Justin Goodbread CFP®, CEPA, CVGA, at WealthSource Partners, LLC, is a financial educator, wealth manager, author and speaker.
A major, yet often overlooked, aspect of exit planning is determining who you’re going to sell your business to, and how it will transfer once the sale is lined up. Oftentimes, family business owners have someone in mind, and those who are selling on the open market are open to many different possibilities. But what if you’re planning to sell your company to a key employee?
Selling the business to an employee (or even a group of employees) has a very unique set of pros and cons. In order to have a smooth and successful exit, you’ll need to be aware of the challenges that can present themselves during a sale to an employee. Once you’re aware of the ups and downs, you can devise a plan to address them.
Benefits Of Selling To An Employee
One of the most obvious benefits of selling your company to an employee is familiarity. Chances are, your team member has a keen understanding of the vision, mission and values of your business. This means, they’re more likely to carry on your business legacy and can lead to a smoother transition.
Additionally, your team members have seen you run the business. They’re aware of the obstacles you’ve had to overcome. This familiarity and understanding is very likely the reason that businesses that have transferred from owner to employee have a higher survival rate than their third-party counterparts.
According to a study conducted by the University of Caen Normandy in France, businesses that transfer employees have a 97.3% survival rate through year one. This is only a slight advantage over companies that transfer to outside buyers, which have a 97% survivability rate. However, this advantage in survivability increases year over year.
At year five, businesses that were sold to employees boasted a 13.7% edge in survivability over those that were sold to outside buyers. Therefore, the mode of transfer matters if you’re interested in seeing your legacy preserved long after your exit. But what are some things you should watch out for if you’re planning to sell to a key employee?
The Potential Consequences
Great employees don’t always make great entrepreneurs. There are greater risk dynamics for business owners that the employee may not be comfortable with. Simply being a great manager doesn’t mean you’ve got what it takes to be an entrepreneur. Entrepreneurship requires tenacity. So, you must really evaluate whether the employee you’ve identified as a potential buyer has what it takes to step into that ownership role.
Additionally, deciding to only sell to an employee decreases the field of potential buyers. With less competition, this could negatively impact your business’s purchase price. Likewise, you probably won’t receive a lump sum payment. The odds of your employee having a rich uncle that can come in with an all-cash offer are slim to none.
Because your employee may not have the means to make a cash offer, you will likely need to be flexible in how you structure the purchase. This could mean selling the company through a seller carry note or an installment sale. Essentially, you become the bank in each of these types of sales. But this opens you up to greater risk.
If your employee is too comfortable with your relationship, they could become cavalier with making timely payments. While they may not be intentionally taking advantage of you, it is a risk that must be addressed in the purchase agreement. When using an installment sale, you must work with your attorneys and advisors to ensure you’re not opening yourself up to increased taxation. Likewise, you will need to include some provisions that protect against your employee diminishing your company’s value.
Even if the employee is making all of their payments on time, you must protect the equity you’ve grown in the business. Therefore, you need to be able to review the key performance indicators and critical success factors on a regular basis throughout the term of the installment sale. Monitoring the business’s equity can protect your ability to sell the company to another buyer, should your employee default on the sale.
Selling your business to a key employee can be a great way to ensure that your customers are cared for in the same way you’ve cared for them, long after your exit. There are many benefits that come with that type of familiarity. However, a great exit plan accounts for all possible outcomes.
Understanding the risks involved will enable you to plan for them and, in many cases, eliminate them. If you’re planning to sell your company to an employee, take some time to meet with your advisors. Review your plans and revise them according to the individual needs of you and your business. Taking time to do this now can make selling to your team members a much more enjoyable process in the future.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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