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Is Selling Your Business to Employees the Right Move? The Benefits and Downsides of Making an Employee a Buyer

If you have given some thought to one day selling your business to your employees but have also wondered how that might work, you are not alone. Meet “Jasmine,” a typical–but fictional–owner, who came to us with her questions about transferring her 23-person D.C. architectural firm to her employees.

 

We had done personal planning and business work for Jasmine and, over the years, had frequently invited her to consider how she might want to exit her business when she felt the time was right. Like many owners, Jasmine had been so busy working to grow and manage her company that she just hadn’t found the right time to add “exit planning” to our meeting agendas. When she scheduled this meeting, we were surprised to learn that exit planning was exactly what she wanted to discuss.

 

        “I just turned 63,” Jasmine began. “For years you’ve been telling me to think about my ‘endgame’ for my business, and believe it or not, I’ve been doing just that.”

 

        “That’s great,” I responded. “What are you thinking?”

 

        “Well, I’ve done more than think,” she said. “I’ve actually had some conversations with third-party buyers and learned that I’m not opposed to the idea in principle, but I just don’t see the practicalities of it working out.”

 

        “Practicalities,” I interrupted. “Tell me what you mean.”

 

The Future of Jasmine’s Business Was Worth More to Her than the Highest Price

        “I think we could have a meeting of the minds on the purchase price,” Jasmine explained. “But I just don’t see a culture fit. There’s just too big a gap between how my people operate and interact with clients and how these prospective buyers do. And honestly, I like how we do things. I’ve worked hard to create the relationships I’ve built with my clients and our culture. I really don’t want to sell that out from under my clients or employees.”

 

        “Okay, so let me ask you the same question I’ve asked you when we’ve done your other planning,” I said.

 

        “I know what you’re going to say,” she laughed. “’So Jasmine, what are your goals here?’ Am I right?”

 

        “You took the words right out of my mouth,” I responded.

 

        “Well, obviously continuing the culture I’ve built is more important to me than I realized,” she said. “But that raises a whole new set of practicalities. Meaning: I just don’t think the three employees who could keep this thing running once I’m gone have the money to buy me out.”

 

        “Well, most employees don’t,” I responded. “That’s why we structure these sales so employees have money to buy the company from you in a way that minimizes your risk and keeps you in control until you receive your purchase price.”

 

        “You’ve got my attention,” Jasmine responded. “Please continue.”

 

Would You Sell Your Baby (er, business) To the Highest Bidder?

Jasmine’s desire to exit her company in a way that leaves its culture intact and employees onboard is one we run into every day in our work with business owners.  But rather than dive right into outlining the terms of a transfer plan, we begin by discussing the owner’s goals. This response is generally quite different from the ones owners can expect from many of their other advisors.

 

For example, if you told your CPA that you were thinking of selling your company, he or she would begin by estimating its value and possibly the tax consequences of the sale. If you told a business broker or investment banker the same thing, they would also make an estimate of value for several reasons including the fact that transaction intermediaries are paid using a percentage of purchase price. Attorneys, hearing about your desire to sell, will begin to prepare your company for a buyer’s due diligence.

 

Estimates of value, purchase price and tax liability, and preparation for due diligence are all necessary parts of the sale process, it’s just that we begin, as Jasmine expected, where we always do: understanding an owner’s goals. We ask:

  • How much cash do you want/need when you exit to live the post-exit life you desire?
  • Are you willing to work in your company for the period of time that it will take to complete the transfer?

 

With those two owner-related pieces of information, we turn our focus to the employees:

  • Do employees want to own your company?
  • Are they willing to assume the debt, leases and bonds (if applicable) that you have personally guaranteed?
  • Do they have the skills to grow your company before the transfer is complete?

 

Only then do we look at your business:

  • Is business cash flow consistent and strong enough to support an employee buy-in?
  • Is the business ready for you to step out of your role as leader, rainmaker and /or strategic planner?

 

Your Goals: What Do You Want to Achieve Selling the Business to Employees?

Our article, “The Seven Steps of Small Business Succession Planning” describes our owner-centric approach to helping owners plan to exit their companies—no matter what type of successor you choose. Once we calculate how much cash you need to support your post-exit life, we talk about how long you are willing to remain active in your company. When you tell us that you are considering a sale to key employees, we probe the timing issue because selling a business to employees takes time to complete primarily because employees do not have the cash to pay you for ownership.

 

Which Employees Are Willing and Able to Take the Risk?

You may have noticed that we put the question about whether employees want to become owners at the top of the list. That’s because not all of them do.

 

Our next question is really about risk: are employees willing to take the risks that you have? Putting the question in terms of leases, debt and bonds puts some specifics around the more general assessment that we help you make about your employees. The most capable and willing employees in the world may not be risk-takers in the way that owners must be.

 

Every founding owner we’ve met has that entrepreneurial spark. In starting a business, we suspect that you expected to succeed but acknowledged the possibility that you might not. As you’ve grown your company, you’ve taken a risk every time you have launched a new product or service or entered a new market.

