Feb 28, 2023
The [Pros and] Cons of Selling a Business to Employees
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Around 15% of the business owners we work with used to work in the very same business as an employee. They may have joined as a tech or crew member and approached the owner with interest in buying him out. They may have been a family member who worked in the back office and had the opportunity to take over the business from their father or mother.
Regardless, it's no shock that many owners used to be employees. And, it's no shock that many owners express interest in selling their business to an employee. After all, there are a lot of upsides: low friction, keep the legacy and culture alive, and stay involved as an advisor after close.
That being said, we've also seen employee transfers or sales go pretty poorly. In this post, we'll outline some pros and cons of selling a small business to a key employee. At the end, we'll give some tips on how to maximize the chance of success.
What are the pros of selling a business to employees?
1. The employee buyer is more likely to keep the legacy of the previous owner alive.
Given that the buyer has been an employee with the business for a while, they typically are less likely to make drastic changes to the business. There's a lower chance they change the name, or do some fancy overhaul to the traditional services and offerings.
Why is this the case? Well to start, employees know what matters. Unlike more corporate types, employees know that it comes down to selling jobs or SKUs or pizzas, building a good team, retaining the team, and driving costs down. It's not complex, but it's not easy either.
Some other types of buyers may want to immediately come in and change things up on day one. Some may want to lay off employees and move to only 1099s. Others may want to do an entire rebrand with a fancy website. That's not to say you cannot succeed with these approaches, but it increases the chance that the business is a lot different from how the owner left it.
2. The employee buyer already knows the company's way of doing things.
Relatedly, an employee can smoothly transition into the owner seat without a ton of risk of things going wrong. By being able to watch the owner operate over the course of a few years, the employee knows how to handle the common edge cases and fires that come up.
They also know who in the company knows what. They know their colleagues' unique strengths. This will allow them to quickly go to the right person when something inevitably goes wrong.
This is different from a third-party buyer who will take time to transition ownership responsibilities and get a lay-of-the-land inside the small business they bought.
3. The employee buyer is already a culture fit for the current business.
The employee buyer wouldn't still be an employee if he or she were not a good culture fit for the business. Owners are often surprised but culture fit can make or break an ownership transition.
If a high-flying buyer comes in the door and starts barking orders at employees, you can have a transaction fall apart the day after the bank loan closed. After all, most employees do not have equity or profit sharing arrangements in small businesses, so there's nothing keeping the employees at the business once the sale closes.
4. The business transaction can be smoother with an employee.
Given that there is already a basis of trust between the owner and the employee buying the business, the actual transaction can be a lot smoother. Why? Instead of getting in a board room and debating details with expensive attorneys, an owner and employee likely have good communication habits. They can chat through any issues that come up for debate.
Additionally, because employees will typically already know the good, the bad, and the ugly of the business, there is less "due diligence" that needs to be done. In fact, we've seen instances where the owner and employee will even share an attorney to draft up the agreements. Additionally, we've seen times where the owner will also help the employee get a bank loan by introducing him or her to the owner's preferred lender.
5. The owner can gradually hand things over to the employee buyer.
Many owners do not want to immediately go into retirement. At Beacon, we even call retirement the "R-word". Owners have spent decades building their business. Their personal identity is tied to being a business owner, and they take great pride in providing for their customers, employees and partners. Moreover, most entrepreneurs love making things happen. The last thing they want to think about is twiddling their thumbs with nothing on the agenda.
One pro of selling a business to a key employee is that the transition can be gradual. In fact, some employees will not even know they are being groomed for ownership initially. The framing of a potential sale to an employee can be around giving the employee an opportunity to "buy into" the company. A common progression is "employee" > "team lead" > "general manager" > "president" > "CEO".
What are the cons of selling a business to employees?
1. The buyer may not have the same level of commitment or motivation as a regular business owner.
As any owner who's promoted employees before will know, some employees simply aren't cut out for more responsibilities. They may be great at their craft, diligent on delivering a great product or service, and a great team member to their colleagues. But, they may lack the prioritization, financial responsibility, and delegation skills that being an owner requires.
Owning a business comes with an existential weight and a high bar of required effort. Most owners are thinking about their small business day and night. They slowly blend their personal and professional lives. They worry about what can go wrong, what customer may leave a bad review, what supplier may hike prices.
Being an owner requires a lot of grit and a love for the game. Some employees may not have this. When that's the case, the business could go under when an employee takes over. If an owner has seller financed a lot of the transaction, this means the previous owner will need to either step back in as the owner and right the ship, or he or she will need to cut their losses and miss out on a fair payout.
