Selling a Business to an Employee
When is it a bad idea to sell a business to my employee?
Employees buying out a business is likely a bad idea if one of the following statements is true:
- Your business would be valued by a third party at more than 12 times its profit, where we define profit as your annual discretionary earnings minus a full-time market-rate salary for you.
- You lack employees capable of managing the business without significant assistance from you, even after a 1-3 year transition period during which you would reduce the time and energy you devote to the business.
- You want to continue working full time in your business for more than the next 3 years.
- You have a strong desire to receive cash within one year and your employees are unable or unwilling to make a significant financial commitment, either by investing their own money or borrowing.
A good first step is evaluating these four dealbreakers.
Benefits if I sell my firm to my employee
Higher purchase price because of less informational asymmetry
Ask yourself this: “If I sell a company to my employee, will they have more certainty about the business’s future profit than a third-party?” The answer is usually yes. That increased certainty results in a higher valuation. Your employee(s) can and should pay a higher price than a party who does not know your business. See the next section to learn how they can afford to pay a higher price.
Higher purchase price because of lower transition risk
Next, ask this question: “If I sell my business to my employee, will they have a lower likelihood of making critical mistakes when transitioning the business from my control to theirs than a third-party would have had.” One of the reasons that buyers discount the value of a business is that they expect some value will be lost during the transition process. If an employee is in charge, transition-related losses are less likely to occur, which means the buyer can afford to pay a higher purchase price.
Lower transaction fees
M&A advisors will be willing to charge lower fees to you because you will be introducing the buyer to the transaction. You can choose to pay an advisor an hourly fee and/or a percentage of purchase price.
Transaction structures
Payment structure options for employees buying out a firm
There are several ways you can receive payment for your business:
- Cash paid at closing. This is an option if your employee has liquid assets available or is willing and able to borrow.
- A fixed amount the employee pays to you over time in fixed quarterly or monthly installments with interest. The challenge with this form of payment is determining what you will do if the employee fails to make required payments. Will you take back ownership? That might not be a desirable outcome.
- A fixed amount paid to you over time with interest, where each installment payment depends on the business’s recent profit distributions (higher distributions implies higher installment payments). Each installment payment is strictly less than the amount of profit distributions received by the buyer. This resolves the problem of the second form of payment.
- A percentage of the future revenue or profit of the business for several years. This also resolves the problem of the second form of payment. However, it is riskier for the seller because the total purchase price is indeterminate at the time of closing.
Protections
In the case of employees buying out a company, it is common for part of the purchase price to be paid via options 3 or 4 above. When those options are selected, the seller effectively shares sales or profit with their buyer post-closing. If that is the case, the seller needs protection. For example, the seller should:
- retain control over the business during the transition.
- have the right to unwind the deal if certain requirements are not met.
- ensure that you receive the amount of money you are owed.
We recommend the following:
- List (with your advisor) the adverse outcomes that can occur from the employee buyout. For each, design a resolution mechanism that protects your assets.
- List (with your advisor) the possible disputes that can arise between you and your buyer. For each, implement a binding procedure for resolving the dispute fairly and at a low cost, ideally without involving courts or lawyers. We recommend expert determination.
Deep expertise in designing protection mechanisms matters. (We are exceptional at it.) Lawyers will draft the legal language that implements protections in a contract, but only a capable advisor can design protection mechanisms. Proper protection design requires economics and finance expertise in addition to legal expertise. We possess this rarely held combination of skills.
We have developed a 12-page expert determination agreement by working with several attorneys and business owners. If incorporated into any contract, this agreement provides a legally binding answer to any objective or subjective question. It can thereby resolve most predictable disputes. It resolves disputes at low cost, at relatively fast speed, with minimal vulnerability to the answer being overturned by litigation, and with a high level of fairness and justness.
Instead of selling the full business, can I sell my equity to an employee?
You can either sell your entire business or sell equity to an employee and retain some equity for yourself. By retaining equity, you stand to earn more over the long-run than you would by selling your firm entirely. Keeping majority ownership (over 50%) offers more flexibility and control than having minority ownership.
Should I sell my practice to my employee?
Employees buying out a practice is commonplace. Professional services businesses are well suited to being sold to their employees for two reasons:
The first is because the customer relationships and specialized expertise of one or more key employees are critical in many of these businesses. If an outsider acquires such a firm, they will risk losing key employees. That will reduce purchase price or necessitate that part of the business’s value be paid out to key employees. On the other hand, if a key employee acquires the firm, they can afford a higher purchase price because that risk does not exist.
The second is that selling a professional services business often requires the seller to continue to own a portion of the business or to earn some of its revenue or profit for a few years after the sale (during the transition period). Some owners feel more comfortable being effectively co-owners with an employee than a party they have just met. Ask yourself this question: “If I sell a practice to my employee, would I be comfortable being co-owner with them if I maintained a controlling ownership share?”
The first is because the customer relationships and specialized expertise of one or more key employees are critical in many of these businesses. If an outsider acquires such a firm, they will risk losing key employees. That will reduce purchase price or necessitate that part of the business’s value be paid out to key employees. On the other hand, if a key employee acquires the firm, they can afford a higher purchase price because that risk does not exist.
The second is that selling a professional services business often requires the seller to continue to own a portion of the business or to earn some of its revenue or profit for a few years after the sale (during the transition period). Some owners feel more comfortable being effectively co-owners with an employee than a party they have just met. Ask yourself this question: “If I sell a practice to my employee, would I be comfortable being co-owner with them if I maintained a controlling ownership share?”
Selecting an advisor
Selling to your employees with assistance from an M&A advisor will help you avoid your deal falling apart prior to closing or failing after closing. In dealmaking, value is created by intelligently implementing a structure that protects all parties. Having been established for 13 years, Next Bridge Advisors has a unique combination of expertise in the finance, structuring, and dispute prevention aspects of business sales. We sell businesses anywhere in the US and internationally.