 

That willingness to risk is not always present in second-generation owners or in the employees who owners hope will step up to succeed them. Successful owners must accept risk if their companies are to grow. If they are not, stagnation sets in.

 

Only after we assess your employees’ willingness to buy-into and assume ownership do we look at whether they have the ability to grow a company. That ability is key to the success of this type of transfer because a company’s cash flow / profits funds the transaction.

 

Is an Employee Purchase Right for Your Business?

If you have been taking distributions of cash flow and cash flow is static during the period it takes for employees to buy in, you will feel the pinch of not taking home the “compensation” you’re used to. If, on the other hand, cash flow and profits grow during the transfer period, that pinch is a whole lot easier to tolerate.

 

In addition to cash flow and profits, we look at the role you play in your business. Early in a company’s maturity, owners are critically important in recruiting new customers, maintaining relationships with existing customers and making strategic decisions. Often, they are the brains behind the service or product that the company sells. When people think of the company, they think of the owner.

 

As a business matures, however, we help owners transfer many (if not most) of those key roles to employees because the real value of a business to a buyer lies in what it is worth without its seller. So, when you tell us that you want to transfer your company to employees, we have to look to see how far along you are in transferring key responsibilities to your successor owners. We ask if you are ready to let go of those responsibilities. If you aren’t ready to let go or haven’t started transferring responsibilities but want your employees to take the reins in the next few months, we all have a lot of work to do.

 

The Pros and Cons of Selling Your Company to Employees

If you are thinking about selling your business to employees, there are some great reasons to do so, as well as some drawbacks.

 

The Benefits

Employee Reward

Many owners want to “reward” their key employees for the years of effort they’ve put into building the business. Selling the business to them can do that, but keep in mind that employees may not view purchasing a business that they’ve helped to create as the “reward” you think it is.

 

Community Presence

Owners, especially in small towns, want to keep their companies in their communities and are legitimately concerned that a third-party buyer may not do so. Depending on the type of buyer, those fears may be justified. Recently, we watched a buyer acquire a broker/dealer only to release its 500+ employees. The purchaser wanted only access to the broker/dealer’s customer list.

 

Owner Legacy

Jasmine didn’t use the word “legacy” in telling us what she wanted to preserve, but if she had, we would have understood. In talking about her company’s culture, Jasmine was also talking about her legacy. She treated her work, clients and employees in a certain way and wanted to see that continue after she left. Employees who are steeped in a particular culture are good candidates for maintaining your legacy.

 

Team Success

It is quite common that owners want to “dance with the ones that brung them.” Most appreciate the team of employees that have made the company successful to date and expect that success to continue, even though that team may require some new members after owners depart.

 

The Devil Owners Know

Few (if any) owners believe their employees are perfect, but they often fear the devil (buyer) they don’t know more than the one they do (their key employees). Knowing their successors gives many owners the peace they need to move on to the next phase of their lives.

 

Ongoing Cash

Compared to sales to third parties (assuming those third parties pay all cash at closing) selling a business to key employees takes more time. During the buy-in period, owners continue to receive their salaries and all the perks of ownership. If the transfer is well designed, you can reduce your involvement in running your company to only those activities that you enjoy and adjust your departure dates.

 

The Drawbacks

Little Upfront Cash 

As we’ve mentioned several times, rarely do employees have sufficient cash to buy you out. If transfers are well designed, over time, however, you will receive cash for your ownership interest.

 

Funding the Purchase

If you are thinking about transferring your company to employees but don’t like the idea of funding the purchase out of your pocket, you have a point. The profits of the company will fund your employees’ buy-in. If profits grow during the buy-in period due to the effort of those same employees, that pill is much easier to swallow.

 

Time

If you tell us that you want to be on the beach in six months, selling your business to key employees is not likely the best vehicle to take you there. We’d argue that no sale process can move that quickly, but depending on how much cash you need the transfer to yield, transfers to employees take longer than other types of sales.

 

 

So you work in Washington DC and you want to sell your business to your employees….

If these thoughts have crossed your mind, you are not alone. Many owners would prefer to sell to their employees but become so overwhelmed by these questions that they “punt” and sell to a third party.

 

Selling Your Business to Employees: Transferring the Culture of Your Business While Moving Towards Retirement

Just like Jasmine, the way you operate your business and interact with customers may be the very reasons you own your own business.

 

As you think about your business after you leave it, you want the culture and relationships you’ve built to continue. Depending on your business, selling to an employee may be the answer you are looking for. If you’d like to sit down to talk about your goals and how a transfer to employees might meet them, give us a call.

 


2099 Gaither Road Suite 110 Rockville, MD 20850 info@obsidianplanning.com 301-990-4395




2099 Gaither Road Suite 110
Rockville, MD 20850
info@obsidianplanning.com

301-990-4395