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How to Sell Your Business to an Employee (and How Not to)

An interesting way to exit your business might be to sell it to an employee.  Sometimes, there is an heir apparent.  Other times, an employee expresses interest in buying the business.  In most cases, the employee has plenty of knowledge about the business and desire to own it, but is lacking one essential element – money.  

There are a couple of ways to transact with an employee.  One is a more traditional approach and the other will force you to think outside the box a little.

The Traditional Way to Sell to an Employee

The traditional way to sell to an employee involves coming to terms on a valuation of the business, creating a note, and then using the profits of the business to make payments.  The note is generally secured by the stock or assets of the company (and perhaps a personal guarantee from the employee).

There are a couple of things you will want to note here:

1.  You don’t actually get any cash at the time of sale.  Your friends that are selling to third-party buyers get big checks and buy boats, designer dogs, and summer homes, but you will be receiving your payment over time – usually five to seven years.  

2.  Your employee/buyer can really mess things up and you might not get paid.  The company, under your leadership may have performed well, but if your employee/buyer can’t keep things running smoothly, your payments are in jeopardy.  

3. The valuation of the company can be tricky when you are negotiating with an employee.  Of course, you want to get a full value for your business, but employees have a tendency to undervalue what the business would fetch if you ran a professional sale process.  

4.  If you can’t come to an agreement with the employee/buyer on value or terms and you decide to sell the company to a third party, you may have a disgruntled key employee on your hands.  There is really nothing worse than explaining to a buyer how wonderful your management team is, only to have them pout and not play nicely during due diligence.  

Think About a Management Buyout Using a Private Equity Partner

This option can go one of two ways.  

Management Buy Out – Employee/Buyer Picks the Financial Partner

You can allow your employee/buyer some time to find a private equity partner who will finance the purchase of the business for them.  It goes something like this, “Mr. or Mrs. Employee, I will give you 60 days to find a financial partner so that, together, you can put together an offer to buy my business.”  Mr. or Mrs. Employee/Buyer finds one of the 6,000 very eager private equity firms in the US to engage and together they put an Indication of Interest in front of you to buy the business.

Here are the downsides to this approach:

1.  The value or terms that they put together might not be what you want.  See point #4 above.  You are stuck with a disgruntled employee.

2.  Now you have a professional buyer in the mix (the PE group) and you don’t have a lot of negotiating leverage.  What happens when you can’t agree on an escrow amount?  Or other key terms in the purchase agreement?  You don’t really have another buyer to turn to, so you might be artificially inclined to accept terms that aren’t in your best interest.  

3.  The employee/buyer has picked a partner, but if that doesn’t work out for you or they never make it through due diligence, they are stuck without a backer.  [note;  this is really more common than you might think.  Private equity firms are interested in buying almost any business…until they are not

4. You might want to try to sell the business yourself if things don’t work out, but you don’t know what your employee/seller has put into the marketplace while he or she has been trying to attract a partner.  You have lost control of the marketing of your own business.

Management Buy Out – Seller Picks the Financial Partner

“Wait just a minute!,” you say “This isn’t an employee purchase at all.  This is just me selling the business to private equity.”  Hang with me here and I will explain.

You can run a sale process for your business, target private equity buyers, and make it clear that the employee/buyer wants to be an owner post transaction.  

It can be structured this way:  

– run an investment banking sale process – targeting private equity buyers.

– create a “transaction bonus” for the employee/buyer – which he or she can use to purchase equity once the deal is complete.  Private equity buyers will welcome this.   A bonus need not be huge, just something to get the ball rolling for the employee/buyer.

– most private equity firms will put together option plans to incentive management teams post-transaction which will give the employee/buyer the opportunity to own more during the period of the private equity ownership. 

The benefits of this approach are many…

1. You will receive a market-based (and higher) purchase price for your business.  It will probably be more than enough to cover the transaction bonus you are paying the employee/buyer.

2.  You will have negotiating leverage during the deal process because you will have other buyers if things get tense with the first one you go down the path with.

3. Your employee/buyer will have the benefit of being aligned with whomever you choose to buy the business.  Because you will have pre-screened them for their willingness to work together with your employee/buyer, they won’t be stuck without a partner.

But there are also some challenges…

1. You are limited to private equity buyers.  If you run a competitive sale process, you can be fairly certain that you are receiving a full valuation.  A process without strategic buyers though, can leave out some of the buyers that have that have the ability to pay the most.  That being said, your investment banker can run a very good and competitive process only including private equity firms.

2.  You employee/buyer might be unbackable.  If your employee/buyer is an irresponsible goof, it is going to be difficult to find a private equity firm that will stand behind him or her.  Worse yet, the buyer could back him or her during the process only to turn around and fire them later for being incapable of leading the firm.  My guess is that you wouldn’t have such a manager in your organization and if you did, that’s probably not the person you would pick to sell the business to, but be honest when evaluating your employee/buyer.

In summary, you can certainly sell your business to an employee.  I encourage you to understand the risks before you go down that path and think of all the possible structures.  There are plenty of examples of transactions we have been involved in where managers have successfully purchased the business in partnership with private equity.  Consult with an investment banker if you think this might be the right path for you.

You will notice that I did not mention ESOPs – which are an entirely different animal.  In an ESOP, you sell your business to many employees, not just an interested key manager.  ESOPs have gotten a lot of publicity as of late, but aren’t always a great answer for business owners that want the highest value for their business

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