Tough Love and The Buyout Agreement

By Mike Cohn

Even when transferring the business to your kids, you should insist on legal safeguards to protect your income in case things go wrong—because they often do.

“Trust in God, but tie your camel first” is an old Sufi proverb that family business owners should heed when considering an ownership transfer. Even when giving the business to your children or selling it to them, you should exercise extreme care and negotiate safeguards that will protect you and your spouse from a disastrous loss of income. Your successors should understand that such precautions do not imply lack of trust or love but are necessary in case things go wrong after the transaction is completed—because they often do.

Take the case of the funeral home operator who I will call Don Smith. Don transferred the business to his son, Lowell, as part of an overall estate and succession plan but remained owner of the funeral home property, which he leased back to the company. The father believed that the fixed rent he received from the property would be sufficient to provide him and his wife, Martha, with an income for the rest of their lives. And since the rent he charged was below the prevailing market rate, the deal would help Lowell keep down costs and succeed in an increasingly competitive business.

What the parents hardly expected was that Lowell would turn around and sell the business; no provision restricting such a sale was written into the transfer agreement. When the son sold the company to a large, Midwestern acquisition firm for $5 million, there was little the parents could do. Lowell and his wife are now enjoying Florida, while Don is locked into his fixed rental income and a long term lease with a new, non-family owner.

Consider, too, the case of Lanson Morris and his sister, Laura, who sold their family business to three key employees in a leveraged buyout. Their family's building supplies distribution business had always been profitable, and so the Morrises agreed to accept some of the value for stock in future installment payments. In the sale negotiations, they did not, however, think to restrict the buyers from expanding the company.

After the transaction was completed, the employees promptly opened a new distribution center and have now run into financial difficulties. Lanson and Laura are hoping that the new center will be successful. But in the meanwhile they are wondering whether their retirement income and the value of the business that is due them are in jeopardy.

As in the Morrises' case, most ownership transfer plans involve some form of deferred payout, which creates a risk that promised and expected funds may not be collected. Often the seller transfers stock in exchange for an interest-bearing installment note. Or he may be given a supplemental pension plan with payments to be funded by future earnings of the business. Whatever the terms of the transaction, the sellers take on some risk—and the business owner facing retirement wants security, not risk.

There are a number of security measures that sellers can insist on to legally ensure that the proceeds from a sale or income from a pension will not be interrupted. The hard call is: How far can you go to protect yourself without strangling the golden goose? If you put liens on all business assets to secure collateral, that may prevent the company from obtaining needed capital and defeat your purpose, which is to perpetuate the family business and secure your future income.

The big question is what happens if the business is mismanaged by the successors and defaults on obligations to the seller. In the case of a leased property, the owner simply reclaims the property; whether it's a building, a piece of land, or a forklift truck, the property owner simply reclaims it. But protecting the seller after stock ownership has been transferred is much more complex. The sellers' rights to reclaim assets in the business may be secondary to rights of other creditors such as the company's bank.

When a seller steps back into the business after a default on payments, it is usually a last resort. A retired seller who is enjoying life outside the business doesn't want to come back to a mismanaged company and bail it out or turn it around. To avoid such a circumstance, the seller can negotiate protective covenants that give him the power to sell the business to a third party, in the event of non-performance by the new owners, before the damage becomes too severe. An outside owner may then even hire and manage the inexperienced family members.

Of course, the owner can reduce or eliminate the risk of non-payment by pre-funding the transaction. He can begin setting corporate cash aside for himself well before the sale is to take place. Five- to seven-year lead times in succession can also help the owner assemble and groom the next generation of owner-managers.

One way to pre-fund the arrangement is through a supplemental pension plan used in conjunction with a grantor or “rabbi trust” (so named because the first IRS ruling on such trusts involved a retirement fund for a rabbi). An employer puts funds in a rabbi trust to help satisfy non-qualified, deferred compensation obligations to employees—in this case the owner himself. If the company puts $100,000 a year into the trust and it earns 8.5 percent interest a year, at the end of seven years there will be approximately $1 million in it for the benefit of the current owner.

