What Is It?
When selling your business--whether to a family member, a key employee, or a third party--you effectively become a lender to the business unless the sale is entirely for cash. Most ownership transfers are structured so that you exchange stock for an interest-bearing installment note, or you accept payments through a supplemental pension plan funded from the future earnings of the business. You want to do everything possible to ensure the long-term health of the business and to protect your interest until the buyer pays off his or her indebtedness to you. Third-party security measures can help you achieve these objectives.
Third-Party Security Measures
Monitoring the Financial Performance of the Business
An outside accounting firm can assist you in monitoring the company's internal financial statements. Key industry ratios and expenses should be tracked on a monthly and yearly basis, comparing the business's financial position against industry standards. You can include default provisions in the sales contract if the company's performance falls below industry standards. For example, the sales contract could set standards for key financial ratios or establish requirements for managing receivables or maintaining discounts on payables.
Safekeeping You’re Stock
The stock certificates you transfer to the business as part of the sales contract are commonly held in escrow for safekeeping by a third party until the debt owed to you is fully repaid.
Caution: The fact that a third party withholds stock from the buyer doesn't prevent the buyer from altering the nature and financial condition of the business, possibly to its detriment. Also, the withheld stock can only secure your interest if it's tied to indebtedness. If you give the stock to the buyer or if your payment is structured as a supplemental pension plan (which is considered to be equity, not debt), this security device will have no value.
Letters of Credit
Letters of credit can secure a third-party buyer. In a letter of credit, a financial institution verifies the creditworthiness of the buyer and guarantees the payments.
Caution: This device has several drawbacks. First, letters of credit are expensive for the business, possibly costing 1-2 percent per year of the amount guaranteed. Second, they are usually only good for one year at a time; thus, they don't cover the entire term of indebtedness. Third, the guarantor may require the business to set aside a portion of its existing line of credit as collateral to secure the guarantor's line of credit. This could be especially disastrous for a family business dependent on existing lines of credit.
When Can It Be Used?
You can secure your future income stream using third-party measures when you're selling your business with payments to be received over time and you wish to ensure the company's health until the debt owed to you is repaid.
Third-party security measures can strengthen your personal financial security during an extended payment period.
Using a third party to hold stock certificates doesn't prevent the buyer from altering the financial condition and nature of the business, possibly to its detriment. For a stock pledge to secure your interest, it must be tied to indebtedness. If you give the stock to the buyer or if your payment is structured as a supplemental pension plan (which is considered to be equity, not debt), this security device will have no value.
Using a letter of credit to secure a buyer has several disadvantages if the buyer is a family member or key employee. First, letters of credit are expensive for the business, typically costing 1-2 percent per year of the amount guaranteed. Second, they are usually only good for one year at a time. As a result, they don't cover the entire term of indebtedness. Third, the guarantor may require the business to set aside a portion of its existing line of credit as collateral to secure the guarantor's line of credit. This could be disastrous for a family business dependent on existing lines of credit.
How to Do It
Enlist an Outside Accounting Firm to Monitor Financial Performance
Enlist an outside accounting firm to assist you in monitoring internal financial statements. Track industry ratios and expenses on a monthly and yearly basis, measuring the business against them.
Include Default Provisions in Sales Contract
Include default provisions in the sales contract. Default could be triggered, for example, by any of the following situations:
- Failure to meet key industry standard financial ratios
- Failure to manage receivables according to industry standards
- Failure to maintain discounts on payables
- Failure to maintain the letter of credit
Engage a Third Party to Safekeep Stock
Engage a third party to safekeep stock certificates you transfer to the business until the debt owed to you is fully repaid. To benefit from this arrangement, the payment owed to you must be structured as debt (such as an installment note) rather than as a supplemental pension plan.
Require a Letter of Credit Guaranteeing Buyer's Creditworthiness
Require a third-party buyer to obtain a letter of credit from a financial institution verifying the buyer's creditworthiness and guaranteeing the payments.
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