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What are the pitfalls of minority ownership when selling our business?

Question

A prospective buyer proposed that we maintain a 10% to 20% ownership stake in our business instead of us carrying a 10% to 20% note. He didn’t want us to be involved in the day-to-day operations but he wanted us to stay engaged with the business at some level.

I don’t mind remaining involved as long as I don’t have to be in the business every day, so I feel that depending on the actual arrangement, this partial ownership is a win-win for all of us. I think this arrangement addresses several concerns:

  • My husband and I will still be involved on some level with quality control.
  • It prevents the buyer from incurring the debt service of a 10% to 20% note.
  • Employees are less likely to leave knowing we’re still involved in the business.
  • The buyer feels that it will allow us to still reap some of the rewards of the business we created.
  • It gives us a reason to periodically return once we move away from the area.

Are there some pitfalls to this arrangement that we should consider? How should we handle this situation with this potential buyer?


 

Answer

This arrangement is quite common in the middle market, with businesses priced at over $5 million. However, it is rare for Main Street businesses that are priced at less than $5 million. Although this idea could work, you must be on the lookout for several pitfalls:

A 10% to 20% ownership stake is difficult to sell to anyone other than the current business owner.

We recommend considering this option only if you have a buy-sell agreement in place that would force the current owner to buy you out if you ever wish. Without a buy-sell agreement, you will be left with a minority interest that is nearly impossible to sell and would therefore be worthless.

A minority interest in a small, closely-held business is nearly impossible to sell except to your current partners.

If you do consider retaining a minority ownership interest, ensure that you either have a buy-sell agreement that allows you to cash out or consider your minority interest as an illiquid investment that you will not be able to liquidate until the business is sold again.

This arrangement comes with dozens of issues that need to be addressed.

When considering holding a minority interest, you need to address issues on compensation, the ability to exit, liability, and many other factors. Frankly, this isn’t a practical solution for a business that is valued at less than $5 million.

High professional fees relative to the deal size are involved.

The professional fees will also be high since there are lots of legal and tax issues to address relative to the size of the transaction. If you’re paying such high fees, you better make sure you love the buyer because you are effectively getting married and it will be expensive to “divorce” the buyer.

Holding a minority interest in the business exponentially complicates the transaction.

Retaining a minority interest in the business adds a significant amount of complexity to the transaction. Not only are you selling your business, but you are also creating a partnership. Everyone knows the perils of a long-term partnership — if it doesn’t work out, there may be bitter disputes. Having a carefully drafted buy-sell agreement is critical if you want to enter this kind of arrangement.

Unless you’re willing to risk being involved in partnership disputes and litigation in the event the partnership doesn’t work out, I suggest selling 100% of your business, then moving on.


How Should You Address this Proposal from a Buyer?

Examine your objectives for selling.

What are your objectives for selling your business? Most owners want to disentangle themselves from the obligations of the business, walk away, and free up their time to pursue other interests or enjoy their retirement. Entering into a partnership does not help you achieve these objectives.

Again, although this scenario might be sensible for some types of businesses, it does not make sense for a small business.

Analyze the buyer’s objectives.

As the seller, you should analyze the buyer’s objectives. A buyer proposes a creative structure for a reason. What is that reason? What are they really trying to accomplish? Only after you uncover their true motives can you attempt to address their concerns.

The buyer proposed this scenario because he wanted you, the seller, to have some skin in the game and to have an interest in the business succeeding long term. These objectives are normally rooted in deep emotion. In this case, the buyer is attempting to assuage his fear by keeping you engaged in the business on a long-term basis.

The real issue is fear. Now that we have identified this, we can address it directly.

Address the Issue.

In this real-life scenario, we confronted the buyer’s fears directly. We simply told him: “It appears you are a bit hesitant to make an offer. We sense some fear on your part. Tell us how you feel. What is going on in your head?”

The buyer told us that he had never owned a business before and he felt that having the sellers stick around might help ensure his success. When we discovered the root of the issue, we confronted it head-on and eventually achieved a successful sale.


Conclusion

A true professional does not blindly respond to a party’s requests. You can’t tell a competent doctor, “I think I have XYZ diagnosis, please prescribe me ABC medicine.” Unfortunately, many professional advisors simply respond to their client’s requests without uncovering the motives, objectives, and reasons behind these requests. Once the true objectives are unearthed, then the issue can be addressed directly.

Some proposals from buyers may initially appear attractive and beneficial to you, as a seller, but a closer look will reveal that it is not only more complicated than you actually thought it was, but also puts you in a situation that you might later regret.

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