Transferability Q&A

The first question is not how. It is for whom. The same business has a different value depending on who is on the other side of the table.

A partner or family member buying in

The number has to work for both sides. How big does the business sales price need to be, and what can the business support in payments to you? That is usually the real constraint, not what a market buyer would pay. The desire to transfer ownership to a known family or team member plays often competes with the desire to sell for the most amount of money.

An out-of-market buyer

This is the most common outside non-PE buyer we see in small business: a firm that wants a toehold in your market. Their math is a payback period. Their valuation questions center around where will the money come from, and whether they can get it back in three to five years?

A private equity firm

PE is asking a different question: what can we sell this for in five years? Their model is assemble a group of similar businesses, achieve some economies of scale, grow rapidly and then sell to a larger PE firm or hedge fund. If PE is in the picture, we usually do not want to put a price on the business at all. We want the market to come to us and tell us what it will pay.

Family offices are another flavor of private equity, but they are less interested in selling over the next five years. They want the better returns a small business can achieve over the financial markets, but they still need to be able to sell if markets shift and a rebalancing of their holdings becomes necessary.

A strategic buyer

A strategic integrates your business into theirs, often vertically (your business looks similar to either their customers or their vendors). They value you on what their profits become once they own you, which is where the outsized prices come from. Ultimately your business represents an opportunity to guarantee either a future revenue source for their existing products and services or an opportunity to lower the cost of delivering their product or service.

Know your range, every year

When we start with a client, we do a benchmark valuation: if we took this business to market today, what is the realistic range? Then we update it every year, because the things that drive value often move faster than net income does.

Say net income went from $1,000,000 last year to $1,050,000 this year. A 5% increase does not blow the doors off. But last year you had no second in command, no controller, and no sales manager, and this year you have all three. Earnings barely moved, but the risk a buyer is taking dropped dramatically. The bottom line: value can move much faster than net income.

You should know what your biggest asset is worth. You should also know why.

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Start with the 90-day test. If you stepped out of the business today and did not come back for 90 days, what would happen? If your number two says “all right, it’s on me” and can handle 80% of what you do, you are in good shape. If you picture a few okay weeks, then a stalled pipeline, late projects, and customers starting to leave, that is where your value is leaking.

Most owners go after the visible things first: profits, sales and marketing, documented operations. Those matter. But they sit on a foundation of two things buyers and successors cannot see on a tour: culture and leadership.

Culture: four elements

• Values. Your rules for behavior, defined so nobody has to interpret them. They are what make gossip, politics, hidden mistakes and toxic team members addressable.
• Vision. The over-the-horizon destination. A team that knows where it is going will help you find ways over, around and through all of the inevitable obstacles.
• Why. The reason the vision is worth your team’s best effort. It tells them what motivates you. If you are motivated to achieve the same thing for the same reasons you will be virtually unstopable.
• Mission. How every person wins the day when everything else goes wrong.

Leadership: three habits

• Encouragement. As the leader you speak with a megaphone. Use it to call out the right behavior.
• Exhortation. The hard conversation that always ends with “I believe in you. Tell me what you need to fix this.”
• Empowerment. Moving areas of responsibility off your shoulders and onto people who have earned it.

Find the habit that is hardest for you and work on that one. For most owners we work with, it is empowerment.

A business can look great from the front door and still have a rotting foundation. The foundation is what transfers.

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Work backward from your life, not forward from the business. What do you want your lifestyle to look like after the sale? How much money does that take? Then: what does the business need to look like for the market to offer that price?

The first two questions belong to a financial planner, ideally one who is a Certified Exit Planning Advisor (CEPA). The third is ours. When those two conversations happen together, you get a real answer instead of a feeling.

We worked one sale where the planner told the owner he needed $6 million to accomplish his goals. He got well more than that. He was done, and he knew he was done. The owners who get into trouble are the ones who never defined what “enough” is.

Sometimes the answer is that you could sell today and accomplish everything, and you decide not to. One owner we work with is in exactly that position. He wants to take a shot at growing it for a few more years. The difference is that he now knows it is a choice.

Owners under financial pressure make worse decisions. Knowing what is possible today takes the pressure off.

One more number to keep in mind: only 20 to 30% of businesses that go to market actually find a buyer at any price. If you wait until you are worn out to find out whether you can afford to sell your business there is a 70-80% chance you wind up having to work in the business for another two to four years. 

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The specifics depend on how your company is set up, and no web page should answer them for you. What I can tell you is where we see these deals go wrong.

Separate the owner hat from the employee hat

A partner who works in the business wears two hats. The employee hat is the job: the role, the responsibilities, and a W-2 paid at market rate. Every position needs a Job Blueprint, including the CEO position held by an owner. The owner hat is governance, capital decisions, and distributions... all laid out in the operating agreement.

