Recently, we’ve had several clients start down a path of selling their companies to a group of trusted employees. Which is understandable. Many of these companies owe much of their success to key employees, and the owners want to reward them. Plus, owners are positioned to establish a legacy by selling to insiders, a highly fulfilling outcome for many.
Foremost, we should point out that many employees like the idea of eventually being an owner, but, in our opinion, only a subset is really “owner material.” The employees don’t fully appreciate the stresses, including possible financial, that accompany business ownership. Sometimes a couple of pointed conversations with an outside, trusted advisor can be illuminating for many employees who, instead, may decide they’d be happier with a simple raise.
What are some of the issues owners need to consider before making an inside sale commitment?
The following is a partial list of critical issues:
Purchase Price. In most cases, insiders won’t be able to pay as much for the company. Typically, these are long-time salaried employees without the requisite wealth to pay as much as an outside buyer. Outside buyers are often “strategic” (i.e., operate in the same industry) and can pay much more because they can save money through cost synergies.
Which can be acceptable. In many cases, the owner can make up part of the difference through various strategies like remaining a consultant to the firm. Or the owner may be in a secure enough financial condition to be willing to forego the differential due to the emotional pluses mentioned above.
Working Synchronicity. How well has the owner gotten along with the insider buyers over a long period (most notably, during times of stress)? This is a big deal as the owner usually “finances” most or all the buyout, so the relationship will continue for years. The risk can be mitigated by a tight operating agreement, but people can change over time. And the owner needs the succeeding team to perform well to get paid!
Timeline. There are a lot of considerations here. When does the owner want to exit, and when would they feel comfortable doing so? Where is the company in its lifespan? How much more seasoning do the employees need?
Would the employees be buying in early enough to make sufficient returns on their investment?
It’s essential that the owner and buying employees agree on a timeline regarding the ownership shift and the changing responsibilities, decision-making, and presumably shrinking involvement by the exiting owner.
Cash Flow Forecasts. Most private companies we’ve come across don’t forecast beyond perhaps a current year budget. However, since the business’s cash flows will, in most cases, be used to pay the owner for the company, all parties should agree to a realistic yet conservative forecast going forward. This should include considerations for new products, new geographies, capital spending, pay levels, etc.
Operating Agreement. While many businesses, i.e., those sole owned, rely on a set of (often outdated) By-Laws as the background governance source for their companies, a well-thought-out, up-to-date Operating Agreement is critical if the owner is considering bringing in new owners. There are numerous potential areas of conflict for which an Operating Agreement can spell out remedies years before such disputes result in resentment, lawsuits, or a hopeless stalemate. Ensure your attorney understands how to craft a sophisticated arrangement and doesn’t rely on a quick but insufficient template.
Tax Considerations. Unfortunately, owners underestimate how Uncle Sam takes part in inside transactions. In fact, he is literally the third party at the table.
This is because the owner, facing a capital gains tax, is typically paid through the after-tax bonuses/distributions to the employees. As a result, cumulative taxes can comprise two-thirds of the purchase price.
Why does this matter? It impacts how much the employees can “afford” to pay for the company and ultimately places stress on the cash flows. The good news is that there are many good tax strategies available. But, of course, it’s essential to develop such strategies with substantial input and buy-in from the firm’s trusted advisors (CPA, attorney, wealth advisor).