A Firm Conversion
The process of transferring ownership in a privately held company to the next generation is often a difficult and time-consuming task. Sometimes, there is an obvious leader that the second generation willingly accepts. At other times, there are several qualified candidates who undergo training and development until a leader emerges. In some cases, a leader must be brought in from the outside.
Considerable thought needs to be given to the process. Questions such as the following need to be addressed:
Most of these questions will be addressed in an ownership transition plan that provides for a smooth transition and allows the present owners to gradually reduce their involvement. The first step in developing the plan is to identify the successors and determine their interest.
Reconciling Different Goals of OwnersThe process of ownership transition recognizes that the goals and objectives of buyers and sellers are different. Sellers are generally retirement-minded and concerned with estate planning, since the bulk of their estate is often comprised of their ownership interest in the company. Retiring owners are also faced with the prospect of paying a capital gains tax on their investment. Sellers generally hope to sell at a premium above fair market value, which is defined as a price that is fair to both buyers and sellers. They justify the premium price as compensation for years of struggle to achieve the company's present status.
Buyers are generally younger and face different problems. They are buying homes and raising families. Usually they have no other source of income and require all of their salaries for living expenses. Most of these new owners have never acquired ownership in a closely held company. Many do not understand why it is important for them to become owners. Buyers often hope to buy at a discount below fair market value because of a perception that this is a reward for their years of effort.
A successful transfer can only be accomplished in an atmosphere of mutual trust. Sellers must be trusted to carry out the plan and turn over increasing responsibility to the new owners. Sellers need to recognize that the purchase price has to be affordable. Buyers must be trusted to continue to perform at a high level so as to generate the profits necessary to accomplish the transition. Buyers must understand the risks, as well as the rewards, of ownership.
The plan assures the continuity of the company and significantly impacts client relationships. Clients are much more likely to continue working with a company that is gradually transferring to the next generation rather than facing an abrupt change. In fact, the next generation within the client's organization is likely to be making a similar transfer. This allows individuals of similar ages and experiences to begin working together to extend the relationship into the future.
Another advantage of a smooth transition is that it allows older owners to gradually withdraw their investment while still contributing to the success of the company and training new owners. This is much more satisfactory than paying off the older owners after they retire. Younger owners tend to forget the terms of these agreements and may resent having to make payments to those who are no longer contributing to the company's success.
In addition, bringing buyers into an ownership position early allows them to spread their financial obligation over a longer period of time, which eases the burden. It also gives the younger people an incentive to stay with the company and to help it grow.
Funding the BuyoutBecause of the often limited resources of new owners buying in, the buyout options are often limited to using bonuses or bank loans.
Bonuses are the primary source of funds. However, this means using after-tax dollars, and individuals often need these funds for personal expenses. An alternative is to expect the new owners to forego salary increases as a source of funds.
Some companies expect the new owners to pay for their stock with funds borrowed from a bank. The loans are then repaid out of future bonuses. If bank loans are used, the company should make arrangements with its bank to permit employees to borrow at attractive rates. The stock is used as collateral for these loans, and the bank usually asks for the company's guarantee. In order to avoid any repayment problems, it is helpful to set up a payroll deduction plan whereby the funds go directly to the bank from salary or bonus checks.
Keys to a Successful TransitionFollowing are some considerations that will assist in a successful internal ownership transition.
Work within a strategic plan. The ownership transition plan should be a subset within the company's overall strategic planning process. Ownership transition is an important phase of the strategic plan.
Begin the transition process early. It is never too early to begin the transition process. Some owners are interested in early retirement, and others may be contemplating a second career in an unrelated activity. A gradual transition also allows for a change in leadership if the wrong person is selected at first.
Develop skilled managers. The second generation of owners must have management as well as technical training. That is, they must have an understanding and appreciation for financial management, human resources functions, marketing and other skills of a well-developed manager. It may be necessary to encourage the new owners to take courses and attend seminars to develop these skills.
Set a realistic stock price. Develop a stock valuation formula that is easy to understand and fair to both buyers and sellers. An alternative is to begin with an independent valuation of the stock and use the methodology developed by the appraiser as a formula for valuing the stock in future years.
Advantages and DisadvantagesInternal ownership transition offers several advantages. It encourages greater effort since new owners will work harder for a company that rewards them with an ownership position. This, in turn, improves employee morale and establishes loyalty to the company. Internal ownership establishes a continuity for the company that is easier for clients to accept.
The disadvantages of an internal transition are the uncertainty that the next generation will be successful and complete the transfer. Internal transition does not offer an immediate payout to current owners. Also, profits must be sufficient to pay bonuses for stock purchases as new owners rarely have funds of their own with which to buy stock.
A Communications Program Is EssentialA critical success factor in ownership transition planning is the establishment of a communications program. This program is designed to help new stockholders understand the benefits as well as the risks of ownership, and why it is important for them to own stock in the company. Normally, the objective of stock ownership is to achieve a return on that investment. However, this is not the case in a closely held company that usually pays no dividends. Instead, certain intangibles, such as the stature of being a company leader, and the likelihood of taking over management of the company in the future are what drive new owners to sacrifice immediate spending for long-term career objectives.
Sharing financial information on the company is essential when offering ownership to new people. Providing a monthly or quarterly review of financial information, such as income statements and balance sheets, keeps owners informed of the progress of the company. New owners also need to be briefed periodically by the older owners on the outlook for the company and what needs to be accomplished in order to meet objectives for the future.
New owners also need to be informed of how the value of the stock is determined. They need to be able to relate the value of the stock to the company's recent financial history. At the same time, discussions should be held on the options available for financing the stock purchases.