Buying the Boss Out
Have you imagined owning the company that employs you? Have you thought about the wealth that you could generate? This could be possible if you work for a small business in a management capacity and the owner is close to retirement. The information below provides a foundation.
Based on nature’s life cycle, the company’s owner is getting older. Every business owner knows that, eventually, everyone leaves their company. The retirement of a business owner is more complex than an employee and should be planned years in advance. The reality is that business owners do not plan. Not planning results in the business owners having less options.
According to a survey by the Financial Planners Association and CNBC, 78% of business owners plan to fund between 60% and 100% of their retirement from the sale of their business. Yet, 70% of business owners do not have a written plan for selling their business. A plan that is not in writing is a concept because it lacks details.
For many successful business owners, their business is their most valuable asset. According to a survey conducted by M&T Bank, 98% of business owners do not know the value of their business. Three reasons largely drive this. First, when real estate is sold it is advertised to the world on the internet, with lawn signs and word of mouth. Everybody knows it is for sale. Once it sells, the sales price is published in local newspapers and discussed among the neighbors. Any real estate agent can look up the sale price free of charge if you are outside the loop. Businesses are sold confidentially, so it is difficult to obtain information about similar sales. In addition, it is easy to compare houses in the same neighborhood and make adjustments for condition, bedrooms, and bathrooms. There are many more differences when comparing businesses ranging from gross sales, profit margins, location, number of employees, the skill level of the employees, types of clients, and so on.
Second, a formal business valuation can be expensive. Typically, business valuations start at $5,000 and increase based on the company’s size and complexity.
For small businesses that expect to continue to operate in the future, as in the past, we suggest a broker’s opinion of value. This is similar to a comparative market analysis (CMA) prepared by real estate agents before a property is listed for sale.
When a bank finances a real estate purchase, they order a formal, written appraisal to ensure that the bank is not lending more than the value of the real estate. If you are buying a business with bank financing, the bank will hire an outside, third-party valuation person to ensure that the bank is not lending more than the value of the business.
A purchase and sales agreement used to purchase real estate contains a clause providing the buyer the option of exiting the contract. A properly drafted purchase and sales agreement will provide the buyer of a business the option of exiting the contract if the business valuation is below the agreed-upon price.
The third reason business owners do not know the value of their business is time. Business owners are focused on the business’s day-to-day operations and do not invest the time to learn the value of their business.
The owner of the business is a successful person, that is why you have worked at the company for years. They have successfully guided the business through recessions, Covid, other challenges, and expansions. Yet, they fail to plan for their retirement.
This inclination not to plan is primarily believed to be emotional. Business owners spend more time working on their businesses than they do raising their children. Their business is like another one of their children. Many baby boomer owners started their businesses with an idea and have spent decades building it. Their identity is tied to the business. So, it is understandable why business owners do not want to let their “baby go.”
Second, some owners fair the unknown. They do not know what they will do in retirement, which makes them nervous. This can be mitigated if they have a plan. (Playing golf every day doesn’t count.) Beyond traveling and spending time with family, we suggest volunteering, mentoring students, writing a book, taking classes, and developing a hobby.
Business owners need to determine if they are going to leave the business on their terms or let things happen by default. This results in you having an opportunity to purchase the business.
The Obstacles and Solutions
Your first obstacle is getting the boss to consider selling the business to you. Most business owners overlook employees believing they don’t have the money to purchase the business. The reality is that most buyers don’t have the money. Like them, you will borrow it.
The Small Business Administration (SBA) helps facilitate the buying of businesses with very flexible loan terms. The SBA’s Standard Operating Procedure (SOP) allows the buyer to invest as little as 10% of the “project cost.” The word “project cost” is used because the SBA SOP allows the bank to provide money for working capital and closing costs. For example, if the closing costs are $20,000, the working capital needed is $100,000, and the price of the business is $880,000, the total project cost is $1,000,000. The buyers’ equity injection (down payment) would be $100,000. Many employees have this in the equity in their homes or retirement accounts.
Also, according to the SBA, lack of collateral is not a reason to decline a loan. The business is the collateral for the loan.
The SBA guarantee is for the bank and not you, the borrower. The SBA generally covers 70% of a bank’s loss. So, the bank does have some risk. Yet, at the same time, they receive all the loan’s interest. This results in banks having different levels of risk tolerance. Most banks prefer to lend on hard assets such as commercial real estate. Other banks with a higher risk level may require a larger down payment and require the buyer also to have working capital to mitigate the bank’s risk. Selecting a bank for business acquisition financing is of utmost importance. See our article on Business Acquisition Financing for a more detailed discussion of this issue.
The second obstacle is the business owner’s confidence in your ability to operate the business. Let’s acknowledge that the business owner doesn’t believe that anyone can operate the business as well as they do. That said, the owner has developed incredible business knowledge, and you should learn from them.
If the owner is not ready to sell, suggest they use the time to teach and mentor you to become a business owner. If the business owner is ready to sell, suggest that you hire him/her as a consultant to teach you to manage the business. The owner can work part-time, which makes their transition to retirement easier.
Many prospective employee buyers make the mistake of suggesting that the owner should be their bank, and they will put some money down. They then propose making payments based on the income the business generates. We call this installment loan structure the “Daddy Loan” because the owner is giving up control and has most of the risk. As noted above, most business owners expect to fund 60% to 100% of their retirement income from the sale of the business. No advisor would recommend/allow such a concentration of risk in a single investment.
It is different if the owner provides a loan for a small portion of the purchase price. When a transaction is larger or has more risk, a bank may request that the seller provide the buyer with a loan. This is typically a maximum of 10% of the purchase price or to assist with working capital. This should be suggested by the bank and not you. If you selected a bank comfortable with business acquisition financing, typically, seller financing is not a factor.
The third obstacle is the purchase price. The value of a business is determined by the amount of cash it generates and the type of business. An engineering firm and a law firm with the same number of employees and gross sales will have different values. All decisions concerning the value of the business will be based on the filed federal tax returns of the business.
Because you will not have the tax returns before you speak with the owner, contact an advisor to determine value. The advisor will use the rules of thumb as a starting point. Remember, the owner probably doesn’t know the value either. However, if the business has a value of $2,000,000, you don’t want to start a discussion thinking the value is $500,000.
After you have an indication value, tell the owner that you spoke with an advisor about purchasing the business and bank financing for buying the business. Then hand the owner a signed confidentiality and non-disclosure agreement.
In almost every case, the owner will respond by requesting time before a discussion. If the owner does engage, do not discuss the sales price. Tell the owner that the business will be valued based on the filed federal tax returns. If you are comfortable, ask the owner for the gross sales of the company and the filed federal business tax returns.
If you need help buying your employer, contact Allen Business Advisors.
See our article, the 8 Steps to buying a business. https://www.allenbusinessadvisors.com/8-steps-for-buying-a-business