The following is an edited excerpt from the book, Buying Out the Boss: The Successor’s Guide to Succession Planning, by Michael Vann and Kevin Vann.
KD Dynamics Tool Company, a precision manufacturer of engine components, took us on a wild ride through the transition process and back again. The company was started by a very successful entrepreneur who had a number of business interests that were occupying his time and energy. A key employee wanted to buy the business. The entrepreneur wanted to sell, the employee wanted to buy, so they made a quick deal.
The problem was, it was a top-of-the-market deal that was highly leveraged. The buyer was in way over his head, but he’d been running the business and thought he could manage the payments. He was confident, the banks were confident, and the deal went through. Six months later, the recession hit, the business tanked, and the bank foreclosed.
What went wrong?
The inside buyer was too confident. He placed too much emphasis on his knowledge of the opportunity rather than exploring the risks. He didn’t look at the risk factors and didn’t take into consideration the reality that he was undercapitalized. He anticipated growth, which would allow him to pay off the purchase, but he left himself with no room for error and no room for the unanticipated. Because of the recession, the business declined and couldn’t survive with the debt load.
The original owner was able to buy the business back from the bank for pennies on the dollar. Today, he once again owns the business — and the buyer is back to working for him. The company is doing very, very well. The big loser was the bank, of course, but also the buyer. He had put up his house as collateral and had also borrowed heavily from family. When he went into personal bankruptcy, he had some severe financial and family pressures as a result of the deal.
An insider buying out the boss is in a different position than an outside buyer.
As an insider, whether you’re a longtime employee or a family member, you know the business. You know things that someone on the outside doesn’t. That creates both a tremendous advantage and an unexpected disadvantage when you’re thinking of buying the business.
On the plus side, you know things no outsider can know. You know where the bodies are buried; you know the personality traits and the quirks of the owners and other employees, and how to push their buttons. The disadvantage is you know these things. Sometimes that can cloud your judgment.
Your relationship with the owner might be good, it might be bad, or it might be love-hate. Whatever it’s like, your personal biases can put blinders on you when it comes to handling the sale. You may think you know the seller well, but you’ve never dealt with them in this situation. Quite frequently, buyers are surprised when it comes to talking money with the seller. As soon as the discussions start, the dynamics in the relationship change.
The seller’s objectives ultimately are to maximize the price and protect their interest. Likewise, the buyer’s objectives are to minimize the price and protect their interest. No matter how close you were with the boss, you now have competing interests. That puts a lot of pressure on the working relationship.
There’s more at risk with an inside sale. If somebody from outside, whom the seller doesn’t know, tries to make a deal and it falls through — well, it falls through, and there are no hard feelings. But if an employee or a family member tries to make a deal and it falls through, that individual is still working for the seller. What happens to their relationship and their job, then?
We worked with a business in which the kids were negotiating to buy from their parents. We put a fair market value on it, but the father said, “This isn’t enough money. You want me pushing carts at the grocery store when I’m seventy-four years old?” The kids were under pressure to come up with more money so that their parents would be taken care of in their retirement.
On the other hand, Dad shouldn’t have expected to get a premium on the business just because he hadn’t done any planning. The situation caused a lot of family conflict, both at work and at home. We were able to structure the deal in a way that gave him somewhat more money, but there are limitations, even when the family buys the business.
If you’re an insider, you’ve got a good perspective on where the flaws in the business are and where the traps might be. But as an insider, it’s sometimes very difficult to ask the tough questions required by due diligence.
You may not want to ask a question that’s going to affect your relationship with the boss, another employee, or another department or division. As an insider, you think, “I’ll worry about that later.” You tend to overlook the flaws. An outsider, however, thinks, “I don’t know much about this business. I’m going to spend a lot of time and money digging as deep as I possibly can and I’m going to ask those hard questions.”
A good example is the payroll. As an insider, you might be aware that the boss’s wife is on the payroll for a hundred grand a year but doesn’t do anything to earn it. You’d be reluctant to question that when you go through the books. In fact, that’s such a sensitive issue that the boss might not even want to show you the payroll. But an outside buyer would have no problem asking that question and insisting on seeing the relevant documents. The insider’s advantage, however, is they know who’s overpaid, who performs, who produces, and who doesn’t.
Over the years, we’ve developed twelve laws that apply to every insider deal. If you bear them in mind, your chances of being successful in buying out the boss will improve.
That line comes from the novel The Godfather. In the movie, the line was changed to “It’s not personal, Michael; it’s just business.” The book got it right.
You put everything on the line when you own a business. You put your family, your way of life, your ego, your wealth, and your time on the line. All business is personal. It’s personal to you and it’s most definitely personal to the seller. Always demonstrate a healthy respect for the personal nature of the business when putting a deal together.
You’ve got to listen and learn and understand the nuances while you do the deal. Don’t just rely on your attorney or accountant to say, “This is good,” or “This is bad.” Don’t be too trusting. Have the knowledge yourself. If you don’t know something, find out.
Don’t be afraid to question your advisors. Because of the lingo in the industry, they may be talking over your head — we do it sometimes, even though we try not to. There are no dumb questions — make sure you listen carefully to the answers. When you’re excited about buying the business, you may not have the perspective to see it the way it is at the moment, rather than as you hope it will become.
Good advisors are critical to your success. You need lawyers, accountants, financial planners, and business consultants like us. You also need trusted mentors — anyone who has the experience to tell you what it takes to close the deal successfully and help you stay calm and objective.
