The Staged Buyout

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When it comes to succession, some business owners prefer to pass the business on to their employees. Instinctively, they know that this can be a very risky way to transition the business. On the other hand, they like the idea of passing on the business to employees because these are the very people that helped to make the business a success. I assist many business owners with planning and executing tailored business succession strategies.  In particular, one method I have used successfully is what I call the staged buy-out process. In that process I consider three critical elements. First, the need for the business succession plan to create an alignment of interests between the owner of the business and the proposed successor. Second, the need for the business succession plan to set measurable milestones to ensure that the proposed successor has financial targets to meet that will generate the income needed to buy the owner’s interests in the business. Third, the need for the business succession plan to provide “escape hatches” that will allow the owner to unwind the buyout if things were not working out as planned. When these critical elements are present, the likelihood of a good result is increased.

When effectively implemented, during the transition period this strategy allows the business owner to maintain the same flexibility and control he had over his business prior to implementing the succession plan. This is a key benefit in the staged buyout strategy but not the only benefit. In addition, the business owner always retains the option of selling the business outright to a third party. That’s good for the owner and the employees because, the proposed successor would also benefit by receiving value for the acquired interest.

The succession plan would also provide sufficient incentive for the proposed successors to put in the necessary time and effort to grow the business over the buy-out period without harming their chances of acquiring the business. In other words, the proposed successors wouldn’t be working against themselves by working hard to increase the value of the business. Under my plan the proposed successors would not have to pay for value that they had created upon the buyout. As a result, they would have sufficient incentive to add value and prove their worth as the successors.

I have implemented this strategy numerous times and it has been very successful. The first thing the business owner notices is that employees who had become shareholders express renewed interest in the business, are willing to put in longer hours and are invested in making improvements. These employee shareholders are also committed to meeting the financial milestones established under the plan, because failure to do so may result in the owner unwinding the entire succession plan. In reality, the unwinding of the succession plan would likely only happen following consultation with the employee shareholders and a review of economic conditions. The real objective of this plan is for things to proceed so well that there is no need for the owner to ever use his “escape hatches”. The staged buy-out can be so effective that year after year, financial milestones are exceeded by the employee shareholders, rapidly increasing the value of the business. The employee shareholders are happy about this because much of the increase in value can be attributed directly to their shares. This strategy is part of the “alignment of interests” concept I champion in the staged buy out.  In some cases, the plan is structured so that the owner also receives the benefit of the increased value of the business creating an even bigger win/win.

Business succession planning is not something to be taken lightly and the assistance of an experienced adviser to guide you through the process is a key factor in controlling how you exit your business.

Don Sihota is a partner of the firm and a member of the firm’s Private Company Transaction, Business Succession and Wealth Preservation Groups.
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