Internal financing is a common method to facilitate the transition of ownership between current owners and the next generation. By internal financing, we generally mean that the cash flows of the business support the transition, often in tandem with seller financing. This is especially common when ownership is gradually transitioned over time to select employees. Let’s dive into the mechanics of how this works.
Seller Financing
Very simply, seller financing means that the owner (or seller) holds a promissory note instead of a bank. Advantages to this are that the seller realizes a little more income in the sale in the form of interest (because they collect it as the “lender”).
It also allows for some flexibility in the event the buyer faces a challenge with making a payment (though rare, this typically occurs when the business – or industry – encounters a material adverse effect where revenue drops, compensation is adjusted downward, and/or distributions are nonexistent) – both parties can agree to a change and amend the agreement. This is often preferred to defaulting, especially since the buyer is usually a key and tenured employee.
With seller financing, the seller retains the purchased ownership interest as collateral in the event of default – which is also generally preferred over that of an outside lender holding it – providing an additional level of comfort for the seller.
One of the few disadvantages to seller financing is that a seller might not feel there is adequate security; some sellers prefer the certainty third-party lending can provide. Along those lines, a seller tends to feel more comfortable with seller financing when the buyer is an existing employee rather than that of an external third-party. Regardless, ultimately it all comes down to personal preference and how much risk a seller is willing to take.
Buy-In via Distributions
Using profit distributions from the company to pay off seller financing or facilitate a buy-in are commonly used for privately held companies. In this instance, a next generation employee purchases a share of equity and receives an equal distribution of company profits each year. It’s also not unusual for the seller to hold a promissory note for all (or a majority portion) of the buyer’s purchase price.
By way of example, John Doe owns 100% of his company and wishes to sell and transition 10% equity to his key employee, Jane. The company is valued at $2mm so Jane would pay John $200,000 for the 10% equity stake. Jane unfortunately doesn’t have cash for the buy-in, so John agrees to hold a promissory note for the full amount for five years (i.e., $40,000 annually plus interest).
At the end of the year, the company has $500,000 in profit (revenue minus expenses). As a 10% equity holder, Jane is entitled to 10% of those profits – $50,000. Under the terms of the promissory note, Jane will use those distributions to make her annual installment payment to John.
*Note: It’s also possible to use a combination of internal and external financing. Going back to our example, perhaps John would like 50% as a down payment – Jane could finance that through an outside lender and John would hold a seller note for the balance.
Using Insurance to Purchase Ownership
A third way to facilitate the sale/purchase of ownership is through the use of insurance, particularly in the instance of an unplanned transition. Insurance is frequently used for owners, key executives, and other individuals who are considered critical to the business (it’s also known as keyman insurance) and can include the use of both life and disability insurance. These policies name the company as the beneficiary and the company pays the premiums.
Life insurance can provide an immediate source of funds to purchase a decease owner’s interest (or serve as a down payment). With the correct policy, if the triggering event is something other than death, the policy surrender value can be used to partially fund the buy-out.
Equally as important is the use of disability insurance to fund a buy-out. You can even implement a pre-established waiting period (e.g., two years) during which the extent of the disability can be assessed.
If a cross-purchase agreement is funded with insurance, there may be many policies to monitor and administer, and premium outlays will differ among shareholders due to differences in age and ownership interests. The number of policies in a cross-purchase agreement may be reduced by establishing a business insurance trust; in this situation, the trust would own the life insurance policy on each shareholder.
Finally, if insurance is not desired for funding purposes or if the triggering event is something other than death or disability, the corporation may maintain a capital fund to make necessary payments; however, the capital fund may not have sufficient deposits made by the time it is needed to purchase the shares.
Conclusion
Whether you’re a sole owner transitioning to a next-gen employee or a large company with several owners, there are numerous (and creative!) ways to finance the transition of ownership. Be sure to work with knowledgeable advisors and/or lenders that understand the goals and objectives of all involved parties and will find the solution(s) that works best.
