exit Planning,” and few advisor practices, if any, were focused as a discipline to the ultimate and inevitable event of selling one’s business. Kudos to John Brown and his impact on the community.

Clarke is a valued member of the BEI community and we appreciate his behind the scenes look at his practice and involvement with business owners. For follow up questions you may have or to follow his story, please connect with Clarke Langrall on LinkedIn.

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5 Insider Transfer Challenges for Business Owners

Fri, 01/19/2018 - 10:00

Written by: eswanson

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:

  1. Maximize the amount of money the business owner receives.
  2. Keep the business owner in control until he or she receives all monies.
  3. 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:

  1. 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.
  2. 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.
  3. 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.

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3 Risks of Transferring Business Ownership to Insiders

Mon, 10/27/2014 - 13:24

Written by: eswanson

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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