Selling Your Business to Your Employees

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There comes a point in every business owner’s career where he or she is ready to sell the business… So, who are the buyers? Well, the bottom line is that when a business sells it will sell to one of 3 entities: an external individual or group, a family member or an employee or group of employees.

Today I would like to discuss the latter option of Selling Your Business to an Employee and – just How realistic is it?

It is realistic. However, the option of selling to staff is not one which most owners think about and is worthy of consideration as it can be an efficient route for business transfer. I say that with a caveat…not without careful planning, proper due diligence, documentation and professional advice.

When selling a business, owners often neglect to look around them for prospective buyers. In many cases, the buyers are your colleagues, sitting right beside you. Your employees know the business intimately and it may not be such a hard sell. If you have carefully picked and mentored your team, these individuals may emerge as logical, ready-made buyers.

So assuming you have identified a suitable employee…What are the risks?

The biggest risk is that your employees will not manage the business well on their own and your old business will end up in financial trouble. “Best Employee” is not necessarily synonymous with “Most Successful Entrepreneur”. If the business defaults on its commitments with you as a guarantor of the loan, you could end up owning the business you thought you had sold, quite frequently showing significant loss in value.

If the employees have the cash to buy your company, by all means let them. If not, allow them to borrow from someone other than you and if you must carry back some portion of the price, negotiate as much security for your note as possible.

The larger risk is leaving money on the table. If you do a deal with your employees without proper valuation of your business, you likely will not experience the effect of competitive market tension associated with having an intermediary or business broker promote your business. In addition, management teams rarely have the money to buy your business for cash so you may end up taking a lower price paid over time.

It’s a trade-off between the relative ease of an employee buyout at a lower multiple AND demand for more arduous diligence associated with selling to an external buyer.

One of the methods of selling your company to your employees is through an Employee Share Ownership Plan or “stock ownership”, or ESOP – how do they work? and what are the options?

To establish an ESOP a company sets up a trust to hold the assets and makes contributions to it of stock or cash. Each employee participates by receiving a contribution based on his or her earnings or performance. When the company makes cash contributions to the ESOP, the company or a shareholder can sell his or her stock to the ESOP and receive the cash.

The key aspect is that employees have an ownership stake in the company they work for, and share in the risks and rewards that accrue to it. Among a host of advantages, benefits include the opening of an exit strategy, creating tax benefits, and reduced workforce turnover.

What Types of ESOPs Are there?

Loosely, Employers can choose between two main types:

Basic or Non-Leveraged ….AND Leveraged ESOPs.

In a basic ESOP, the employer simply contributes securities or cash to the plan every year—like a profit-sharing plan—so that the ESOP can purchase stock. Contributions are tax-deductible up to a certain allowance or percent of payroll.

In contrast, leveraged ESOPs obtain bank loans to purchase the company’s stock. The employer can then use the proceeds to support business growth and it can repay the loans through contributions to the ESOP that are tax-deductible up to again a certain percent of payroll.

You may be wondering…Does employee ownership work?

The most definitive study to date in Canada was done by the Toronto Stock Exchange, comparing ESOP versus non-ESOP public companies. For ESOP companies:

Five-year profit growth… 123% higher

Net profit margin…95% higher

Productivity measured by revenue per employee… 24% higher

Return on average total equity… 92.3% higher

Return on capital… 65.5% higher

So, if you are thinking of setting up an Employee Share Ownership Plan, what steps should you take?

  1. Determine Whether Other Owners Are Amenable: This may seem like an obvious issue, but there is no point in taking further steps unless the existing owners, all of them, are willing to sell.
  2. Conduct a Feasibility Study: First, assess how much cash flow the company has available to devote to the ESOP, and second, determine if the company has adequate payroll for ESOP participants to make the contributions deductible.
  3. Conduct a Valuation: The valuation consultant will look at a variety of factors, including cash flow, profits, market conditions, assets, comparable company values, goodwill, and overall economic factors.
  4. Hire an ESOP Lawyer: If these first three steps prove positive, the plan can now be drafted. Seek advice from legal counsel.
  5. Obtain Funding for the Plan: Banks are generally receptive to ESOP loans but other sources include ongoing company contributions, existing benefit or profit sharing plans and employees wage concessions.
  6. Establish a Process to Operate the Plan: A trustee must be chosen to oversee the plan. An ESOP committee will direct the trustee. And establish a process to communicate to employees how the plan works and involve them more as owners.

There is so much matter on the subject of Selling Your Business to Your Employees… and this has only been the tip of the iceberg…thanks for joining me again on another aspect of business