We see new owners walk in the employee entrance the morning after the buy-in wearing their owner hat: “you have to do this, because I’m an owner now.” Nobody walks in the door of the shop wearing the owner hat, ever.

Pay the people who work in the business a market wage

If you are an S corporation, the IRS requires owners who work in the business to pay themselves what you would have to pay a third party to perform the same responsibilities. Put a clause in the operating agreement that partners providing services are paid market rates, reviewed at least every three years against an outside compensation study or other benchmark. That gives you better ground with the IRS, and it takes the “I want to make more” argument off the table. If you want more, become a better GM, or make the business more profitable so you earn more as an owner. It also helps at exit, because a buyer will adjust the price for owners who are underpaid. If you want your business to sell like a real business in the future, treat it like a real business now. Don't play games with owner compensation.

Be careful with a discount

Selling shares to a key person below what they are worth can create taxable income for them on day one. One structure we have seen tax counsel use: the partner buys in at a discount, and if they are later bought out, they sell back at the same discount. If the whole company sells, they receive full value. We also see discounts applied for family succession and estate planning purposes. The point is, whatever structure you use, have it designed before the offer goes out or you talk about next generation ownership around the Thanksgiving Day table.

Get the tax memo from your CPA and attorney before anyone signs. Fixing structure afterward is expensive.

Go deeper on the podcast: episode 179, episode 180.

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Partner buy-ins are typically about one of two things: retention or succession. The purpose drives the price and the terms.

Retention buy-ins

Your best people often want the opportunity for co-ownership. They want a seat at the table and a long-term stake in the financial future of the business. Retention partners can be admitted 10, 15 or even 20 years before the founding partners’ planned exit. Their role is to keep growing the company.

The biggest issue facing these new partners is how to pay for their shares. If you grant the shares outright, they still pay tax on the fair market value. If you sell them their shares, they have to be able to afford it.

In these cases the value of the business is usually discounted or conservatively determined, and the payment terms are structured so the new partner's distributions from profits can pay for the shares.

Succession buy-ins

If the admission of new partners is primarily about succession, the deal terms look more like a third-party buyout. Using the same example business, the terms might be:

Below-market transfers

Sometimes the owner’s financial independence lets them essentially “give the business away” for less than market value. Our advice is to tread cautiously, for two reasons.

First, recipients of this generosity need to fully appreciate what they are being given. We have seen resentment, animosity and entitlement instead of gratitude because those involved were never educated about the value of what they received. The incoming generation of ownership needs to understand what the owner’s other options were and why those options weren’t chosen.

Second, despite the best intentions, below-market transfers can trigger tax consequences that take years and thousands of dollars to resolve. Get clear on intent and reasoning first. Architect the plan with good tax counsel. Communicate the full story to the new owners. Take time to answer questions and concerns. Then close the deal.

Decide in advance who buys

Before a new partner is admitted consider what needs to happen if they leave. Who buys their shares? At what value? Where does the cash come from? If you don't answer these questions beforehand they become very expensive to answer later.

Fund the events you can’t schedule

Almost no business has the cash sitting around to buy out a partner who dies unexpectedly. I lived through this with a client. One of three partners passed away, and the company had bought life insurance on each of them. The insurance paid into the company’s account, the company bought the shares from the surviving spouse, and nobody had a contentious conversation about money at a time when money should have been the last thing on anyone’s mind. Once your business has real value, review your buy-sell agreement with a qualified financial professional who can put the right insurance in place.

The money had been taken care of years in advance. That is the whole point.

Go deeper on the podcast: episode 182.

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Start with the end in mind, and say it out loud. Most partnership problems come down to assumptions and expectations nobody ever voiced. The big ones:

• The end goal. One partner wants to grow hard for five years and sell. The other wants to hold it and pass it to the kids. That has to be addressed early, especially in a 50/50 partnership with no tiebreaker.
• Exit timelines. If there is more than about an eight to ten year age gap between you, assume one of you will want out first. Same if one partner has income from somewhere else and doesn’t need this to work. Plan for the other partner to become the majority or sole owner.
• Reinvest or distribute. One owner wants to buy equipment and hire. The other wants the boat. Without clear rules on distributions, that becomes a fight.

The best time for this conversation is before the partnership starts, ideally with spouses in the room. The second best time is now.

Then put it in a buy-sell agreement

Every partnership needs a buy-sell agreement inside the operating agreement. When attorneys and advisors pull an operating agreement, the buy-sell section is the first thing they turn to, and it is often getting attention for the first time in ten or fifteen years. It should cover:

• Triggers. Death, disability, divorce, bankruptcy, voluntary exit, termination.
• Price. “We will mutually agree on the price” is not a price. What happens if you can’t agree?
• Who buys, in what order, and how it’s funded. See the financing question above.
• No passive passengers. A departing partner keeping their shares, collecting distributions, and holding a title nobody acknowledges is not an outcome to leave open.

