By: Patrick Ungashick
Selling to an inside buyer such as one or more of your business partners or employees can be deeply rewarding. Long-term, valued co-workers become like extended family to many owners. To see the business continue forward under the leaders that you helped develop acknowledges all your efforts, and launches your business legacy. In some situations, your employees may be the best potential buyer. They know the business, and would rather own it after your exit than go work for somebody else.Despite these advantages, successfully selling to an insider buyer can be difficult. There are nearly a dozen major issues that may arise which could prevent the successful completion of an internal sale. Based on our experience, below are the four biggest mistakes to avoid when selling your business to an inside buyer:
1) Waiting too long to come to agreement on how the deal price and terms will be determined. In any business sale, buyers want to pay less and sellers want to receive more.
Internal sales are no different. However, what is different with an internal sale is the buyer (which we will assume is one or more key employees) already works for the company. With the buyer already working at the company, waiting until the time of sale to determine the purchase price and terms risks several negative outcomes:
- If the selling owner and buying employee(s) cannot come to agreement at the time of sale, the selling owner may be forced to change plans and pursue selling the business to an outside buyer. More often than not, the key employee(s) will become frustrated and disappointed, possibly to the point of quitting. It can be difficult to sell a business for a good price if one or more key employees are disgruntled or have recently quit.
- Key employee buyer(s) often expect a price discount—in their mind, some portion of the business’ success and value is attributed to their hard work, and the purchase price should reflect this. Selling owners, in our experience, often agree to this too—at least in principle. The challenge becomes determining how much of a price discount. Waiting to address this issue until shortly before a desired sale causes stress and stirs up negative emotions, all of which make a deal harder.
- If the selling owner and buying key employee have not laid out a clear process for how the future purchase price will be determined, in our experience the key employee(s) buyer may grow worried and discontent because they realize that their hard work now is potentially only increasing their future purchase price. We have seen key employees become emotionally disengaged and work less hard because the future purchase price issue has not been addressed.
2) Failing to do the math.
Selling a business to an internal buyer presents several financial challenges, any one of which can undermine everybody’s success:
- The selling owner and buying key employee(s) need to carefully model the business’ future financial performance, especially free cash flow in future years. Most key employees do not have sufficient cash and collateral to purchase the business without debt. Therefore, to do a deal with the selling owner there often needs to be a significant increase in debt, and that debt will need servicing. (This is true whether the selling owner is the lender, or a third party lender such as a bank is used.) Both the selling owner and the buying key employee(s) need to carefully model the business financial performance to make sure that the business can cash flow the debt service requirements. This financial modeling should consider scenarios where the future business results are significantly worse than planned—both parties need a margin of safety. Ideally, the business can still cover its debt load even if there is a significant reduction in revenue and/or profits. Both the selling owner and buying key employee(s) risk much if the deal they make falls apart somewhere down the road because the business cannot meet its debt and other financial obligations.
- Make sure to not overlook taxes. Internal sales typically require after-tax dollars to buy out the selling owner, and/or to service the debt used to buy out the selling owner. This tax burden greatly adds to the cash flow burden, making the matters described above even worse. Owners need to work closely with their tax and financial advisors to model and address taxes as part of the deal’s financial structure.
- Be sure to address personal guarantees, where present. Typically, owners of small to mid-sized businesses have personally guaranteed financial obligations such as lines of credit and real estate leases. Also typically, the key employee(s) who may purchase the business lack the personal net worth to cover these obligations. The selling owner and key employee(s) buyers need to address this issue well before doing a deal to make sure the business operations are not interrupted, and to avoid the selling owner having to stay on the financial hook any longer than necessary.
3) Assuming co-key employees want to be co-owners.
If there is only one key employee buyer involved in a potential transaction, then things are straightforward—that one key employee will presumably purchase 100% of the company. More commonly however, there are two or more key employees in the picture as a potential team of buyers. This changes the situation considerably. Employees who work well alongside one another may have different feelings about being a business co-owner with the other person or persons. Being business partners with somebody is commonly compared to marriage, for good reasons.
The financial, legal, emotional and practical ties between co-owners are real and serious. In our experience, once the current owner leaves the room and key employees feel free to speak openly, it is not unusual for us to hear “Oh, I want to buy into the company, but not if Joe (or Jane) is part of the deal…I would never want to be business partners with him!” Even if the employees genuinely get along well, two or more employees coming together as a buying team will need to determine issues like ownership structure, voting rights and control, and compensation—all issues which could derail their ability to come to harmony as an ownership team. It is generally better for everybody involved if the current owner and all the potential key employee buyers address these matters well in advance, rather than risk coming to roadblocks late in the process.
4) Not testing that the key employee buyer(s) can run the company on their own.
By definition, key employees are high performers in their current roles and responsibilities. That alone does not guarantee that the key employee buyer(s) can run and ultimately grow the business going forward on their own. First, the current owner may have played an important role in the company, and after he or she is gone it may be difficult to replace that person. Additionally, just because the key employee buyer(s) are high performers in their current roles does not mean they will succeed when they are in charge. Too many owners simply assume that their key employee buyer(s) will be able to get the job done after a sale, and never test that assumption. Testing the assumption prior to a sale is not complicated—the current owner simply has to delegate a high level of authority to the key employees, monitor their performance, and periodically unplug from the business for several weeks or more at a time to test how well things run without that owner. Many owners do not take these steps prior to sale however, at their peril.
Because selling to an inside buyer is difficult, owners considering this strategy need to start as soon as possible working on their exit plan. If your desired exit timeframe is five years or less, you are in the homeward stretch to prepare for a successful exit.