Exit Planning, Part 3: Structuring a Successful Employee Buyout of a Business

Financing options for an internal business sale give workers the means to do the deal

Selling the business to an internal successor is a viable option for many owners, whether it’s used as a Plan B if no external buyers are available or when it’s preferred from the start. Select employees know the business, they already have a stake in the company, and they provide a good chance that it will continue to perform—the latter benefit often being necessary for a seller to receive a full payout after a sale. But there is typically one dominant challenge of selling internally: the ability to afford it.

Most people aren’t in a financial position to buy the company they work for—and even if they conceivably are, it’s unlikely they have enough liquid cash on hand for the sale. But proactive owners can set a key worker or a group of them up to complete a successful sale.

Part one of this series discussed the basics of proactive exit planning—no matter the buyer—while part two explored the benefits of an internal successor and how to choose one. In this installment, we take a look at the ways to actually get the financing of an internal buyout done.

6 options for structuring a sale to employees

1.  Seller financing

In this scenario, the seller acts as the bank, having confidence in both the continued performance of the business and the buyer’s basic financial viability. The employee pays you back over time. Generally, there’s a down payment of at least 10 percent, then monthly or quarterly payments with interest until the purchase is paid in full. After the exact terms of the loan are negotiated, they should be clearly laid out in your succession plan.

The major downside, of course, is the amount of time it can take the owner to be paid in full. And if the buyer fails, the note receivable can also become worthless. Thus, an internal successor should be carefully chosen along with taking a hard look at the stability and growth potential of the business at the point of sale.

2.  Acquisition loan

The fastest transaction, this is a loan acquired by your buyer from the US Small Business Administration (an SBA 504 loan) or a bank, generally for between 70 and 80 percent of the purchase price. However, it can be difficult for employees to qualify if they have an insufficient down payment or collateral, and note that the process will still take 90 days or longer. The financing challenge here is usually greatest for businesses with intangible values, which make for bad collateral. But in others, some of the below stock options can give the employee needed collateral over time …

3.  Employee Stock Ownership Plan (ESOP)

Instead of selling the business to a single employee, an ESOP enables you to transfer ownership to all qualified employees. In the most common scenario, the company establishes a trust fund where it contributes new shares of its own stock or cash to buy existing shares. ESOPs are usually treated as a workplace benefit: employees receive an ownership stake as part of their compensation that the company must buy back at fair-market value if they leave. Shares are allocated to individual employee accounts based on relative pay or another formula.

In some instances, the ESOP can be funded through commercial financing, so the seller receives proceeds from the sale faster. But most often, the ESOP relies on seller financing, acquiring all of the owner’s shares at once and paying for them with a note that yields a healthy interest rate.

4.  Incremental stock transfers

Instead of attempting to sell the entire business at once or doing an ESOP, owners can sell or grant small percentages of company stock to their dedicated successor over a number of years. Not only does this make the purchase incremental and affordable, but it allows ample time for training as well as exploring other potentially lucrative options for a sale. The successor can also use these shares as collateral when obtaining a loan from a financial institution.

5.  Performance-based compensation program

In this scenario, you establish key metrics—generally both operational and financial—and reward performance with company stock or cash that’s used to purchase stock from the company or the majority owner. The key to this is defining smart metrics, as this is not a giveaway. Certain individual and company-wide financial targets (such as increasing net sales by 20%) will both incentivize performance and ultimately reward the owner in increased profits and personal income while he or she is still running the business.

6.  Buyout/liquidation fund

Under this arrangement, the owner puts cash into an appreciating, separate account that’s derived from profits and adds to the value of the business. These funds can be put in an investment account or an insurance policy, depending on the need for tax benefits and key-person policies. Once the fund has grown to a sufficient level, the seller/owner can take the cash out of the business in return for ownership shares. The key to making this work is ensuring that it is structured properly for both the employee(s) and the business.

And what happens if you receive an attractive external offer while structuring the sale to internal parties?

You take it, and be fair to your employees with the proceeds of the sale.

Any exit plan—but especially an internal-succession plan—benefits from an absentee owner strategy

Of course, all of these deals rely to some extent on the business continuing to perform after you sell it. This is not unique to an internal sale, however. Many deals to external buyers have contracts that stipulate that the company must continue to function well for a period of time, and often require the owner’s continued involvement. In either type of sale, slowly transitioning duties until you are removed from day-to-day operations gives a key employee and/or multiple employees the opportunity to develop essential business relationships and gain experience making critical decisions—while you retain ownership and remain on-call to provide guidance.

Not only does this enable you to continue to draw income from the business while alleviating the daily headache, but it proves that the business can be successful when it is eventually sold to your successor or a third party. Again, the continued performance of the business may be essential to receive all funds after a sale in a variety of sale contracts.

Smart exit planning conquers the challenges of employee-based sales

Selling your business to existing employees can reduce the uncertainty, hassle, and disruption of the traditional sales process—and it is a smart back-up option in a proactive, well-rounded exit plan. It provides for better business continuity as well, adding the benefit of knowledge and experience from existing employees.

But grooming employees as successors also poses many challenges, from the risk that they will leave before buying the business to a lack of adequate funding. A qualified HR solutions company can help you create a succession plan that accounts for the many contingencies that can occur. This plan includes structuring a smart financing plan and considering the tax implications that can result—and it will ultimately help ensure a smooth exit.

To learn more about how to implement HR solutions that benefit your employees and improve your bottom line, contact Karp HR Solutions today for a free consultation.