Family Members (FBO)
Good news: It is easy to transfer a business to family members.
Bad news: Family members typically do not have the cash necessary to buy a business. Consequently, they not only pay a lower multiple of EBITDA but they also create a contractual agreement to purchase the company. This contractual agreement is typically called an “earnout.”
Definition: An earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings. If an entrepreneur seeking to sell a business is asking for a price more than a buyer is willing to pay, an earnout provision can be utilized. In a simplified example, there could be a purchase price of $1,000,000 plus 5% of gross sales over the next three years.
There are no hard and fast rules with the payout’s level dependent on a number of factors including the size of the business. This can be used to bridge the gap between differing expectations from the buyers and sellers. The earnout helps eliminate uncertainty for the buyer as it is tied to future financial performance. The seller also receives the benefits of future growth for a period of time (Investopedia.com).
Risk: The earn-out will mean the owner’s retirement income will be affected by the decisions of the children running the business. This loss of control may be infuriating, and the owners will not stay on the sidelines for long. (Sell Your Business Your Way, p. 83).
Risk: Owners who transfer their companies to family members typically are emotionally involved in the business for many years, even decades, after the sale is completed.
The seller’s retirement, or standard of living, is often subject to the way family members operate the company. It is normal for sellers to keep an emotional attachment to the operations of their former company that has been sold to family members. The seller may have continued and/or increased future stress instead of the desired rest and relaxation after a long career in the business.
Even if they may be able to restrain themselves from second-guessing their children under ordinary circumstances, they now have to protect their investment. This will give them reason to meddle in the operations and decisions of the children – after all, it is their money at stake! It can be much harder for the children to take charge in such circumstances.
Even if the owner is able to bite his tongue and watch as the kids make their inevitable mistakes, the earnout creates added pressure on the children. Children will feel the responsibility for supporting their parents and other family members. At the same time they are already assuming considerable pressure just in running the business, this is an added weight on their shoulders. It should be done with caution, and the family and emotional issues should be discussed explicitly (Sell Your Business Your Way, p. 83).
Risk: Business owners build key relationships. There may be risk if those relationships are not maintained after a family transfer. Owners who sell their business to family members might consider listing all the key relationships and other topics that have helped the business grow. Planning might be considered to help keep these key relationships in place after the sale to family members. Additionally, certain operational issues need to be considered.
Key Relationships to Consider
Bankers and Lenders
Does the seller have personal guarantees or personal assets pledged on loans? If so, will these be released after the sale to family members?
Bankers and Lenders
Are these relationships important to the continuation of the business? If so, who will be the person who maintains these relationships in the future?
Who currently has the relationship with key customers? Do those relationships need to change with someone inside the company in the future?
Who currently has the relationship with the key vendor? Do those relationships need to change with someone inside the company in the future?
Who has the current relationship with key professionals, such as attorneys, CPAs, webmasters, IT specialists, your company’s software, third-party administrators for retirement plans, etc.? Who is best in your company to build relationships with these key professionals in the future?
Will the legal entity and EIN remain the same after the family transfer? If so, what is the seller’s role in these tax returns (Income taxes, sales taxes, use taxes, payroll, foreign, etc.)?
How will the seller deal with the new owners and the risk of them burying personal expenditures in the Income Statement, which might have an impact on paying the earnout?
Financial Statement Accuracy
How educated are family members on interpreting financial statements, such as Balance Sheets, Income Statements, etc.? Who will be responsible for maintaining the future financial statements that will be used to calculate the payments on the earnout?
All of the important relationships the company currently has should be written down. A plan of action should be carefully considered prior to the sale.