2. The employee may not have much capital for a down payment.
Most employees of small businesses do not come from a lot of money. Additionally, they typically haven't been earning a lot of money. For instance, if you've been making $80-100K/yr as an auto technician with a family of 4, you likely haven't had the opportunity to save up a big nest egg for business ventures.
For owners considering selling to a key employee, this means that they will need to seller finance a lot of the transaction. By "a lot", we mean often north of 60-80%. Why? Most SBA lenders need at least 10% of the purchase price put in by the buyer as a down payment. On a $500K auto shop, this means at least $50K before factoring in capital to make payroll, transaction expenses and more. Most employee buyers won't have that, or, if they do, they may have bad personal credit that prevents them from qualifying for financing.
If the employees can scrape together some money, the owner will often need to work with them to cobble together the rest. That can mean chatting with family and friends of the employee buyer to help them raise more money, or even going to bat for the employee to a lender.
3. Other employees may begin to resent the new owner.
When an employee is in talks to buy out the business owner, there are two instances when things can go wrong: (1) during deliberations and (2) after the close of the sale.
If word gets out during deliberations, some employees may feel upset that they were passed over for the opportunity. They could start resenting the employee buyer in talks with the owner. Or, worse, they could decide to quit and start their own business in spite of not being able to take over as CEO of their previous employer.
If the sale is done completely confidentially, there is still a chance that the employees are upset after the close of the sale. When this happens, they can start causing issues under new ownership: asking for a raise, demanding more PTO, questioning the owner in front of other employees, etc.
4. The transaction could drag on and fall apart.
When an employee is buying out an owner, there is often a lack of urgency to the transaction. This is because the owner typically isn't pressed to sale and the employee has no competition in the transaction.
As such, selling to an employee could drag on for many months or years. This will ultimately distract the owner from running and growing the business. It can also distract the employee from being focused on doing their current job.
In the worst case, an owner has been emotionally preparing to transition out of the day-to-day only for life to happen and the transaction to fall apart years later.
5. The owner leaves money on the table.
When selling to an employee, the purchase price is often more dictated by the employee's ability to pay than what the fair market value for the business is. As such, it's common for owners to leave money on the table when selling to an employee.
The owner likely didn't work with a business broker to get an accurate business valuation. The employee likely didn't have to compete against other buyers to win the deal.
For some business owners, this is completely fine. Perhaps they don't need an upfront payment or they don't care about the money. But, for others, they lose out on much needed funds for their retirement.
Tips for Selling Your Business to a Key Employee
Start Early: By starting early, you can approach an employee with "succession" planning years before an eminent sale. This will allow you to have a frank conversation without spooking the employee with fears of a new owner coming in the door. Additionally, it will give you time to vet that the employee will be a good owner and to have a backup plan in case things do not go to plan.
Frame as a Partnership: By framing the sale as a partnership, the employee will be less likely to do anything brash and other employees will not start to resent the employee. You can frame the transition as the employee buying into the partnership.
Set Checkpoints along the Way: Work with advisors to set up a playbook for exploring and executing a sale of your business to a key employee. This should include a timeline for approaching employees with the opportunity, a plan for testing his or her abilities (e.g., promotions to managerial roles or the addition of back-office tasks), a target deadline for having a letter of intent agreed to, and an understanding of when the employee will have financing arranged and the deal ready to close.
Run a Competitive Sale: My best piece of advice is to run a competitive sale in the background and be upfront about that to your employee. This will make them work harder to deserve the ownership title and allow you to get a fair payout for the work you've put into the business. You can use the offer prices you're receiving from other buyers to help you understand what your business is worth. You can use the interested buyers to make the employee take the ownership opportunity seriously and move quickly.
Know Your Minimum Price: While you explore a business sale to a key employee, it'd be ideal to have conversations with your financial advisors on what minimum price you need to fund your next chapter, whether that's a new business venture or retirement. With your minimum price in mind, you can know how much the employee needs to bring to the table at closing.
Understand Your Desired Involvement: One risk we haven't discussed above is previous owners becoming entangled in operations after selling to an employee. Often the employee will struggle with "letting go". He or she will want to call the previous owner with questions, concerns, and ideas. It can feel as if an owner sold to an employee but still kept the job. Having an honest conversation with yourself and the employee will ensure you don't get more involved post-sale than you want to.
Not quite ready to sell?
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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.
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.