Corporate funds deposited in a rabbi trust are earmarked and set aside for the participants but actually remain a corporate asset. To protect these benefits, the participants may negotiate a “call-down” provision in the pension plan document. This feature establishes that if the company falls below a certain measure of performance, the participants have a right to “call down”—collect —the present value of all benefits in a lump sum. (The plan usually provides for a forfeiture of 5 percent to 10 percent of the benefits if the call-down right is exercised; otherwise, the Internal Revenue Service would consider money in the fund taxable, since the participants would have a right to collect it at any time.)

Most family business owners, unfortunately, are not foresighted enough to set up such funds in advance. Or they find better things to do with income from the business that, at the time, seem to be wiser investments. But when these owners get older and are ready to let go, they find all the birds in the bush, so to speak, and none in the hand.

For business owners who do not want to place burdensome liens on the company but do want to protect their retirement income, there are some alternative ways in which they can secure their rights. These legal security devices are much the same as the ones used by any lender, which is, in effect, what the seller holding an installment note becomes.

     

  1. Personal guarantees from the buyers. If the kids are not willing to put up their house or bank account or car as collateral, then they are not ready to be entrepreneurs. By insisting on such guarantees, the parent gives his successors a strong incentive to keep the business on course.

     

    One 63-year-old owner who insisted on such a guarantee learned a lot about his son's lack of dedication. The owner was selling the business to the son on an installment note; the son had put no money down. At our recommendation, while the owner was at his attorney's office ready to sign the agreement, Dad asked his son to sign a personal guarantee. The son refused and “walked the deal.” The father later confided that he was glad to discover that his son did not have the needed commitment before it was too late, since his retirement income would have depended on the son's efforts. Instead, the father sold the business to a third party, receiving half the amount in cash and placing the other half in a secured installment note.

     

  2. Compensation/bonus caps. The first two or three years will be the toughest for the new owners. If they expect to take the same income out of the company as the parents did, to equal the parents' lifestyle right away, they may not be able to make a go of it. To keep sufficient cash in the company and to be sure the new owners have a long-term view, the parents may want to have a provision in the sale contract requiring the new owners to maintain existing compensation levels for two or three years or to restrict bonuses and perks.

     

    Of course, the level of compensation established for the new owners should be fair. It should cover the jobs that they had been doing before the sale and will continue to do afterward, plus an increment for any new responsibilities that they assume following the sale.

     

  3. Restrictions on dividends during the deferred payout period. If the business is a C corporation, it's unlikely that it pays dividends. However, if it is an S corporation —as many family companies are—stockholders often receive dividends to pay income taxes on the profits that are passed through to them. The sellers in this case may want a provision in the agreement that prevents larger dividend distributions until the new owners have finished paying for the business.

     

     

  4. Measures to restrict the buyers from taking on new debt. In the event of a business default, some methods of deferring payment in a sale have a higher claim on the business's assets than others. It is therefore in the seller's interest to prevent the buyer from taking on debt that might subordinate what is owed on the installment note.

     

    The holder of an installment note that is secured with collateral is typically in a more senior position to collect money owed than a general creditor (such as the participant in a supplemental pension plan). On the other hand, the company's bank may require the business to maintain a specific debt-equity ratio in order to avoid having the bank call inventory loans, working capital loans, or other borrowing. If the ownership transfer is structured as a long-term installment note, this additional debt may tip the debt-equity ratio unacceptably and result in a not-too-friendly visit from the banker.

    In contrast, bankers view a supplemental pension plan as a junior obligation that is subordinated to their loans. In their debt-equity calculations, the pension plan is often considered to be “above-the-line equity” instead of long-term debt. So if the bank objects to a long-term installment note, the owner who wants to be sure the business remains viable may have no choice but to opt for the non-qualified pension plan, which offers less protection in a default because it is not secured by any collateral.

    Even if the bank raises no objections, sellers will want to install other devices to protect what is owed on the note. In any default, the sellers usually occupy a second position after the company's regular lines of credit. They may therefore want to prevent the new owners from incurring further indebtedness that subordinates them to a third or fourth position on collateral. In the sale agreement, they will typically ask the new owners to pledge that existing lines of credit will not be expanded without their (the sellers') consent for as long as they remain creditors of the company.

