SELLING A BUSINESS

Mar 8, 2022

A Guide To Selling A Business To Your Key Employees

After investing years in building it, it is only natural that you will have a deep emotional attachment to your business. Yet, you won’t be  running it forever. Every business owner should have an exit strategy for the future when they want someone else to take up the risk and turmoil of ownership.

Selling a business to key employees is one of the more popular forms of exit planning. Sometimes there is a clear internal heir apparent. In other instances, one or more employees may express interest in purchasing the business. If you are considering this exit avenue, you must have concluded that your key employees not only have knowledge of the business but also the desire to own it.

Advantages

An exit to key employees has multiple benefits.

• Key employees are interested in growth, stability, increasing profitability, and building long-term business value. They are vested in its success and won’t jump ship shortly after the transaction is concluded if they own the company.

• Key employees are more likely to remain committed to the mission, culture, value and legacy of the business.

• There is a smoother transition. Why is this important? If something happens to you (such as an abrupt disability) or you otherwise have a need to rush the process, it is easier to accelerate the process when dealing with key employees.

• Key employees have had years of observation and on-the-job training to prepare them to take full control. They have more confidence in their knowledge of the company than an outside party does. No steep learning curve.

• You transfer ownership to a tested management team from the get-go.

• Key employees are an ideal successor if your business model relies on niche knowledge and experience.

• It is an opportunity to reward key employees for the years they’ve put in to build the business.

• For businesses in small towns, it makes it more likely the company will stay in the community. A third party may choose to close the business or transfer operations elsewhere.

• Key employees already have a good relationship with customers, vendors, and other employees.

• Complex tax planning may be arranged between you and the employees thanks to the trust built over the years.

Disadvantages

There are some downsides to this sale process.

• Employees’ and entrepreneurs’ mindsets are markedly different. A superstar employee may not necessarily be as competent in handling the risks and dynamics of ownership. They may not have that entrepreneurial spark.

• If selling the business to multiple employees, there is a risk of conflict may pull you back into the business to restore cohesion.

• Selling to key employees limits the range of potential buyers. The lack of buyer competition could lower the purchase price.

Types of Deal Structures

The main reason that deals involving the transfer of ownership to an existing employee fail is because of the employee’s inability to raise sufficient funds for the transaction. So a key concern is how to pay for the purchase if you choose this type of business exit. There are different types of deal structures you could leverage. Here’s a look at the four major ones.

Long Term Installment Sale

An installment sale is the traditional way of selling a business to key employees. It usually commences with a business valuation that determines how much the company is worth - a process for which Beacon provides a complimentary valuation.

Next, identify the key employee(s) or open the offer to any employee interested in buying. Agree on the repayment period and interest rate then have a promissory note signed by you and your key employees. The employee banks on the company’s future profits to make the installment payments. An installment sale is secured by the company’s stock, assets and the employee’s personal guarantee.

With an installment sale, there’s a risk the business could land on hard times and employees fail to make future installments. As an owner, you can mitigate against this risk in several ways.

• Transferring excess cash from the company before you sell it. This has to be done carefully to avoid plunging the business into cash flow problems in future.

• Participate in running the company for as long as needed to be certain that cash flow will continue.

• Retain the right to buy back the business if certain triggers occur

• An acceleration provision that requires the key employees to pay the remaining installments faster if they do not meet predefined financial targets

• Make nonqualified deferred compensation payments, lease payments, severance payments or other means of receiving tax-deductible payments directly from the company. In addition to providing liquidity to the owner, these payments lower the business valuation–making it more affordable for employees while minimizing the tax obligation for the seller.

Pros

• Rewards key employees since little to no money is paid upfront.

• Employees take control of the business.

• You receive a steady income stream over time.

• You are in a better position to structure a transfer that suits their needs and interests, unlike the inflexibility of working with a third party buyer.

• Your salary and perks may continue through the multi-year transition. Continued cash flow is a valuable source of asset accumulation.

Cons

• Employees rely on a promissory note and thus future earnings of the business. Poor performance can extend exit timelines and make installments protracted.

• You will receive little to no money at closing. This is unlike the large or full cash payouts you’d receive with other deal types.

• There is no guarantee the employee will steer the ship as well as you did. If the business stops performing well, future installments are in jeopardy and the value of the business drops.

• If you fail to close the sale to your key employees and instead opt for a third party, you may end up creating disgruntled employees.

• Transferring ownership takes longer than other deal types.

Leveraged Management Buyout

A leveraged management buyout is financed by a conventional lender, venture capitalist or private equity firm. You or your employees find a financial partner that will finance the key employee’s purchase of the business.

