We recently published a recent article on the three types of buyers an owner might consider. One of those options is to sell to a key employee. The reason for choosing key employees when planning their exit, is that employees already know and understand the business. They often have a similar visions as business owner, and in many instances, the key employee is already running the company when the owner is ready for the sale. But selling a business to a key employee is not as simple as handing over the keys to the kingdom and cashing the subsequent check. In most cases, employees don’t have cash to pay for the business and may not have the financial resources to get a business loan.
Putting a Deal Together
There are unique issues sellers should consider when selling to an employee:
· If the business has no immediately identifiable candidate, the business owner will need to choose and prepare a successor.
· The business owner and employee must agree on a fair value of the business and determine whether that value is adequate to move forward with a sale.
· If the buyer isn’t already running the business, the seller must consider how best to involve the employee buyer in running the business during the transition period.
· The parties must develop a deal structure that works for both parties because key employees often don’t have the resources or the capital of a strategic buyer or private equity firm.
· The owner may offer equity as part of the employee buyer’s compensation several years before the owner wants to sell as a way to convey company equity to the employee.
· The seller’s tax considerations is likely to determine the deal structure.
Financing the Deal
Typically, business owners use one of two sales methods when selling a business to key employee(s): a long-term installment sale or a leveraged management buyout.
Seller Financing Using a Long-Term Installment Note:
Under the long-term installment method, the owner is paid in a series of installments over a set period of time using the company’s revenue stream. A long-term installment sale is generally structured as follows:
1. The owner and the key employee(s) agree on a valuation of the company.
2. The key employee(s) pay the purchase price using a promissory note, with a reasonable interest rate and a schedule for installment payments. The note is often secured by the company’s assets and equity, and the key employee(s) makes a personal guarantee, including pledging some personal collateral, usually in the form of property they personally own.
3. Often little or no money is paid to the business owner at closing: the value from the sale is paid out over time. This is something business owners should keep in mind if the business owner is looking for an immediate payout from the sale of their company.
Management Buyout Using Debt:
The leveraged management buyout method draws upon the company’s management resources, outside or seller equity and significant debt financing. This buyout can be ideal for business owners who want to reward key employees, position the company for growth and minimize the selling business owner’s ongoing financial risk as compared to the seller financing model.
To effectively execute this buyout, a business needs to have many the following characteristics:
1. The company’s management team is capable of operating and growing the business without the business owner’s involvement.
2. The company has stable and predictable cash flow.
3. The company has strong prospects for growth described in a detailed business plan.
4. The company has a solid tangible asset base, such as inventory, machinery and equipment. Hard assets make it easier to finance a sale using debt; however, service companies without significant tangible assets can still obtain debt financing, albeit at higher cost.
5. The company has a fair market value of at least $5 million.
If a business possesses some or all of these characteristics, a leveraged buyout may the better option. Still, a prerequisite for a management-led leveraged buyout is that the selling business owner and the management team need to agree on a fair value for the company. Once that occurs, the parties will then obtain a letter of intent that gives management the exclusive right to buy the company at the agreed price for a specified period of time.
Next, the management team and its advisors arrange for a portion of the transaction to be funded by the senior bank debt. Bank lenders usually require the management team to make an equity investment prior to closing. Alongside accruing debt, the management team may seek an equity investor as well. The new management team should provide a complete package of price, terms, debt financing and management talent to the equity investor.
PUTTING IT ALL TOGETHER
Under either method, a business owner has the flexibility to structure a transaction to best meet his or her personal goals and goals for the company as it transitions into new ownership. Which option they choose will be dependent on their own goals and needs, and the companies existing assets and revenue streams. Part of merger and acquisition advisory, is helping owners determine which option will suit them, and help them come up with a plan of action that will benefit both parties after the sale is completed.
- Sheila Seck is the founder and managing partner of Seck & Associates, a law firm specializing in mergers and acquisitions, startups, corporate counsel, technology and licensing, and securities and private equity. Call Sheila at 913.815.8485 if she can answer any questions about the sale of your business.