Selling Your Business to a Key Employee
Owners wishing to sell their businesses often look to key employees as a way to transition the business to someone who knows and understands the business and often has a similar vision for the business.
But selling a business to a key employee is not as simple as handing over the business and cashing a check. Here are some steps you must still take:
- Identify and groom a successor if the business has no identifiable candidate.
- Calculate a fair value of the business for the sale and determine whether that value is adequate to move forward with a sale.
- Consider how involved the owner wants to be in the business during a defined transition period.
- Develop a deal structure that works for both parties because key employees often don’t have cash or the ability to raise capital.
- Evaluate the tax implications of any deal structure.
Financing the Deal
Typically, business owners use two types of sales methods when selling a business to key employee(s): (1) long-term installment sale and (2) leveraged management buyout.
Long-Term Installment Sale
Under the long-term installment method, the owner is paid over a period of time using the company’s cash flow to support such payments. A long-term installment sale is structured as follows:
- The owner and the key employee(s) agree on a valuation of the company.
- The key employee(s) pay the purchase price using a promissory note, with a reasonable interest rate and installment payments. The note is often secured by the company’s assets and equity, and the key employee(s) makes a personal guarantee, including pledging some personal collateral (usually residences).
- Little or no money is paid to the business owner at closing.
Leveraged Management Buyout
The leveraged management buyout method draws upon the company’s management resources, outside or seller equity and significant debt financing. This buyout can be ideal for business owners who want to reward key employees, position the company for growth and minimize his or her ongoing financial risk.
To effectively execute this buyout, a business should possess some of the following characteristics:
- The company’s management team is capable of operating and growing the business without the business owner’s involvement.
- The company has stable and predictable cash flow.
- The company has strong prospects for growth described in a detailed business plan.
- The company has a solid tangible asset base, such as inventory, machinery and equipment. Hard assets make it easier to finance a sale using debt; however, service companies without significant tangible assets can obtain debt financing, at higher cost.
- The company has a fair market value of at least $5 million.
If a business possesses some of these characteristics, a leveraged buyout may be a good option. Still, a prerequisite for a management-led leveraged buyout is the business owner/seller and the management team being able to agree on a fair value for the company. Once that occurs, the parties execute a letter of intent that gives management the exclusive right to buy the company at the agreed price for a specified period of time. Next, the management team and its advisors arrange for a portion of the transaction to be funded by the senior bank debt. Bank lenders usually require the management team to make an equity investment prior to closing. After bank debt, the management team may seek an equity investor. An equity investor would receive from the management team a complete package of price, terms, debt financing and management talent.
Under either method, a business owner has the flexibility to structure a transaction to best meet his or her personal goals and goals for the company as it transitions into new ownership.