Minimizing Risks When Selling Your Business to an Employee

by Dave Driscoll

The transfer or sale of a business to a current employee is considered an insider sale. That’s good, right?? Well….it’s complicated!

An insider sale can be one of the best ways to transfer ownership of your business. It’s emotionally satisfying and removes some uncertainty about the business’ future because the buyer is familiar and presumably competent and knowledgeable about the company.

But, the major obstacle to insider sales is usually the employee’s lack of cash and assets to leverage, limiting their ability to finance the acquisition in the traditional fashion. To make the transaction feasible, the seller will probably have to finance a significant portion of the sale in the form of a seller note. Seller financing is frequently used to assist the right buyer in “getting over the hump” with lender equity ratios.

A seller note represents a buyer’s commitment to pay a portion of the total purchase price over a defined period, at a defined interest rate. This means the seller may wait years to receive all the money from the business sale, while carrying risk during that time - risk of default, risk of business downturn or failure, and risk of market collapse. This risk is totally acceptable if the seller has the confidence in the buyer to continue to run the business profitably.
The deal structures that govern seller financing and ownership transfers to insiders are numerous and often customized to the specific situation.

However, a few considerations will improve the chances for an insider sale to be successful for both the seller and buyer.

First, make sure that the employee(s) to whom you sell your business is capable and dedicated. This person (or group) holds the key to the success of the sale! In some cases, owners are frustrated to eventually realize that a third-party sale is not happening on their time frame for whatever reason, and are anxious to find someone (anyone!) who can provide a way out. They are ready to move on to enjoying their Life Beyond Business.™ The vetting of viable inside candidates is often fraught with emotional complications. Failure to objectively evaluate the candidates’ potential for success as an owner can be a recipe for disaster, especially if your future financial security is dependent on realizing value from the sale of your company.

Second, the continued success of the business after you leave is essential to collecting all the money owed to you from the sale. This means you need to prepare the business for your departure well in advance by building a competent staff and developing productive systems and procedures. Selling a business that is not operating efficiently will place the buyer in a difficult position to succeed. However, turning over a well-running company will certainly minimize your risk in a seller note. An additional goal is to position the company with as little debt as possible because you may continue to be responsible for repayment.

Third, maintain a healthy separation between yourself and the buyer. You’ll still need a broker/intermediary to control the flow of information and be the seller’s advocate in negotiations. It’s very tempting to discuss ideas (that may be taken as promises) around the water cooler. It’s essential, however, to remember that the actual sales process is no different between selling to an employee or an unrelated third-party, and the broker performs a critical role in protecting the seller.

Finally, any deal must be structured with a clear understanding of the tax implications for the seller. Since the seller is waiting, possibly for years, to receive full payment, the deal structure should be tax efficient to maximize seller cash. As we all know, it’s not what you get, it’s what you keep after taxes that matters. Be sure to seek the advice of your accountant and a transaction attorney to avoid nasty surprises later.

Imagine you have fully embraced retirement and are really enjoying your freedom from the responsibility of business ownership. Maybe you’re out West on a cattle drive when you receive a frantic message, “We can’t make payroll…not going to be able to catch up on the delinquent buyout payments after all... the business is in crisis!”

Your future financial security and sanity are worth cautiously considering and addressing all aspects of an insider sale to avoid being in a costly and chaotic situation.

Dave Driscoll is president of Metro Business Advisors, a business brokerage, valuation and exit planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at DDriscoll@MetroBusinessAdvisors.com or 314-303-5600. For more information, visit www.MetroBusinessAdvisors.com.