You want to buy a business but do not have the capital to finance the entire acquisition. Your banker will not lend you money but the owner of the business is eager to retire therefore he is willing to provide you financing. The owner is a wise man and he realizes that if you destroy the business by making bad decisions, he has lost his business and will not collect on the amount that you have promised to pay for the business. What does the owner do? He sells you a bit of the company at a time. Effectively you are buying the company from the profits of the company. Your share of the profits will be used to buy the shares of the owner.
How do you value the business and determine the purchase price? One option will be is that the owner sells you 100% of the shares at a predetermined price however, he keeps the shares as security until the last dollar is paid for the shares that you acquired. You are just valuing the company once and there is no problem. But what happens if you will need 10 years to buy the business? If you have no money, it may take a long time to buy the company. You buy 10% of the company today but pay for it over the next 3 years. Once you completed the payment of the 10%, you then acquire an additional 10%. What happens if the company is booming and sales have doubled and this is 100% a result of your efforts. Do you have to pay the old owner for your accomplishments? Remember, he gave you the environment for you to excel and he paid you a salary to expand the business. Are you expanding the business because you are an employee or are you expanding the business because you are an owner?
I have seen many individuals who will allow the company to deteriorate so that the value of the business declines. As soon as they buy the business, magically, they start to create sales and the business is now booming. This happens more often than you may want to believe. How do you get the best of both worlds?
If you review the company with the owner and determine where is it in the life cycle – is the company in a high growth period, has the company peaked and sales are deteriorating – has the economy had an effect on the profits etc. Determine a target but realistic normalized profit. Then make a decision based on salary allocation. If you are able to increase the profits over this normalized profit level, you will earn a bonus equal to 50% or 75% of this excess, that is for you to negotiate. What does this accomplish? This gives you an incentive to increase the business, gives you and incentive to earn more money to purchase the owners shares faster. The old owner may make a stipulation that you need to pay tax on the profit and use the after tax amount to buy out his shares. As a a result, the old owner gets bought out much earlier than otherwise would happen. The company continues to grow despite the transition from the old owner to the new and the old owner gives you the recognition for being the driving force of the business. You will have to pay an extra amount to the old owner for his share of the growth but that will be relatively small and that will be because you were also working as an employee and a good employee would have generated some of those profits if they had been doing their job correctly.
If you did not have this type of a clause in the series of acquisition of the shares to buy the business, the company could stagnate. The business could deteriorate therefore the old owner may get less for the shares of his business or if you follow my suggestion, both the buyer of the business and seller of the business could both be happy with the success of the company.