By John Henegar, CPA, CMA
TRANSITIONING YOUR BUSINESS TO MANAGEMENT
The spring edition of Decosimo Advisory Review introduced the concept of strategic transition planning, describing the three types of buyers for a privately held business: family members, the management team, and third parties. We included a case study about a transition to a third party. Following is an example where Decosimo assisted an owner/manager in a successful transition to a group of key management employees.
A transition of ownership and related chief executive responsibilities to management can be challenging, and it is important to formulate a plan well in advance of the anticipated change of control. Recently, the Chief Financial Officer of a large construction contractor called DAS for assistance in planning an ownership transfer. The founder of the company had created a successful business, and, while he did not have children in the business, he did have a seasoned group of key executives and managers whom he considered his extended family.
The tough work had been done: the founder had groomed senior management to handle the responsibilities of owning and operating the business, and he had decided that he wanted to retire in five years. This is not always the case, as we have seen instances where the current owner or owners do not want to give up control of their business, and they deprive the future owners of the opportunity to prepare for the transition. Such a lack of preparation can cause the future owners to see less value in owning the business and to be less interested in the company’s success.
THE STRATEGIC TRANSITION PLAN
Since the owner had already decided on the method and timing of the transition, we began determining the most efficient means of executing the transition. The sourcing of capital is a primary concern in all management transitions. Since the requisite capital is normally acquired or accumulated over a period of time, it is important that the plan address both employee retention and tax efficiency during the accumulation phase. With five years to retirement, the founder needed a comprehensive plan for transitioning the ownership of the company to management that would ensure that key managers stay on with the new ownership. The first critical questions/points that this plan needed to address were:
1. What is an appropriate price to be paid for the owner’s stock?
2. What mechanism should be in place to ensure the highest probability of retaining key managers?
3. In this particular case, bonding capability was a concern, so the plan had to operate within the financial covenants of the company’s bond underwriters.
To determine the answer to the first question, we were retained to perform a valuation of the company’s equity. After completing the valuation, we consulted with the founder and management to educate them about the value drivers in the business and the level of operational performance that would be required to support the transaction. Through their better understanding of the company’s value, the founder and management were able to agree on a price for the company’s stock, as well as better understand the ongoing capital needs of the business. In addition, this process assisted in identifying the key managers and their strategic importance at each level. This identification was critical in developing a strong and cost-effective retention plan.
THE STRATEGIC SOLUTION
Once value was determined, the owner was positioned to initiate the first phase of the transition: locking down commitments from key managers. It is critical that all the company’s key managers, not just those who are slated to become owners, buy into the process and stay with the company to insure smooth operations. To accomplish this, we brought in one of our business partners to design a unique non-qualified deferred compensation plan. The plan provided an incentive for the key managers to stay with the company without generating a deferred compensation liability on its balance sheet, which would have impaired the company’s ability to bond.
- The loyalty of the company’s managers was greatly improved. For example, one of the managers had tried for years to get life insurance, but had always been determined uninsurable. Since the plan was a “guaranteed issue” plan, this manager was able to provide a life insurance benefit for his family that was not otherwise available. This benefit was of great personal importance to this employee, and his loyalty to the company increased as a result.
- The plan benefit was non-transferrable; therefore, the managers were incentivized to stay with the company with a clear contractual understanding of the benefit they and their families would realize by remaining with the company.
- The company was better able to maintain its bonding capabilities. The structure of the plan allowed the company to transfer cash on its balance sheet to the insurance policy without a charge to earnings. Since there wasn’t a charge against the company’s net capital computation for bonding purposes, the company’s plan did not affect its bonding capabilities.
With the proper planning before a management transition, business owners can experience smooth, effective, and efficient transitions of their most valuable asset—transitions that maximize their after-tax proceeds and best position them for retirement. With such planning, the to-be-owners of the company can experience a stable transition of ownership and end up owning a stronger company—one whose value has been protected during the transition period.
WE CAN HELP
At Decosimo, our Strategic Transition Planning team consists of many experienced professionals with specialized knowledge in the various aspects of transitioning private businesses. Without the help of such a team, we believe it would have been difficult to structure a plan like the one mentioned above, which met the objectives of both the owner and the management team. If you would like to discuss the transition of your business to management, family, or a third party, please contact Decosimo’s Strategic Transition Planning team leader.
Mike Costello, CPA, ABV, CFF, CFE, ASA | Principal