Internal succession: what is it?

Internal succession: what is it? 

Internal succession in real estate businesses has been common. In the current environment where it is difficult to retain staff, it may become even more prevalent.

In simple terms, internal succession is where the existing owners of the business sell down part of their interest to people who already work in the business, and on some occasions sell part of their interest to an outside third party who will join the business.

What it is not, is selling the whole or part of the business or rent roll to an arm’s length third party.

Why do it? 

Historically, the best prices have been obtained when the existing owner’s interest is sold to the existing employees.

One of the benefits of this is that there is little or no disruption to the business, so it just continues as normal. An example of a lack of disruption would be that in the change of underlying ownership there would not need to be any notification to clients of the change. This is not the case in a sale of business.

Another reason why existing owners of a business would wish to sell their equity in the business to existing employees, is that they often feel they owe something to long standing employees. From experience, this does not usually mean that the purchasers get a discount in the price, but they may get more favourable terms of purchase.

Further, internal succession commonly allows for the existing equity owners to sell down their interest over time, rather than selling the whole of the business in one go. For example, an equity owner could own 50% of the business and over a five-year period sell out, allowing them a transition that may emotionally and financially suit them.

Process

The process of sale is not particularly complicated but does take some time.

The first issue is to identify whether an internal succession process would suit you or your organisation.

The second part of the process is to decide who should be made an offer to purchase. If an offer is made, then there is normally just an informal discussion with the internal potential purchaser to ascertain if they are interested. If they are interested, then on occasions a formal valuation is done of the business but not in all circumstances.

There are normal sale documents prepared but again, these are not particularly complicated and normally do not involve a due diligence process as it is more than likely that the existing employee already knows the business.

Sale documents are prepared and executed. Again, this process should not take long but for some reason, these internal successions seem to take up to a year from the decision to final settlement.

The runway

One consideration is you need to be mindful because if you start offering equity to some but not others, you may need to deal with the people who are not offered equity. It could be that it would be your intention to eventually offer equity, but the person may be too young or not have enough money, or simply have what might be called faults that need to be dealt with. The faults could be a lack of financial understanding of how a business runs or it could be that their interpersonal skills are poor.

In these circumstances a potential seller may tell a person that they are on the ‘runway’, and once certain issues have been resolved, they would then be made an offer.

We have sometimes been involved in the ‘runway’ process, in providing legal training to potential purchasers.

No money

It is not uncommon for the potential purchaser not to have much or any readily available funds to pay an appropriate price for their interest. Ideally the potential purchaser would have cash, as this is commercially and legally simpler.

If you want the purchase to proceed and the purchaser doesn’t have the cash, you may be able to arrange for your bank to fund the purchaser’s purchase of equity into the business. The bank would probably improve the strength of its relationship with their client if they were prepared to do this. On some occasions, while a bank might be prepared to lend in these circumstances, they may want to take security over the main business to protect their loan.

There are other ways to deal with the situation, where you have the purchaser who wants to buy but does not have sufficient funds to purchase. There are variations on the theme, but in simple terms they probably could be regarded as vendor terms. Often the purchaser will purchase the legal interest in what they own, but they are paying it off over time under a formalised arrangement.

Shareholders agreement

As mentioned earlier, internal succession requires sale documents and, on some occasions, an IM is provided to the purchaser. Cornwalls can assist with both documents.

In many circumstances, the main document you need is a shareholders agreement that governs the relationship between the incoming shareholder and the existing shareholders, as well as the vendor.

Proceeding with a sale to a potential purchaser prior to executing an appropriate shareholders agreement would be ill-advised.

Most organisations have shareholders agreements, and the incoming purchaser signs what is known as a deed of accession. From here, the purchaser simply adopts the existing shareholders agreement. This is a streamlined process, eliminating the need to redraw the whole of the shareholders agreement and have input from different parties, which can cause delays and increase costs.

With that said, a deed of accession may work in the instance that a business utilises the incoming buyer’s purchase as a reason to update their shareholders agreement.

If you don’t have a shareholders agreement, it is highly recommended that you attain one.

The main elements in a shareholders agreement are:

• How do partners get in and out of the business;
• Who decides to sell the business if a strong offer is made (otherwise known as an Alan Bond offer);
• How to deal with death or disablement;
• The relationship of the parties, which normally means having formal employment agreements, so everyone understands what they are getting paid for their differing roles;
• Who decides on expansion of the business;
• Who decides if the business is to go into a new direction;
• If someone wants to sell, are the remaining shareholders required to purchase their interest; and
• How is the business valued?

Change

Estate agents have been sent on a roller-coaster in recent years, with many wondering whether they were going to survive and at other times trading extremely well. They’ve battled a relentless mood shift between relief when approaching the top of the roller-coaster and unease at the prospect of another dip.

As economic changes remain prevalent in the real estate industry, and for the sake of your personal life, a timely suggestion would be to consider taking in new partners. Often, new partners provide new ideas, vibrancy, and a new direction.

Further, due to the differing environments among each state, there are vast fluctuations within the real estate market at the present. This in turn, heightens the risk involved in purchasing property. Currently, real estate in Queensland is in high demand. Due to this demand, properties are being sold for arguably much more than what they are worth. If an outbreak arises in Queensland and the state is impacted as significantly as Victoria and New South Wales, it is not unlikely that the tables will quickly turn regarding real estate demand and price. Thus, seeking expert advice is highly recommended.

Queries

For further information please contact the author, or any member of our Corporate & Commercial team.

Disclaimer

This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.