It is not uncommon for the owner of a dealership that is operated by a general manager (GM) to at some point make that GM a partner. Though a common practice, there are certain elements of this arrangement that we have found may lead to better results for the majority owner.
Often a GM will not have the financial wherewithal to write a check for a FMV purchase price for the stake he or she is acquiring. This can lead to a common practice of permitting the GM to pay for the equity stake with “sweat equity,” no cash payment. We would recommend instead that the GM always pay for the equity at fair market value, regardless of the GM’s current cash on hand. A GM who pays for their equity with “sweat equity” will have a very poor tax position; current taxable income equal to the value of the equity received, often a very large tax bill that the GM cannot afford to pay.
A GM who pays nothing for equity does not have their life tied to the success of the store that they have been charged to operate for YOU. Instead, we believe it is important that even a GM without great financial wherewithal pay up front as a down payment, in cash, an amount that represents “all the money in the world,” or at least a substantial sum, for that person. That sum may differ greatly from person to person; $10,000, $50,000, $250,000, whatever it is for that particular person, get that down payment up front immediately.
Structuring the Payment of the Purchase Price
After the down payment is paid up front, sometimes the balance is paid with a note, with the lowest interest rate permitted, the “Applicable Federal Rate.” At this point, we recommend a heart-to-heart conversation with your GM. Their compensation plan will likely now have three components; base salary, bonus, and profit distributions, as an owner from the percentage interest they just purchased from you. You should agree upon the minimum amount that the GM needs to support their family and all amounts received, after taxes, in excess of such amount MUST BE applied to pay down the note. In fact, the company would pay those amounts directly to you, the noteholder, in accordance with the terms of your operating agreement. Depending upon the deal and the GM, some may insist the note be non-recourse except to such amounts, some may not, or you can land upon some hybrid. In any event, you are no worse off than the “sweat equity model.”
If a note does not work in your deal, only issue to your GM a percentage of equity that the initial down payment is worth, even if it is only 1 percent or 2 percent. Give the GM the option to purchase more equity over time. Now, you need to incent your GM to be as profitable as possible. Keep the option price for future purchases as the original purchase price, otherwise if the future option price increases with future profitability, the GM may be incented to keep profits down. However, since you are keeping the option price level, what had been an “option” to acquire additional equity should now become mandatory purchases of additional equity, whether the dealership is going through good times or bad. It is really not an option at all. All amounts the GM receives in excess of the “Family Support Amount” from whatever source (salary, bonus, or profits) must be used on an annual basis to acquire additional shares at the same price.
Locking Up the GM
Now you have your GM making at least a minimum investment in an amount that means all the world to them. You also have them obligated to reinvest everything they will earn from the store to either pay down a note or acquire additional shares. You have accomplished tying your GM’s financial success to the success of your store. We must now contemplate the potential exit of your GM, either voluntarily or involuntarily which may trigger a buyback of the GM’s equity.
This will be handled in your operating agreement. This should be crafted carefully and for your best protection with an attorney experienced with such matters. For example, it would be wise to require in your operating agreement that your GM must sign any and all guarantees that you must sign.
Regarding buying back your GM’s equity upon their departure, there are many nuances to discuss. One major point to keep in mind is if either the GM resigns voluntarily or you terminate the GM FOR CAUSE, the purchase of the GM’s equity should be at YOUR OPTION, it should not be mandatory. You should not give the GM the ability to force you into buying back their equity by leaving or behaving so badly that you are forced into firing the GM for cause. If times are tough and the value of the dealership is declining, the GM should not be in a position to compel you to buy back the GM’s shares permitting the GM an avenue to cash out which you yourself do not have.
Finally, if you own any of the real estate which your dealership occupies, you may wish to consider letting your GM acquire a similar percentage of the real estate as the GM owns of the dealership. Because your GM likely has limited dollars as discussed above, perhaps the GM owns 5 percent of the dealership and RE company rather than just 10 percent of the dealership, for example.
Not every owner likes doing this. However, it nicely keeps your interests aligned with your GM, reduces conflict and when you sell the dealership it will prevent disputes between you and the GM in valuing the buyer’s offer as it is allocated between the dealership and the sale price, or rental rate, of the real estate.
Note: this article does not constitute legal advice. Please consult an attorney for the matters discussed herein.
Cyruli Shanks Hart & Zizmor LLP: The Members of Cyruli Shanks Hart & Zizmor have been representing auto dealers for over 25 years. Andrew Zizmor oversees the corporate and real estate transactional practices, which includes dealership buy/sells, real estate sales and leases, all related financings, Shareholder and Operating Agreements, construction agreements and factory audits. Russell Shanks runs the firm’s commercial litigation practice, which includes all commercial disputes, factory terminations, chargeback disputes and other issues, and attorney general and other governmental agency claims. Our extensive experience representing auto dealers and insight into that business enables us to perform legal services in a manner that is most meaningful, and best caters to, the needs of auto dealers and their businesses. For additional information, please contact Andrew Zizmor at (212-661-6800) AZizmor@cshzlaw.com