Since an external party is driving the transaction, certain conditions will often have to be met. First, you must demonstrate a capable management team that can run the business in your absence. Second, the business must have sizable cash flow with promising future growth prospects. Third, the company should have an asset base that facilitates the debt financing. Fourth, the business should have a fair market value of at least $5 million but preferably $10 million or more.

If your business meets these requirements, you and the management proceed to agree on a valuation of the business. A letter of intent is executed that gives a grace period of 90 to 120 days during which the management team purchases the business. They do so by obtaining bank debt and/or approaching an equity investor. The equity investor will evaluate the viability of the projected return on their investment before making the decision to finance the deal.

Pros

• Rewards employees by ensuring part of the business may be acquired at a reduced price.

• Key employees gain operating control.

• Minimizes your ongoing risks as the business owner. You exit the business much quicker than through a long term installment sale.

• As the business owner, you receive an immediate cash payout in full.

• The business may get additional financing from the equity investor in future to fuel further growth.

• If a suitable equity investor cannot be found, you can choose to maintain an equity position.

Cons

• Not every business will be attractive enough for a leveraged buyout

• Key employees may not be satisfied with a minority stake and instead want control of the entire business.

• Burdens the business with debt

• If the deal falls through, your employees may be disgruntled if you instead opt for a third party. You do not want to have influential employees who resent the new ownership.

• The entry of an external financier may reduce your negotiating leverage and compel you to accept a deal you aren’t satisfied with or is not in your best interest.

• If the key employees were responsible for finding a lender or equity investor but the transaction fails to go through, you do not know what information they may have put out there while looking for financing. You lose control of the seller’s narrative of the business.

Employee Stock Ownership Plan (ESOP)

An ESOP is a well-established technique businesses use to reward and motivate their key employees even when the end goal is not necessarily to sell the entire business to your staff. It is a profit sharing scheme that makes employees part-owners. You would make tax-deferred contributions that may only be invested in the company’s stock.

Still, the ESOP can be a means of accumulating cash and borrowing money aimed at eventually transferring ownership to key employees. The ESOP eventually uses the cash and debt to buy your stock.

Key employees could choose to circumvent ESOP and directly buy your remaining stake in the business. If that happens, the end result is a structure that’s markedly similar to the leveraged management buyout. In this case, the ESOP buys a majority stake in the business while key employees own a significant proportion of the business directly.

The ESOP becomes a foundation for key employees to satisfy leadership and collateral requirements in order to qualify for financing and therefore the ability to complete purchase of the business. This strategy lends itself to a gradual transition involving your continued involvement as the owner.

Pros

• Rewards and motivates employees by allowing acquisition of part of the business at a reduced price.

• Key employees get operating control of the company since ESOP allocations are tied to compensation.

• Other employees have shares in the company and are motivated to contribute to its growth.

• Immediate cash payment at closing.

• Tax deductible to the business and tax-free for the ESOP and participating employees.

Cons

• Makes it harder for you to sell your remaining interest to any third party who wants full control of the company.

• Initial funding is by company money that would otherwise be paid to you as the business owner

• There are significant financial and non-financial costs that come with maintaining an ESOP

Modified Buyout

A modified buyout combines elements of an installment sale and a third party’s money. It involves initially offering a minority non-voting interest of 30-40 percent of the company’s stock for immediate and future purchase by employees. The stock is valued then downward adjusted so it is affordable to interested staff. Employees receive an extended payment period of several years that encourages them to stay with the business.

When the payments for the minority interest have been completed, you can thereafter sell the remaining ownership interest to key employees either in cash or as an installment sale. Alternatively, the owner may choose to sell the business to a third party at true fair market value.

Pros

• Reward employees by offering business at a reduced price.

• Key employees can acquire a majority stake or the entire business.

• Receive a fair market value of the business.

• Adjust the timing of ownership transfer depending on the business performance or defining events in your life.

Cons

• As a multi-stage transaction, a modified buyout takes time to conclude. You do not receive the full purchase price for a number of years. You should work with a timeline of at least five years.

• You have to remain active in the company at least until the initial minority interest buying is complete.

Conclusion

Valued employees who’ve been with the business for years eventually feel like extended family to you. To watch your business move forward in the hands of leaders you helped mentor can be deeply rewarding. Employees know the business in detail and may rather own it instead of moving to a different employer when the business is sold to a third party.

Selling to key employees has advantages, but you cannot ignore the risks of this exit path as well. When selling to employees, it is vital that you evaluate the opportunities and shortcomings of the different types of deal structures to identify the one that is most viable for you.

John McCleary

Transaction Advisor

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.