Experience is key. Just because someone is an attorney doesn’t mean she can draft and go through commercial transactions effectively. You may not want the lawyer who handled your divorce handling your purchase. If you’re searching for referrals to the best people, try talking to your local commercial bankers. They know who’s good and who isn’t, and will refer you to capable advisors. (We’ll talk more about how to build a great team in chapter 4.)
You need to find a balance between what’s good for the buyer and what’s good for the seller. You have to be willing to give a little bit and come to a compromise instead of an impasse. Also remember, the more of the deal the seller is financing, the more likely it is that you will be compromising a bit more than you would like.
As a buyer, you almost certainly don’t have enough cash on hand to do the deal. You’re going to have to borrow, most likely from both the bank and the seller. You’ll also probably have to fill in a gap and borrow from the three Fs: friends, families, and fools. (We’ll discuss ways to finance your deal in more detail in chapter 11.)
If you’re the average entrepreneurial buyer, you’re in your mid-forties, you own a home and have a family, and you don’t have a lot of liquid wealth. Seller financing is going to be necessary — and it’s going to have to be for more than the seller wants.
Everyone wants to get all or mostly cash when they sell their business, but that doesn’t usually happen. You’re also probably going to have to finance more than you want. (We’ll go into ways to finance the deal in detail in chapter 11.)
There’s never a good time for a deal-killing issue to arise, but they always seem to come up at the most inconvenient time — including at the closing and even afterward. Sometimes the deal killer is emotional: greed or ego. Sometimes it’s something that was uncovered at the last minute by due diligence.
We had one case in which due diligence uncovered an environmental health issue with the building being sold, just as the deal was about to close. It didn’t kill the deal, but it caused a lot of problems and cost a lot of money. More commonly, last-minute issues over money or employment can derail the deal.
For example, a key employee may decide not to stay on because the company is changing hands — that can kill the deal. (For more on deal killers and how to get past them, see chapter 12.)
The actual selling price of the company matters far less than what the seller nets at the closing. The sale price is like your paycheck. You don’t care what the gross is before deductions. You want to know what you’re taking home.
We did one deal where the sellers had a strong inside offer. It was a stock deal, all in cash. That meant the sellers were going to pay the lowest possible tax rate on the gain, and that there would be no risk to them regarding earnouts or seller financing.
Even though they were going to get more money than they’d originally projected, they still weren’t happy with it, because the total capable advisors. (We’ll talk more about how to build a great team in chapter 4.)
You can only do so much with the numbers when it comes to financing, whether with a bank or anyone else. The seller may show you the tax returns and the financials but also tell you that they’re not the full story. What they’re reporting to the government isn’t the real income, because they were taking cash out in some way. Illegality and ethics aside, when you go to a lender to borrow, they will look only at the documents, and the documents may not justify the amount you want to borrow.
When the numbers are real and honest, the seller may still want more money than the value of the company can support. One of our clients was convinced that he should put a much higher value on the company than it was really worth. He was sure he could get the full asking price because anyone who took over could come in and make more money than he did. But the current value is what counts — the cash flow would only support financing at a lower price. Wishful thinking doesn’t work.
Conventional lenders don’t see themselves as investors. All the bank wants is to be paid back with interest. They’re very conservative when it comes to risk — they take a rigid approach to lending, because the regulators and the credit department strictly limit what they can do. A banker once told us, “We’re allowed a delinquency rate of one-and-a-half, maybe two, percent of our total asset base.” That means they have to be right more than 98 percent of the time on their loans, otherwise they’re out of business. That doesn’t give them much capacity to take a risk.
If you have a good deal that makes sense, and you’ve got some down payment money, and the seller’s going to do some financing, and the company has a good financial history, go to the bank. More likely than not, you’ll get a good deal with goodterms.
If some of those pieces aren’t in place, as a buyer you need to find a lender that has more flexibility but will charge you a bit more. You’ll have to go with an unconventional lender. These go by a lot of names: nonconforming lending, gap lenders, mezzanine lenders, angel investors, peer-to-peer lenders. You can go online today and probably raise $150,000, but you’re going to pay a premium for that.
All our clients start out telling us, “We just want a win-win deal.” Well, that never happens. A good deal is when both sides end up a little disappointed. Not so disappointed that they’re later sorry they did the deal, or so disappointed they back out, but just disappointed enough to realize they can’t get everything that they want as a buyer or a seller. After all, when you don’t get the steak cooked exactly the way you want it, you can still eat it.
When you buy the company, you’ll discover things you didn’t necessarily know about and that weren’t uncovered during due diligence. Or maybe you knew about them and went ahead anyway. You still have to deal with them. For example, you might find customers who have special considerations for their terms and conditions, or an employee who’s overpaid because the previous owners didn’t want to lose her, or maybe the company is stuck with a bad lease.
To take one example, we have a client who never had uniform terms and conditions for their sales. It’s always been very informal, but the new owner wants to get things on a more consistent footing. He’s discovering that it’s difficult to do that with the company’s long-standing customers.
You may also have to deal with a situation in which the previous owner didn’t want to deal with an issue, such as a problem employee; now it’s up to you to fix it instead. (See chapter 13 for ideas on how to develop your transition plan.)
In our experience, each of the twelve rules strongly influences every step in the deal-making process. Keep that in mind as we break apart and explain the elements of a deal in the next chapter.
For more strategies and analysis on succession planning, check out Buying Out the Boss: The Successor’s Guide to Succession Planning, by Michael Vann and Kevin Vann.