Selling to a Key Employee or Management Team

Selling to a key employee or management team is often the smoothest transition and the hardest transaction to finance. The buyer knows the business, the customers and the staff. What the buyer rarely has is capital. An internal sale succeeds when the owner accepts that fact early and structures the deal around it, with a bank, a seller note and enough time.

Why owners consider it

The advantages are substantial.

• Continuity. Customers and employees deal with someone they already know.
• Confidentiality. There is no marketing process and little risk of a leak.
• Speed of diligence. The buyer already understands the operation.
• Legacy. The company remains independent and local, which matters to many owners.
• Reward. The sale recognizes people who helped build the business.

The trade-offs

The disadvantages are equally real.

Price. Without competing buyers, the price is set by valuation and negotiation. A strategic acquirer might have paid more.

Capital. Most employees cannot make a large down payment, so more of the price is financed, and more of that financing comes from the seller.

Capability. An excellent operations manager is not necessarily prepared to be an owner. Ownership brings responsibility for sales, finance, banking relationships and risk that the employee may never have handled.

The relationship. If negotiations fail, the owner has a key employee who knows the company is for sale and who wanted to buy it. That is a delicate position.

How these transactions are financed

Four approaches are common, and they are frequently combined.

Bank financing with a seller note. The buyer obtains an acquisition loan, often through the SBA 7(a) program, contributes equity, and the seller carries a note for part of the price. SBA rules require a minimum equity injection of 10 percent of project costs for a first-time acquisition, and no more than half of that may come from limited sources such as a seller note on full standby. The employee must therefore bring real cash, typically at least 5 percent. Owners planning an internal sale should encourage the buyer to begin saving, or to identify family support, well ahead of time.

A gradual sale. The employee buys a minority interest first and the remainder later. This gives the buyer time to accumulate capital and the owner time to evaluate the buyer as a partner. SBA rules treat partial purchases under a separate owner buyout category, which requires at least one original owner to remain in the business and personally guarantee the loan. An owner contemplating a staged sale with bank financing should understand that continuing guarantee before agreeing to the structure.

Seller financing alone. The owner carries most of the price, repaid from the company's earnings over a number of years. This is the simplest to arrange and the riskiest for the seller, who is in effect being paid with the business's own future profits.

An employee stock ownership plan. An ESOP is a retirement trust that buys the company on behalf of all employees. It offers significant tax advantages and suits companies with stable earnings and enough scale to bear the legal and administrative cost. For most Main Street businesses it is too complex, but owners of larger companies should have it evaluated.

Setting the price

An independent valuation serves both sides. The owner gains assurance that the price is fair, and the employee gains a figure a lender will accept. Where bank financing is used, the lender will obtain its own valuation, and under current SBA rules total transaction debt cannot exceed it.

Some owners choose to sell at a modest discount to a valued employee. That is a legitimate decision, but it should be a deliberate one made with knowledge of the market value, and the owner should ask a tax advisor about the consequences of a sale below fair value.

Preparing the successor

The most successful internal sales begin three to five years before closing. During that period the owner transfers responsibility in stages.

1. Open the books. The successor should understand margins, cash flow, debt and taxes.
2. Transfer relationships. Introduce the successor to the banker, the accountant, the insurance agent, key vendors and major customers.
3. Delegate decisions. Let the successor hire, price and resolve problems, and observe the results.
4. Step back. Extended absences by the owner test whether the business runs without them.

This preparation also makes the business more valuable to any outside buyer, so the effort is not lost if the internal sale does not proceed.

Protecting both parties

A few practices reduce the risks described above.

• Sign a confidentiality agreement before sharing detailed financial information.
• Use separate advisors. The employee should have an attorney and an accountant of their own.
• Put the terms in writing early, in a term sheet or letter of intent, as with any buyer.
• Set a deadline. If the employee cannot secure financing within an agreed period, the owner is free to go to market.
• Secure the seller note with a lien, a personal guarantee, financial reporting and limits on compensation and distributions.
• Agree in advance on what happens to the employee's role if the transaction does not close.

Testing against the market

An owner who is uncertain whether an internal sale is the best choice can obtain a confidential valuation and an assessment of likely outside interest before committing. Knowing what the market would pay allows an informed decision, including an informed decision to accept somewhat less for the sake of continuity.

An internal sale is a sound path when the successor is capable, the price is supported, and the financing is realistic. It requires more planning than an outside sale and usually more patience. Owners who begin early have the widest set of choices.

Twelve31 Advisors advises owners and management teams on internal transitions, including valuation, structure and financing.