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When designing Exit Plans for clients who want to transfer ownership to key employees, it is important to consider seven challenges inherent to such a transfer.
This post will address these challenges and provide information on how to best avoid them.
1. Employees Are Unprepared to Put Skin in the Game
Transfers to insiders are not charitable donations. When considering a transfer to insiders, owners must know whether employees to whom they want to transfer the business are prepared to personally guarantee both the loans required to purchase shares of ownership and the funding required to assure ongoing operations. If employees are not willing to provide these necessary investments, then a successful transfer to insiders is impossible.
According to Greg Banner, a BEI Member, most owners fail to notify the key employees to whom they want to transfer the business of their intentions; they simply assume that the employees have equal interest in buying the business as they do in selling it. Greg once sat in on a meeting in which an owner presented a key employee with an opportunity to purchase the business when he was ready to exit. The key employee told the owner that he had no interest in taking over, instead preferring to collect a paycheck, do his job diligently, and not deal with the headaches of owning and operating a business.
Thus, it is important for owners to assure that their targeted buyers want to buy in the first place. Additionally, owners must obtain personal guarantees that insiders will pay off all loans to purchase the business. Failing to do so puts the owner at risk of not being paid the full sale amount.
Finally, one of the most effective transfer plans requires key employees to obtain bank financing to purchase an owner’s remaining ownership after the key employees have gained sufficient experience and have substantial ownership. Banks will require personal guarantees from these key employees. Only at this point (when owners have received the balance of their “purchase price” via bank financing) will control of the business transfer to the new owners. Before losing control, owners should insist that all debt, leases, and bonds that they’ve signed and guaranteed personally be transferred to key employees.
2. Getting Paid
Not getting paid for selling the business to key employees is a risk similar to assuring that key employees are willing to secure debt to purchase ownership. However, unlike assuring that key employees are willing to put skin in the game, this challenge can be overcome through strong planning well before the owner’s exit date. A good plan gives key employees the time to accrue the necessary funds to purchase ownership, test themselves to prove that they have what it takes to be owners, and prove their ambition.
3. The Business Is Not Ready to Run Without the Owner
Too often, owners set premature exit dates that don’t allow transitioning owners to prepare themselves for the role properly. Businesses need to be weaned off their dependence on the original owner just as the owner needs to wean him or herself off the business. Thus, owners must give their successors adequate time to gather enough guidance, leadership experience, and expertise to run the business smoothly.
4. Owners Are Ready to Exit Now
It is imperative that, as Exit Planning Advisors, we help owners initiate their Exit Plans long before they are ready to exit. The best transfer designs follow three guiding principles: minimizing risk, maximizing value , and allowing the owner (i.e., your client) to maintain control of the business until he or she receives the cash to achieve financial security. Since the transfer process often takes 5–10 years from initiation to complete cashing out, most owners will need to stay active in their businesses until their successors are ready to take over.
5. New Ownership Is Untested
Working for an owner and becoming an owner imply vastly different responsibilities. As Exit Planning Advisors, we must be certain that owner-clients are confident in their preferred successors’ abilities to run the business once they’ve exited.
6. Cash Flow/Growth Is Inconsistent
Businesses with inconsistent cash flows are poor candidates for not only insider transfers but transfers in general. Cash flow is a key element to a business’ value, and inconsistencies in cash flow must be addressed well before considering any kind of transfer, especially an insider transfer. Common designs for transfers to insiders require consistent cash flow as a performance measure to be achieved before the business is eligible for a transfer to key employees.
7. I’m Using My Own Money to Buy Myself Out
Some owners suspect that a transfer to insiders is simply a way to use their own money to buy themselves out. This is only true if owners and Exit Planning Advisors have failed to create a comprehensive transfer plan that reflects the owners’ Exit Objectives.