Five Reasons Owners Sell Their Companies to Key Employees
Originally published on February 22, 2019
Updated on October 30th, 2023
Your key employees are usually an integral part of your business and its success. So when it comes time to sell, it’s no surprise when owners choose to sell the business to key employees to purchase the business and carry on their legacy. Here are five of the reasons why this can be a good choice.
Reason #1: Owner has already achieved financial security. Owners who have already achieved such security (separate from and prior to any sale or transfer of their companies) enjoy the luxury of selling to their key employees. They may have wanted to sell to them because they felt they “owed” their employees or even because they had promised to do so. But the reason they actually do so is because their own financial independence is secure.
Reason #2: Owner has no alternative. With few exceptions, owners whose companies are worth less than $2 million (and who do not have children who can assume ownership) sell to key employees because they do not consider liquidation to be a viable option.
Reason #3: Owner has sufficient time to execute this transfer. Business owners who need full value from the sale of their companies to secure financial independence sell to key employees when they have sufficient time to complete such a transfer. Typically, an owner must stay active in (or at least in control of) the company for at least five to ten years after the sale process begins in order to attain financial security.
Owners in this position have (usually at the prompting of and with the help of their advisors) taken steps to position their companies for a sale to key employees. First, they have hired and groomed employees who not only want to be owners but also have the ability to assume ownership. Because they have this ability, owners have made themselves dispensable to the success of their companies. Their companies can flourish without them.
In addition, these owners have made sure that their businesses are adequately capitalized with little debt so that cash flow can be paid to them, rather than to meet ongoing capitalization requirements and debt repayment.
Reason #4: Low Business Value. Often, the value of the business unlikely to ever be high enough to be sold to an outside buyer (never mind enough for the owner to achieve financial independence). In this situation, a gradual sale to the management team allows the owner to continue to work and receive compensation while promising a key employee group (KEG) the promise of eventual ownership.
Owners first determine the amount of cash they need to achieve financial independence and tells the KEG what that amount is. The KEG then knows the cash flow it must pay the owner through the transition period. The owner’s established amount is a combination of purchase price and “excess compensation” (money the owner can save and invest) paid to the owner. Often this takes the form of increased retirement plan contributions. It can also be in the form of a non-qualified deferred compensation plan that pays the owner after he or she has left the company.
Reason #5: A planned sale to a KEG is faster and less risky. Owners whose companies exceed the $2 million threshold choose a management buyout because, by design, their employees already own a significant portion of the company and they are able to exit with more money in less time.
In the first part of the two-part sale to management (discussed in the book, The Completely Revised How To Run Your Business So You Can Leave It In Style), an owner sells a minority interest in the company to a group of key employees. Before the second phase begins, the owner is paid for the minority interest; the company, largely under the operational control of the key employees, has shown it can generate enough cash flow to fund the owner’s buyout via conventional bank financing. In the second phase, the company funds the balance of the buyout through a combination of debt and equity.
If you are considering a sale to key employees, it’s important to work with advisers skilled in designing this type of transfer. You must also allow adequate time to complete the transfer. Your transition planning CPAs can help you to decide if a transfer to key employees is the best exit option for you.
The information contained in this article is general in nature and is not legal, tax or financial advice. For information regarding your particular situation, contact an attorney or a tax or financial advisor. The information in this newsletter is provided with the understanding that it does not render legal, accounting, tax or financial advice. In specific cases, clients should consult their legal, accounting, tax or financial advisor. This article is not intended to give advice or to represent our firm as being qualified to give advice in all areas of professional services. Exit Planning is a discipline that typically requires the collaboration of multiple professional advisors. To the extent that our firm does not have the expertise required on a particular matter, we will always work closely with you to help you gain access to the resources and professional advice that you need.
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