A Guide To Selling A Business To Your Key Employees

John McCleary
John McCleary
Transaction Advisor

John takes a personal approach when advising buyers and sellers on taking the next step. John has deep knowledge of a variety of markets through his background as a member of the Chicago Board of Trade and experience as a licensed real estate agent in Texas and Michigan. Originally from Detroit, John's passion for automotive runs as deeply as his love of Wolverine Football.

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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.

Disadvantages

There are some downsides to this sale process.

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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.

Pros

Cons

At The Table

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

Cons

At the Computer

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

Cons

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

Cons

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.

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Sell your business with Beacon

Explore your options with a complimentary business valuation.