In our article, Selling Your Business to Employees, we met “Jasmine,” the fictional, 63-year-old owner of a professional services company in the DMV-Washington D.C. area. She was considering selling her business to a group of her key employees.
At our first meeting, we discussed—using pros and cons—whether this type of business exit would meet her goals. We then helped her to divide her decision-making process into three areas:
- Owner-related issues,
- Employee-related issues
- Business-related issues
In our second meeting with Jasmine, we discussed how we design business transfers to employees.
The Conversation of Selling to Key Employees: Where to Begin
Jasmine arrived at the meeting with a legal pad in her hand and three different colored pens. We noticed that the first page was covered in her distinctive printing and the topics above were organized by color. As she pulled the lid off her one of her pens, she said,
“We’ll I’ve worked through the three types of issues we talked about last time. The first set of issues related to me, specifically how much cash I’d need from the transfer to live the way I want after. I have a preliminary number in mind, but let’s talk about that.”
Well, there’s nothing like jumping into the deep end! Jasmine did just that by starting where most people would think to start: how much money is needed from selling her business to retire. But this is not always the best place to start digging (although a very important number to have in mind to get started).
Looking at Jasmine’s Options: Evaluating Her Options with Her Business
To Jasmine we said, “I agree, that’s a great place to start, but can we table the specifics of that conversation until the personal planning meeting we’ve scheduled next week with both you and Emmett (her husband)? What I’d like to focus on today is the related question: Do you want as much as you can get from the transfer of your company or are you willing to sell it for a smaller, but fair, amount so you that it ends up in the hands new owners who will continue your legacy?”
“Since we met, Emmett and I have talked about it,” Jasmine said. “The short answer is that I am willing to take less—the question will be how much less—for my company in return for knowing that my key employees, customers and reputation will be in good hands? I’m also willing to work for another five years or so, though I’d like to cut back even more than I have so Emmett and I can do more traveling.”
“Great, then let’s talk about the elements of transfer process to see if this is still an exit path you want to explore,” we said as Jasmine flipped the page to an empty sheet of paper.
“Go ahead,” she said. “I want to know more before I make any final decisions.”
The Process and Plan Design: Phases to Evaluate Selling Your Business to Key Employees
We still had to talk about two other important issues:
1. Jasmine’s employees’ willingness and readiness to run her company.
2. Her company’s ability to run without her.
Like most owners, Jasmine wanted to see the big picture first: how the sale process would work.
Get Owners What They Want
We’ve already talked about the first element of the plans we design, namely, making sure owners get what they want—which is not necessarily the same as getting a maximum price. In Jasmine’s case, she wanted a combination of a fair price and a successor who would run her company as she had.
Keep Owners in Control
The second element of the plans we design is to keep owners in control until they receive all of their sale proceeds. To accomplish that, we often recommend an incremental purchase process with risk-reducing safeguards.
First, we determine how much non-voting stock you are willing to make available for the employees to purchase. Then we design a two-phase buy-in. For example, we make a small portion of non-voting stock (say 10%) available for purchase initially (Phase I), and the rest at the end of the buy-in period (Phase II).
We bring in a certified valuation specialist to value your company with appropriate minority and other discounts. Establishing a lower initial value makes the stock affordable for employees and motivates them to go through with the purchase.
In Phase I, employees purchase the non-voting stock with cash. (To reduce your risk, voting stock remains in your hands.) If employees need to borrow funds to do that, your company can provide their banks guarantees on their promissory notes. As another safeguard, we set up stock purchase agreements between each employee purchasing stock and the company to protect both parties should an employee die, leave the company or become disabled.
At the end of this first phase—one that typically takes between three and seven years to complete—you as the owner have a choice to make.
1. Sell the rest of your company stock to employees on the condition that they get the financing necessary to pay you cash.
2. Offer to “finance” the deal through a long-term installment sale. (Whether you choose option 1 or 2, you receive fair market value for your stock.)
3. Decide to sell to an outside third party.
If you choose to complete the sale, employees make the final purchase of your stock at a fair market value (Phase II).
This incremental process allows you to adjust the timing of your transfer of ownership for any changes in your company’s performance or events in your life. The beauty of this incremental design is that we can help you tailor it to your company and your objectives.
As we mentioned in Selling Your Business To Employees, employees can view the “opportunity” to buy a company a little differently than you do. Owners tend to think of the sale as a reward while employees can see it as taking on a whole lot of risk. To motivate and reward employees to increase company cash flow and value, we set performance benchmarks. As employees meet the benchmarks, they are rewarded with ownership or the cash necessary to buy it.
In the two-phase process we outlined, employees will pay taxes on the money they receive to purchase stock from owners, and owners will pay taxes on the proceeds they receive. That’s a lot of lost cash.
Using S-distributions and nonqualified deferred compensation (NQDC) payments, our goal is to protect 20% (and often more) of the company’s cash flow from this double-taxation to direct after-tax cash to owners. In addition, because company contributions to an NQDC plan qualify as deductible expenses, they lower the company’s taxable income and thus make it easier for employees to purchase an owner’s stock.
Put It in Writing
Once we work through the planning process with you, we put the transfer plan in writing. Doing so conveys to employees that you are serious about the sale. It is also the blueprint that all of your professional advisors will follow.
Selling Your DMV-Washington D. C. Business to Key Employees: Planning, Preparing, and Transferring
Transfers that allow you to sell your business to key employees take time – so if you want to exit in the next six to twelve months, let’s talk about another exit path. They also require employees who are willing and able to take the reins successfully. Despite these hurdles, transferring to employees is an exit path that many owners want to take—either before they meet with prospective third-party buyers or after, as Jasmine did.
We encourage you to consider all of the pros and cons of a transfer to employees in light of how well it meets your goals. Work with an expert business exit planner to see your options for your Washington D.C. business.