    Another sound safety feature is a cross-default provision, whereby a default on any obligation throws all obligations into a default. This covers situations in which the new owners are meeting their financial obligations to sellers but default on other debt, say, a bank loan; if the bank then moves against the company's assets, the sellers' income is in jeopardy and they may thus want to also assert their claims to collateral.

    If the seller still has personal guarantees on any corporate indebtedness, those guarantees should be removed before the sale or as part of the sale agreement. If for some reason they cannot be removed, the buyers should provide indemnifications that assure the seller that they (the new owners) will cover any claims against him by a third party—even though such guarantees may be difficult to enforce once the business has changed hands. Another reason for removing such guarantees is that if they are passed on to the new owners, according to a recent IRS opinion, their value may be regarded as a gift subject to tax.

    One caveat: Don't expect a bank to automatically accept substitute guarantees from the new owners. It may take a banker several years, and many visits, before he develops the same confidence in the new owners that he had in the old.

     

  5. Establish cash-flow coverage requirements for the deferred payout period. The sellers, of course, have a stake in seeing that cash flow in the business is adequate to pay off a note. The sale agreement should establish a mutually agreed-upon coverage requirement. If cash flow falls below that, it would constitute a default by the buyers. Usually, the sellers require the buyers to maintain the company's historical cash flow, which can be determined by the accountants. But there are a number of different ways of calculating cash flow. What is important is to determine cash flow—defined as earnings before depreciation and interest payments on mortgage and other borrowing, and taxes (EBDIT). The company should be obliged to maintain at least 1.0 times EBDIT coverage. For greater security, some banks and other lenders require 1.25 to 1.5 times EBDIT.

     

    So, for example, if a company's cash flow is only $500,000 and the agreement requires 1.25 coverage, the company would have to increase EBDIT to $625,000 or face default. To do that, the new owners might have to delay plans for growth such as expansion to new locations or purchase of new equipment.

    A seasonally low cash flow can accidentally trigger a default. The accountants can usually spot such trends in historical cash flow or they can sample cash flow in selected periods. Then the sellers can have written into the sale agreement the criteria for judging when the business will be in default—for example, four or more quarters below the norm.

    The cash-flow coverage requirements normally factor in the indebtedness to the sellers. The more that the new owners pay to sellers as tax-deductible expenses (in royalties, consulting fees, as income from a supplemental pension plan, or compensation for a non-compete clause) the better their company's cash-flow picture and the easier it will be to meet the EBDIT requirement.

    But too many payouts of that sort can be a burden to the business. Keep in mind that the purpose is not to make the requirements so tough that the new owners will fail. The purpose is to assure the older owners that if the new owners do not succeed, they can get their company back before it is wrecked and then sell it to a third party.

     

  6. The holders of long-term notes should have the right to review the company's financials periodically. After the transfer takes place, the sellers' accounting firm should receive the company' regular internal monthly and annual statements. The sellers should track industry norms (debt-equity ratios, expenses) and compare them with data in the company's reports. The performance criteria in the sale agreement should perhaps also include measurements important for success in the industry, such as length of time given to customers for payment on receivables and how often the company takes advantage of discounts from suppliers.

     

     

  7. Balance sheet requirements. If an existing lender such as a bank requires a company to maintain debt-equity ratios, along with working capital ratios, these same requirements should be written into the sale agreement.

     

    The remedies for a default or cross-default may vary, depending on the terms of the agreement. With an installment note, a breach could cause foreclosure on collateral. With a non-compete clause, a breach might void the covenant without guaranteeing the seller he'll get paid the balance of what is owed. With a supplemental pension plan, a breach of the agreed-upon financial criteria may trigger a call-down of funds in a rabbi trust (if the trust was, in fact, funded; many are set up with just a token deposit of $1; a “springing” provision enables the participants to require the company to fund the trust under certain circumstances).

     

  8. Put stock in escrow until the buyer pays off debts related to the buyout. This is fairly standard practice. Typically, the attorney for the seller or an escrow agent holds the stock until the debt is paid. If there is a business default, this presumably makes it easier for the seller to reclaim ownership of the business.

