Bite-Sized Bits of Knowledge

Hi. Thanks for tuning in to another dose of Bite-sized Bits of Knowledge, where we give you meaningful information in a short amount of time. 

Today I want to talk about the mechanics of the transfers – the involuntary transfers – and even the regular voluntary transfers that I’ve been alluding to in most of my videos here, as well as one important consideration that often gets overlooked.

In general, the concept of transfers that we try to use in our agreements as at least a starting point, is that when there’s a sale, it will be governed by the terms of the governing instrument – the governing document. It’s usually something like, first there has to be a valuation of the shares, then there has to be a process of selling the shares by way of a closing, and then a financing, and then securing.

So we’ll start with valuation. Valuation-wise, there’s a lot of ways to do it. Every way has a double-edged sword, okay? There’s good and there’s bad about it. So valuation-wise you can agree on it, which is a very loose way to do it, because most people are not qualified to value a business. There’s people who are professionals. All they do is business valuation. So it’s something to think about.

And so for that reason, the next way of doing it is really hiring a professional valuation expert to give you a valuation. It’s not cheap and it’s not quick. It could be $20,000 in today’s dollars – 2021. It could be $20,000 for not terribly complicated business, but definitely $10-25 thousand is a range you need to be comfortable with if you’re going to do the appraisal method.

Now, the appraisal method, often – at least the way we do it – is that we have it structured so that there’s one appraisal, and if the parties don’t agree on that appraisal, then they can get their own appraisal. And then if those two appraisals are sufficiently close, we’ll average them. And if they’re sufficiently far enough away from each other, then we’ll get a third one and we’ll average the two closest ones.

That’s a lot of appraisals. It’s a lot of money. So this approach is not always ideal. It has its place for where it’s appropriate, and there’s other ways to do it sometimes. Like, for example, the third way. Third way is to maybe just do some sort of multiple of EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization. Called EBITDA.

Take that number, average it for the prior three years, multiply it by a reasonable multiplier relative to your industry, and that could be a formulaic way. A way to be done cheap, effective, and quick. It works in some businesses, and it doesn’t work in others. This is not a cookie cutter situation. Everything we’re talking about requires thought and really working through it. I’m just giving you a high level here.

So valuation could be done by agreement, by appraisal, by formulaic approach. Once that value is kind of identified, then we talk about the provisions. We’ll usually talk about – okay, there’s going to be a closing and that closing is going to occur at a certain time, usually a couple of months later, to give people time to get the money to finance it, to deal with what they got to do to come up with the money.

And then closing, there’s usually a down payment. Usually a down payment of a part of it, say 10%, 20%, just like a house. And then you finance the rest. 

The reason why you finance the rest is because you don’t want to overburden the partners. If the partners are overburdened, it’s going to affect the business. If the business is affected, you’re not going to get paid. You’re never going to get your money. 

So, it’s actually beneficial for both the existing partners who are buying, as well as the departing shareholder who’s selling, to make this work. So closing is usually a down payment and usually the balance is financed.

Usually the finance has a promissory note with all the material terms of payment over time. When I reference good notice, bad notice in a prior video, this is kind of the big sticking point where that comes into play. So good notice is usually a shorter financing term. Bad notice is usually a longer financing term. That means you’re getting less money in each installment payment.

If you give bad notice, you screw the company and you make a burden for them to have to hire and replace and train, you’re going to take longer to get your money. That’s the punishment. That’s one of the incentives to try to be a good person and give good notice. Get your money faster on the financing of the sale of the shares.

And then lastly, I’ll mention that usually you’ll see something that says that there’s a security interest in the shares until paid in full. That way, if there’s a default on payment, they can still recapture their shares to protect them. So that’s kind of the mechanics of the purchase and sale.

I want to mention one more thing about that we didn’t really talk about. Ownership in a trust really needs to be thought through, because as a trust, if the person who you’re doing business with as a trustee, then that’s great. But then when that person who’s trustee becomes disabled or that person dies or something else happens, then you have a successor trustee who’s kind of coming in and taking over the shares and management of the trust’s interest in the company, which is the exact same problem that you want to avoid from bankruptcy and divorce. 

You could find yourself in business with a third party who’s now the trustee for whatever reason. And you’re kind of in business with this person, and you really shouldn’t be or don’t want to be or it’s just a bad situation. So you’ve got to think it through when you have trust involved. 

It’s definitely a marriage between estate planning and business planning. Much more so than I think most people recognize and even some practitioners recognize. So think it through.

I hope you found this video helpful. Don’t forget to download our free Business Planning Stress Test and our free Florida Formation Chart. And there’s probably some other goodies in there for you that I think you’ll find very helpful.

Thank you again for stopping by, and stay tuned for more.