If you have an operating agreement but no buy-sell agreement or clause, go get one. That is the first thing.

Go deeper on the podcast: episode 181, episode 182.

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One firm we have known for more than a decade did this well. Two founders ran it 50/50 for years. One drove new business, the other ran operations. Then an all-star performer bought in as a third partner. He was better at sales and sales management than the founder who had been leading it, so they put their egos aside and let him have it. The founder moved over to build new departments, and the other founder scaled the back end to keep up with the growth. When I ask them what made it work, the answer is always the same: each partner knew their lane.

Give every new owner a lane and a job blueprint

A new partner still has an employee hat: a defined role, clear expectations, and KPIs they can measure themselves on. Ownership should never become operational authority. Settle that before the buy-in, not after.

Know how dilution works in your agreement

If you decide to offer a 10% buy-in to your sales manager, where do those share come from? Does each partner sell 5% of their shares? Does the company issue new shares, lower the percentage ownership of existing partners and keep the cash in the business? Does a more senior partner get the option to tender up to 10% of their holdings and cash out? Answer these questions in the operating/buy sell agreements before they get asked.

Draw where you are going

Draw the organizational chart three years out, including the seats that are not filled yet. It shows you where future partners will come from, and it shows your team where the opportunity is.

Go deeper on the podcast: episode 180.

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Not all PE is the devil. In my experience, most of the pain comes from one decision: taking the highest offer.

On one sale we represented, we vetted roughly 20 interested firms and ended up seriously considering two. Those two showed, before anyone signed a letter of intent, that they cared about the people who would be left behind. The CEO of the eventual buyer flew down more than once to meet the founder, talk through where the opportunities were, learn who the best players were, and explain how they could grow those people.

We did not take the highest offer. Today the two young leaders that owner developed are the standouts across that firm’s entire portfolio, so much so that the buyer asked us to do the same work with their other leadership teams.

Take the highest offer, and you will usually take the highest pain with it.

Meet the CEO before you sign the LOI

If you are staying on, or you care about the people who are, talk to the person they will report to before you sign. Not just “do we get along.” Do you believe in this person? Are they competent? Do they understand your business? What is their exit plan? Are they incentivized to stick around or resign when the company hits a rough patch? Evaluate the firm the way it is evaluating you.

Know that their DNA is growth

No PE firm buys a company to keep it the same. Your "someday" list of better systems, better facilities, and better tracking becomes their list the day you close. If you are staying, you need to be ready to let go of decisions that used to be yours.

Check three boxes before you move forward

Is the business ready? Are you personally ready? Are your finances ready, meaning do you know what you need to sell for and what it looks like after taxes? Don’t move forward until all three are checked.

Go deeper on the podcast: episode 191.

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There is a difference between clean financials and buyer-ready financials. Clean means reconciled every month, categorized consistently, and easy to read. Buyer-ready means someone independent has tested them.

Most small businesses never get an audit or a review because they are expensive. And even when a CPA prepares your tax return, the adjustments typically get slammed through on December 31. When we plot a client’s trailing-twelve-month numbers, we see the jagged lines and mouse over them: December, December, December. A buyer looking at four or five years of monthly financials will see the same thing and start asking questions. Every question they have to ask is a perceived risk and buyers account for risk by reducing their offering price.

What a Quality of Earnings does

A Quality of Earnings report is done by a CPA firm that specializes in them. They essentially rebuild your financials, ask you dozens of questions, and calculate your adjusted EBITDA: earnings before interest, taxes, depreciation, and amortization, plus the add-backs that won’t carry over to a buyer, like personal expenses run through the company or a one-time legal settlement. 

A QoE can cost $30,000 to $50,000, and more for larger companies. Against a seven-figure difference in price, nobody walks away from that conversation wishing they hadn’t spent the money.

The buyer is going to do one anyway

Every sophisticated buyer runs its own QoE in due diligence. You do not want your tax CPA going toe to toe with their QoE firm. Have your own QoE done about six months before you go to market. During diligence, your firm only has to roll it forward. More important, the firm you hired is defending those numbers during the long, often painful due diligence process. Hire experts and let them earn their fee many times over.

What raises red flags

• Customer concentration. Any one customer over about 10% of revenue starts to be a yellow flag.
• Inconsistent margins. 30% one year, 15% the next, 38% the year after, with no explanation.
• Aggressive add-backs. Claiming three salespeople’s salaries as add-backs because “we only need five of our eight” invites the question of why you haven’t let them go.