     

    But this “stock pledge” does not prevent the buyers from dramatically changing the financial condition of the business. By the time the former owners take back the stock, it may be too late to save the company. Also, this security device is of no use when the former owners have gifted the stock to their successors and receive their income through a nonqualified retirement plan.

     

  9. Ask the buyers to obtain a letter of credit. When a financial institution issues a letter of credit, it in effect shares the risk with the seller. The institution issues a letter stating that the buyer is creditworthy and guarantees the loan.

    This device, more common in transactions involving a third-party buyer, has a number of drawbacks for internal buyouts by family members or key employees. First, letters of credit are expensive for the company—costing 1 percent to 2 percent each year for the amount being guaranteed. Second, letters of credit are usually good for only one year at a time; they don't cover the entire period of indebtedness. Third and probably most important, to secure a letter of credit a company may be required to set aside a portion of its existing line of credit as collateral. For the family business that is dependent on a line of credit, this could be a disaster.

     

  10. Get the new owners to sign a non-compete covenant. If the business doesn't succeed under the new owners, they should not have the option of being able to leave and set up shop elsewhere, taking advantage of the experience they have gained at the old owners' expense. This may seem to be a heartless provision for parents to insist on when they wish their children well, unless you have seen—as I have—family vendettas in which offspring purposely set up competing firms to drive their parents or siblings out of business.

     

     

  11. Require the new owners to carry life and disability insurance. If the new owners die suddenly or are disabled, the former owners may have to step back in. With the proceeds of insurance that has been collaterally assigned to them, the former owners can be assured of collecting any amounts due them. Insurance thus prevents one tragedy (the new owner's death) from becoming two (the former owners' loss of everything).

     

     

  12. Prohibit the new owners from selling assets, making acquisitions, or getting into an entirely new line of business. The buyout agreement should keep the new owners focused on productively using the assets they have acquired and discourage them from spinning off assets for quick profit. The same goes for acquisitions and expansions.

     

    Some owners approve of such risk-taking, at least within limits, and may not care to protect themselves against them in the agreement. However, the risk-averse owner will want to ensure that the new owners pay him off before embarking on any corporate expansion or acquisition program.

    A client of mine had just such a requirement written into a sale agreement made with his son: If the son wanted to make an acquisition, he could do so under the contract, but payments to Dad had to be completed on an accelerated schedule and be all paid up as soon as the acquisition went through.

    In fact, the son found an acquisition that was sufficiently attractive to pursue. He closed on the deal, thus triggering Dad's payoff. Everyone was pleased: Dad got his money earlier than expected, Son was able to buy the new company that he wanted, and the new company's cash flow helped pay off the debt Son incurred when he cashed out Dad.

Although this list of security devices is not exhaustive, it underscores the importance to the sellers of getting up-front protection in the transaction. Some changes in the company's bylaws may also be required if the sellers are to retain a minority interest.

For example, the seller could amend the bylaws to include a “supermajority” provision that would require more than a simple majority for approval of changes in the direction of the business. If, for example, Dad retained 20 percent of the stock, such a provision could require a vote of at least 81 percent of all stockholders for major decisions. Such a provision could, in effect, give the minority holders a veto over a sale, a merger, or a recapitalization.

Another option is to have a “windfall provision” in the agreement, so that if the new owners sell the business within a few years for more than they paid for it, they would have to share the excess proceeds with the former owners.

If the seller feels the need for such guarantees, however, it may be that neither he nor the buyer is yet ready for the transaction. The process of negotiating these security devices often brings out hidden concerns of the people sitting on both sides. When an owner wants to perpetuate a family business, he has to cut some strings. There is a fine line between what is a fair and justifiable measure to protect the retirement income of the aging owner and his spouse and what is demanded because the owner is not really willing to let go.

 

Mike Cohn is president of The Cohn Financial Group, a family business consulting firm in Phoenix. This article is adapted from a new, revised edition of his book, Passing the Torch: Transfer Strategies for the Family Business, ©1992 McGraw Hill, which will be published this summer. Adapted with permission from McGraw Hill.

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Spring 1992

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