FINANCE: Transferring the Business to Insiders: A Recipe for Disaster?

By Tad Lyle, Planning Resources Inc., Denver
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Steve Smith was no different than millions of other baby boomer business owners. The thought of leaving his business was never far from his mind, no matter how far away his exit might be. He daydreamed about transferring the business to his oldest daughter and perhaps to a member of his management team, yet he couldn’t gauge their passion for owning a business, and hadn’t tested their management skills.

And, of course, they had no money.

Steve’s company was his economic and financial lifeline. Without its income, without his ability to use the business to accumulate wealth, without the ability to sell his interest to a buyer who had cash, and without a plan, Steve’s wishes would remain wishes. To Steve, it was obvious that if he ever wanted to exit his business in style, he needed to wait for a white knight buyer to appear on his doorstep bearing saddlebags full of cash. So, Steve did what many, many other owners in his position do: nothing.

If you think that transferring your business to your children or to your management team is inherently risky, you are right. Insider transfers are risky because:

  1. Insiders have no money.
  2. Successors’ management / ownership skills and commitment to ownership may be untested.
  3. You lose control of the business if you make the transfer before you are completely cashed out.

On the other hand, the possible benefits to this type of transfer include:

  1. Keeping the business in your family or extending your legacy through your hand-picked management group.
  2. Motivating, retaining and rewarding key employees.
  3. Reaping more after-tax money than a third party transfer.
  4. Retaining control until all, or most, of the purchase price is received.
  5. Remaining active in the business while gradually reducing your day-to-day responsibilities.
  6. Providing time for you to build up personal assets (via distributions of cash) before your exit.

The trick is to design a plan that minimizes each risk so you can reap all of the potential benefits. Let’s first look at how that might be done.

1. Insiders have no money; therefore, it is too risky to sell to them. That’s true if you don’t design a transfer strategy that puts money in their pockets as they increase the value of your company. Years in advance of the transfer, you will have to work steadily and effectively to build cash flow (the source for all cash out) through the installation of Value Drivers and through careful planning to minimize taxation.

Unless you carefully plan to avoid it, cash flow can be taxed twice. This double tax (sometimes totaling more than 50 percent) can spell disaster for many internal transfers. Through effective tax planning, however, much of this tax burden can be legally avoided.

2. Successor’s management/ownership skills are untested. If that’s the case, create a written plan to systematically transition management and ownership responsibilities to your successor--beginning today. The transition period, during which you test both your assumptions and your successors’ skills, usually takes several years to complete.

3. You lose control before being cashed out. This is only true if you (and your advisors) fail to implement a transfer strategy designed to accomplish the opposite: you are cashed out before you lose control. In such a plan, you keep control, in part through a well-designed and incremental sale of the company, over time, based upon improving company cash flow over time.

The keys to reducing the risks of an insider transfer necessary to achieve success are:

  1. Plan the transfer well in advance of your desired exit date. Executing an insider transfer takes longer than executing a sale to a third party.
  2. Value building activities are just as—if not more—important to an insider transfer as they are to a sale to a third party.
  3. Plan design must be tax sensitive.
  4. The Plan must be in writing and make advisors accountable.

This type of planning does not need to take an exorbitant amount of time.  By working with a financial planner who is a member of BEI, you will be able to streamline the process.  Like I always say, “If not now, when?”

Article presented by Tad M. Lyle, Planning Resources, tad@tadlyle.com, a member of Business Enterprise Institute’s International Network of Exit Planning Professionals.

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