Selling a Business to the Employees

Though not too many owners think of it, selling a business to the employees is a legitimate option as an exit strategy, particularly during this time of business uncertainty caused by the current pandemic. One reason, of course, is that the employees are likely to have much more faith and certainty that the business will recover from the pandemic-induced downturn than will an outside buyer. They have, after all, been witnessing the business’ growth and progress prior to the current slowdown. But selling a business to its employees also has some drawbacks. Let’s look at a couple of issues.

Financing

As a rule, employees generally don’t have the capital – or access to the capital – necessary to buy the business. So, this means seller financing, at least at some level, will be involved. That said, in the United States, Small Business Administration (SBA) lenders are eager to and aggressive in lending to businesses, not only for working capital, contract performance and expansion, but also for acquisition. One thing SBA lenders like to see is a buyer’s familiarity with and experience in a similar business. The employees of the business could not fit that description any better. But the owner of the business will always have to take a note from the employees, even if the SBA or some other government entity provides some funding. Any guarantors of the funding – and that’s generally what a government entity is – want to see the seller involved so that, should the new owners run into some choppy water, the seller would be there to help. Arguably the most important aspect of any note used to acquire a business is that the business must be capable of paying off the debt. This requirement is a strong argument for the parties to get the business valued. (For more on this, see last item, below.) A professional valuation should always include a debt coverage analysis (a process described in detail in our course).

Transition

First, unlike selling to an outsider, selling a business to its employees is usually a gradual process. Yes, there’s a transition period in both instances but the transition period in a sale to an outside usually includes a specific date on which the deal closes and then a period of time – the transition period – during which the seller stays on to assist the buyer in getting up to speed. When selling a business to employees – one of more – the transition period can extend for a couple of years as employees gradually gain more ownership. This process is called “vesting” or a “vesting period” during which the employees gain more ownership over a period time. This, of course, allows the employees to buy the business over time – reducing the immediate need for what might be an unmanageable level of capital – and for the owner the opportunity to spread out his or her tax liabilities. A longer transition period allows the owners to make sure the employees that will eventually be running the company have all the training they need. After all, running a business involves knowledge and responsibilities that working for the business may not. The company’s performance will be how the owners get paid. It’s incumbent upon the owners to make sure that, as the employees take over management of the business, they know what they’re doing.

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Valuation

No matter how well the business is doing, it’s very likely that the employees will think that the business does not have the value that the owner thinks it does. Where there is a significant discrepancy, the solution is to have the business valued. In fact, whether there’s a discrepancy or not, having a valuation done will all but eliminate hard feelings down the road. We do business valuations, as do most business brokers that are Certified Business Intermediaries. There are professional brokers without that certification that are also able to do competent business valuations. If a broker that does not have the CBI designation, ask for a copy – a redacted copy – of a valuation they’ve done on another business. This will give you a sense of the depth of their knowledge and approach. There are also certified business appraisers (CBA) that can be hired for such valuations. In my experience, certified appraisers are a bit more expensive but their work product is as thorough as any valuation I’ve seen and the three initials after an appraiser’s name – CBA – probably gives the appraisal the most credibility. In my opinion, the best way to handle this is for the owner and the employees to agree as to who will do the valuation. But if that proves unworkable, each might appointment someone who is a valuation expert and have those two appoint the person that will actually do the valuation.