Top issues for selling your business to employees

By Generational Equity

07/01/2016

Often when we meet with potential clients and do our initial compatibility analysis to ensure that our services are a good match for the company’s, we are frequently told, “I sure would like to take care of my wonderful, loyal employees and sell the business to them.” Although we find this to be a noble sentiment, as history has shown, selling to one’s employees carries big potential risks.

Who Will Be Your Successor?

First, unless you have groomed an individual to be a solid CEO type person to replace you, management by committee usually does not yield much success.

I once spoke with a business owner who indicated to me that his VPs were interested in acquiring his interests and running the company. Turns out he had three key folks, a VP of Sales, VP of Operations, and a VP/CFO. Each of them was very skilled in their particular vertical.

But as I began to delve deeper into the relationship, it became apparent that although they had all been with the company for some time, their individual personalities did not mesh. As we counseled him on this situation, he eventually talked himself out of this idea because he realized that it would only lead to eventual strife and the company would suffer, as well as his business legacy.

Are You the Bank?

Post transaction success is especially vital to the ex-business owner when he or she exits via an employee buyout, which leads us to the second major risk when you sell a business to an employee.

Odds are good that you personally will have to finance the transaction; meaning you will be carrying paper on the deal for several years and your buyout will most likely be contingent on the company growing at a good clip so that the new employee-owners can make the quarterly payments that are due to you.

Be honest with yourself: Do any of your employees, even collectively, have the capital available to outright purchase your shares of the company today? Odds are good that they do not. We rarely see employees with the capital to pay.

So this means that you might get 10% down at sale, and the 90% (hopefully with interest) spread over a five-year timeframe. Do the math on what this means. Usually it is the spouse that helps the owner see the folly in this deal structure. They say, “You mean that dream house we were going to build by the lake will have to wait five years?”

A tough reality to face.

What About Experience?

Finally, even if you have a key employee who can raise the capital (maybe he or she has a rich aunt with money just sitting in the bank), do you trust the legacy you built on someone with zero experience as a CEO?

As you know, being a great VP of Operations does not necessarily make you a successful CEO. In most cases, it is far better to let the VP of Operations continue to thrive in that role under an experienced new owner or ownership team that will provide him with the capital and funding to reach his full potential. Promoting him to owner/CEO could be the worst thing for his career.

Other Ideas

Obviously you feel a desire to reward your loyal employees and a new owner definitely has an intrinsic interest in seeing them stay post sale. However, there are lots of ways to structure a transaction where you pay bonuses to your key people, or you have the buyer create new compensation plans that reward them for staying post acquisition.

If you are several years away from an exit, there is always the creation of phantom stock. Phantom stock or phantom equity is a method that allows you to give your employees shares of non-voting stock, which they can redeem later, usually when thecompany is sold or when the employee retires, assuming the employee is fully vested. Unlike traditional shares that need to be repurchased when an employee leaves or is terminated, phantom shares essentially disappear upon certain triggering events.

Generational Equity (part of the Generational Group) does not provide tax and stock structure advice. Before you consider doing any sort of stock sharing plan, consult your CPA and attorney. While talking with them, bring up the subject of phantom equity as an option. It is not widely known and has many benefits.

One of the biggest benefits of creating a phantom stock program is that it is far less costly than creating an ESOP. And, since these are non-voting shares, you can still make key decisions without getting the approval of your employees.

It is this last point that is vital to consider. If you provide company stock to your employees, depending on the way you structure it, they technically become owners. We have seen horror stories where a majority owner decides to sell but is unable to do so because he can’t get approval from the 20 other employee owners.

Don’t fall into that trap. Reward your key folks in ways that also protect and benefit you and the company legacy.

Time and space do not allow me to cover all the other ideas of how you can reward employees AND close an optimal deal. If you would like to learn more about this topic or how to successfully exit your business using any method, I recommend that you attend a Generational Equity succession planning conference. These are designed to educate business owners on the key steps involved in how to plan, and execute, a successful and profitable exit. To find out if you qualify to attend, please call and speak to one of our senior business advisors at 972-232-1121.

Carl Doerksen is the Director of Corporate Development at Generational Equity.