Maintain Control, Reduce Risk by Selling to Key Employees

November 21, 2016

If you own a small, closely held business and are considering a transfer to key employees, chances are you are asking the same perplexing question that millions of others have asked time and again:

“How do I transfer my business to employees when they have limited financial resources and cannot run the business without me?”

Unfortunately, most owners are convinced that a successful transfer to key employees is not possible.

“There are too many challenges and it’s far too risky,” the owner avows to himself. “It will never work.”

Owners often are overwhelmed by challenging questions such as:

• Will key employees put “skin in the game?”
• Do I run the risk of not getting paid?
• Won’t I be using my own money to buy myself out?
• Can the business run without me?
• What if I change my mind? Will it be too late?

While it is beneficial and even healthy to ask these questions, most owners conclude that selling to key employees will strip away control, increase risk and minimize the chance of achieving financial security.

This does not have to be the case.

The most important thing is to work with an experienced and knowledgeable business adviser, attorney and Certified Public Accountant who understand your options and resources.

A look at the these questions, one-by-one – focusing on how time, control and the right advisers can minimize risk and solidify the long-term success of the business and your exit.

Will key employees “put skin in the game?”

It is critical that you verify your employees’ willingness to buy your company before you travel too far down the exit path. That being said, there are ways potential ownership can be tested.

Work with your advisory team to design performance-based incentives that award shares of the company yet keep you in control. These incentives can be benchmarked based on EBITDA (earnings before interest, taxes, depreciation and amortization), revenue, profit margins and free cash flow, to name a few.

An incentive example could be a stock bonus plan with strong forfeiture provisions and a vesting schedule that aligns with your exit date. This will motivate key employees to stay with and grow the company while testing their ambition.

In addition, many businesses simply do not have enough present value to attract the attention of third-party buyers. A properly designed incentive plan monitored over time will test future leadership and grow business value.

Do I run the risk of not getting paid?

Design a plan that transfers controlling interest only when the balance is paid in full. This will decrease the risk of not getting paid.

On the other hand, motivating key employees to increase cash flow is especially important for owners who have value-based goals such as keeping the business in the community, maintaining culture and ensuring the owner’s legacy remains intact.

Won’t I be using my own money to buy myself out?

Selling to key employees is a way of using your own money to buy yourself out if the plan is poorly designed. You do not want employees to receive income from the business, be taxed on that income and then buy shares of ownership with you paying capital gains.

Work closely with advisers to understand strategies for a proper purchase while minimizing the tax bite. Owners who don’t do any transfer planning are better off if they keep the business long enough to obtain the earnings they need to achieve financial security and then turn in the keys.

Can the business run without me?

You must change your relationship with your business to position yourself in the best place to exit successfully. Too many owners “do the heavy lifting” until they want out, only to find there is no one sufficiently trained or qualified to run the company.

An experienced advisory team will implement a timeline that provides accountability for transfer of responsibility – who will do what and when – including you.

By delegating to management and creating systems to manage workflow, business value becomes transferable – the ability to transfer ownership interest in exchange for money. It is the value of your business without you.

What if I change my mind? Will it be too late?

While business owners take risks every day, no one delights in risking their or their family’s financial security. The last thing an owner wants is to be tied to an inflexible plan that may go south.

Design a plan that keeps you in control at all times and provides the ability to change direction. If a key employee were to back out or a third party came along offering top dollar, a well-designed exit plan will be able to adjust.

Brent Saba is a business adviser with Quadrant Private Wealth, Bethlehem. He can be reached at bsaba@quadrantprivatewealth.com or (610) 849-2752.