We work with a lot of family-owned businesses on transition planning and structuring. And while we spend a great deal of time with the exiting senior generation (G1), an important element of our work is focused on the next generation who will be taking over the business (G2). It is very important to include G2 in these planning and structuring discussions, since they will ultimately be running the business and tasked with meeting the obligations related to the buyout of G1. This is not an insignificant milestone for G2, since taking over the business is a big step and it is often the largest single transaction they will participate in until it is their turn to exit.
A well-structured transaction is one that is fair for all involved and avoids putting the company in harm’s way. The critical elements of a transaction include a clear understanding of the relative valuation, the financial capacity of the company, and G1’s financial picture in retirement.
Note that there is one very important item missing from this list - the financial capacity of G2! G2s often have a misconception that they will be expected to come to the plate with a lot of cash to finance the transaction. In fact, this is rarely the case because G2s generally have not yet accumulated enough wealth to put significant, meaningful money on the table.
Instead, these transactions are usually structured so that the company funds the payout to G1 while G2 assumes the role of running the company. The key advantage for G2 is that they have an opportunity to purchase an operating business with relatively no money of their own at risk. This is a unique feature of these types of transfers and not the case at all in transactions involving unrelated parties. In fact, if you find someone willing to sell their business for no money down and take a 100 percent seller note, let me know.I would take that deal!
However, I’ve found that G2 often does not realize that in most cases, they will be able to buy the company without using their own capital. Normally, their only commitment will be to run the company and repay the exiting G1 owners.
So how can G2 create value for themselves and their families in these transactions? There are two ways: First, for every dollar of debt they pay down to G1, they are putting a dollar in their own pocket. For example, assume the company is worth $1,000,000 and the transfer is 100 percent financed with G1 debt. The value of G2’s investment is zero at the start, since the equity is fully encumbered. If the note is fully repaid in seven years, then the $1,000,000 value will belong to G2 (assuming they have kept the business steady and have not done anything to increase or decrease its value).
This brings us to the second way G2 can create value in the transaction. Using our same example, if G2 hustles and works hard over the seven year timeframe to build the business to $2,000,000, then G2 gets the benefit of that increased value on top of the debt reduction.
Family transfers are complex and not without risk to either party. While G1 is often betting their future retirement on G2’s ability to continue to run the company profitably, G2 is also taking on the risk that they will be capable of doing so. However, G2 has a significant opportunity to create wealth for themselves given that they are buying an established operating business without risking any personal capital. While some risk exists, it is substantially lower than buying a company from an independent party.
G2 often sees only the risks, because it may be the first time they are entering into a transaction of such magnitude. The key for G2 is to also consider the upside, which can be substantial if the transaction is properly structured and they are willing to work hard to build the business.