If you are one to three years from selling, start with clean, reconciled monthly financials today.

Go deeper on the podcast: episode 176, episode 177.

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When we see an owner stuck there, the leadership team usually has not kept up with the growth. Not the whole team, typically, but one or two key people who have hit their capacity ceiling. In a growing business that is often someone on the delivery side: a project manager, the head of field operations, the service manager.

The owner sees that person struggling and starts taking on pieces of their job, or putting out the fires their struggle creates. That is where the plateau comes from, and it is where the burnout comes from.

Have the hard conversation

The way through is to increase the capacity of the leadership team. Sometimes that means promoting someone over a person who has been there longer, or hiring from outside and putting that person over people who have been with you a long time. I am not saying fire the person who has been by your side for 17 years. Bring in someone who can use that person’s best strengths and keep them on the team. They may just not be in the leadership room anymore.

You are not doing anyone favors by avoiding that conversation. Your other leaders and everyone who reports to that person pay the price for it, and they didn’t get a vote.

Change how you see your job

Most owners move through three identities. First: I do the best work in my trade. Second: I own a company that does great work, and everything that goes wrong lands on my shoulders. Third: my primary role is to be a great leader, and that means developing other great leaders. The plateau usually lives in the second identity.

That is the empowerment habit in practice. Ask what you are carrying that someone else should be carrying, then give it to them: “Here are the results I need to see, but it’s yours now.” When a capable team gets the non-growth work off its plate, it often just needs to be let go in the direction it has been pulling.

The growth question and the transferability question are the same question. Both are answered by what the business can do without you.

Go deeper on the podcast: episode 192.

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Start with the data. Among businesses older than ten years, fewer than 4% grow meaningfully in any given year. Your first ten years, growth comes easy. People don’t even know you exist yet. After that you are on your competitors’ radar, fighting for the same labor pool, and riding economic cycles.

Growth comes in spurts

In the world we work in, growth rarely shows up on schedule. It comes in spurts: you hang on, stabilize, level out the plateau, and build a platform you can grow from again. The tidy plan of raising marketing from 4% to 6% of revenue, building a war chest, then doing it again is a nice idea. We don’t see it happen much. Funding truly predictable, high paced growth usually takes a major influx of capital, which is what a well-run acquirer brings: they invest in the leadership team, the service headcount, and the trucks at the same time they invest in sales.

Watch the cash

Growth puts tremendous pressure on cash. If you grow 50%, your receivables grow about 50%. Your vendors often won’t let your payables grow with them, and you have to carry more inventory to keep turnaround times the same. That crunch lands on you personally, on top of the strain on your team.

Not growing has a cost too

A players will outgrow the opportunities you can give them. If you do not grow, the new seats on your future org chart never open, and your best people leave to find them somewhere else.

What makes growth sustainable is the unglamorous work: a future org chart, monthly one-to-ones with each of your leaders, their individual goals written down, and leadership rhythms of weekly meetings, monthly financials, and 90-day priorities. Wanting to grow is not the same as having a plan for it.

Go deeper on the podcast: episode 192.

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When owners talk about the vision or the exit, it does not land on employees the way we mean it. “Exit” to an owner means a finish line. To someone without equity, it can sound like “my job is ending.”

Give them a vision worth their effort

If your vision is to sell, that is not usually something you announce. You still owe the team a vision worthy of their best effort, one that reaches past the sale. What opportunity will still exist for them? What kind of buyer will you choose, and why? You will need their full effort for the two or three years it takes to make a sale possible.

Show them where they fit

The future org chart does this. Show the team the organization three years out, with the open seats, and ask where they see themselves. People can commit to a vision once they can see what is in it for them.

Ask about their vision, one at a time

I meet with each of my leaders every 30 days. Two questions every time: how are you doing, and what do I need to do for you over the next 30 days? Toward the end of the year I add a third: what do you want to accomplish next year? Certifications, new roles, and new lines of business have come out of that question.

As one business owner said, "If a person’s vision does not fit inside the owner’s vision, they leave." Sometimes they will anyway. If they leave knowing your values and what good leadership looks like, that is not a loss to the world.

Your people drive the value as much as anything else

Buyers will ask to talk to the people the business depends on. If one salesperson produces 70% of your sales and you refuse to let the buyer talk to him, that is a huge red flag. The buyer assumes they will lose him the day they close, and the response is predictable: lower the price, or take a chunk off the table and pay it to you only if he stays. Buyers also pull years of payroll records to see whether people stay. Your retention is their read on your culture.

You speak with a megaphone. Decide what you want it to say before someone else decides for you.

Go deeper on the podcast: episode 177.

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