Don’t Get Burned When Offering Skin in the Game

Some franchised dealers find it advantageous for a senior manager to have “skin in the game” in the form of owning interest in the dealership to share rewards and risks.

Some franchisors will even require this if the dealer wishes to designate a franchise successor, which should be done. The most common way to achieve this is by selling an equity interest.

Any dealer who considers doing this should keep some things in mind. A written agreement with the manager covering the investment and ongoing equity ownership is a must. Here are important points to consider when designing the deal.

Tax impact. A dealer may wish to reward the manager for years of service by providing a bargain price for an interest in the business. However, that may have an adverse tax impact. 

The difference between the market value of the interest and the bargain price that the manager pays could be deemed as income to the manager in the year of purchase.

After digging deep to make the investment, the manager could wind up with a large and unexpected tax bill. A dealer may want to hire an expert to value the dealership to prevent this problem.

Annual income tax. Another consideration should be the ongoing liability of the manager for taxes on imputed income, if the dealership is a Subchapter S corporation or an LLC.

The agreement should provide for annual profit distributions sufficient to cover the tax liability of the owners, provided that this does not impair the capitalization below that required by the franchisor. Further distributions should be at the discretion of the board or the majority owner.

Duration of ownership. The purpose of the ownership interest is to provide an opportunity while the manager is employed. But what if he or she leaves or becomes disabled?

Unless the agreement provides that the manager must sell the interest upon employment termination, you may find yourself with a permanent, non-working, minority shareholder. The same is true with heirs if the manager dies. The agreement should detail what happens if the manager is no longer employed, including the terms under which the manager must sell the equity interest.

Shareholder agreement. The agreement should address numerous issues covered in any shareholder agreement such as voting rights; go-along obligations if the majority holder decides to sell the stock of the dealership; and any opportunities for future performance-based investments.

Franchisor approval. No equity transfer should occur until the manufacturer approves. Dealer sales and service agreements generally provide that a transfer of an interest to a new equity owner is subject to manufacturer consent.

Some state statutes may restrict the manufacturer’s ability to reject an applicant. While a state law may prescribe the standards a manufacturer must follow in considering the application, the law does not eliminate the need for the dealership to formally seek approval.

From the franchisor’s standpoint, it has the right to know who will own part of the dealership and determine if the person meets its standards as limited by state law. If you are selling an interest to a manager, don’t just accept payment and issue the stock.

To recap:

Think through the terms by which the manager will buy and hold stock. Discuss those terms with the manager.

Consult a knowledgeable attorney to prepare an investment and shareholder agreement.

Submit the agreement to your franchisor to commence the approval process. Have the proposed new shareholder complete an application to the manufacturer, submit it and await approval.

Once you have obtained that, close the transaction. Then the manager will properly have skin in the game with terms that protect everyone’s interests.

Michael Charapp is a lawyer who represents auto dealers. Based in McLean, VA, he is at 703- 564-0220 and [email protected].