This story was published in December 2018
Entrepreneurs work hard to make their businesses succeed, and they often have a large percentage of their personal wealth embedded in those businesses. When they begin to contemplate retirement, it is important to maximize the net proceeds from the sale of their business to provide sufficient resources to support their retirement.
In considering potential exit strategies, one option is to sell the business to one or more key employees. If key employees are instrumental in driving performance, some owners feel those employees have earned the opportunity to become the owner. Others feel that selling to a key employee is an easy transaction that avoids business brokers and the long and expensive process of a third-party sale.
Business owners facing this critical decision should factor the following reality checks into their considerations:
- Is the employee likely to become an effective business owner? – An outstanding employee may not have the personality, motivation, leadership capacity, or risk tolerance to wear an owner’s hat.
- The employee may not have the resources to purchase the business in a cash transaction or sufficient borrowing capacity to obtain a bank loan. – The financing challenge is even greater for businesses with intangible value, which makes for bad collateral.
- The selling owner should not provide a significant amount of seller financing to support the transaction. – The business owner already endured investment while building the business. Why add on collection risk in retirement? If the new owner fails, the note receivable could become worthless.
- It is difficult to complete a 100 percent ownership transfer to an employee via up-front cash transaction. – If the primary objective of the retiring seller is to get paid as quickly as possible, an external buyer may be more realistic.
- To maximize the selling price, an external buyer is likely a better path forward. – A potential buyer that is already in the same industry, or one looking to vertically integrate operations and take advantage of synergies, can afford to pay more than an employee willing to step into the owner’s shoes. For this reason, a preliminary assessment is often performed to demonstrate how much money the owner may be leaving on the table with an employee sale.
For owners that have taken the above factors into consideration and still wish to proceed with a sale to an employee, the following concepts may be helpful in designing a transaction that works for both buyer and seller.
- Transfer the stock ownership of the business incrementally over a period of years. – Instead of attempting to sell the entire business in an immediate transaction, sell small percentages of the company’s stock to the employee over a number of years. This allows the employee to be introduced to the role of owner without being overwhelmed. It also makes the purchase more affordable.
- Introduce a performance-based incentive compensation program for the key employee. – Establish key metrics (both financial and operational) and be willing to reward performance. The program can award bonuses in the form of company stock or cash that could then be used to purchase stock from either the company or a majority owner.
- Transition out of day-to-day operations and into an absentee owner role. – A process of transitioning duties provides the employee with the opportunity, authority, and responsibility to develop key business relationships and gain experience in making critical decisions. If an owner has already moved to become less active in the business or already obtained absentee owner status, congratulations are in order. This effectively demonstrates that the business can still be successful in the hands of another owner. The sudden step-away of an active owner, by contrast, is a major risk factor.
- Reap the benefits of the business’s ongoing profitability during ownership transition. – Monetizing ownership value can be accomplished in ways other than just the selling price of stock. To the extent a business is generating surplus net cash flow, receiving W-2 bonus compensation, shareholder distributions, or partial stock redemptions through the company will help shift value from the company to the owner.
The above can help with the transition to a key employee or multiple employees, and ultimately result in a final stock buyout of the remaining ownership interest at a future date. It is a practical and manageable succession plan design for owners intent on an employee solution.
John S. Stoner, CPA, CVA, is a partner in the business consulting services group of RKL and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.