White Paper: Evaluating Whether to Sell Your Business to Employees

White Paper: Evaluating Whether to Sell Your Business to Employees

Author: Josh Huseman, Vice President, Business Owner Advisory Services

Introduction

As a business owner contemplating the future of your company, you may be considering options for an eventual transition. Research from the Exit Planning Institute reveals that nearly 60% of business owners prefer an “internal” sale when planning for their transition (1). For many owners, selling to employees provides an opportunity to preserve company culture, reward loyalty, and maintain continuity for the business.

This white paper examines the primary considerations, potential benefits, and key challenges of the various options available. The intent is to help you explore these concepts early in your thinking, so when the time comes, you can make an informed decision.

Key Factors for an Internal Sale to Employees

When deciding to sell internally, owners often view employee ownership as a way to maintain the values and culture they have worked to build. Transitioning ownership to employees, whether through direct sale, phased ownership, or other arrangements, can provide stability for the business and continuity for customers and employees alike. Here are several important issues to evaluate when you are considering an employee sale.

• Valuation and Financial Health: Selling to employees does not necessarily mean accepting a lower price than you would from a third party. However, the financial health of the business will likely need to support a structure that will include debt. Most employees lack the financial resources for an immediate buyout and will often require bank financing or debt financed by you as the outgoing owner. To support a successful transaction, your business should have a history of strong profitability, consistent cash flow, and low leverage. This will help the incoming owner sustain current operations while servicing new debt.
• Financing Options: Employee ownership transitions often depend on financing to make the purchase feasible. This can be done through traditional bank loans, Small Business Association supported programs, seller financing, or an Employee Stock Ownership Plan structure. The SBA’s 7(a) program can help facilitate partial ownership transitions, though the process can be somewhat lengthy and process driven. Seller financing is a common choice, allowing outgoing owners to receive payments over time, though these are mostly dependent on the business performance. In many cases, this approach doesn’t provide the seller immediate cash, but it can make ownership more accessible to key employees. Common terms to establish include the valuation, interest rate, and structure of the payment period. ESOPs are often discussed as well, though they can be complex and are typically best suited for businesses with stable cash flow, $1 million in annual payroll, and a willingness to navigate a highly regulated process. For businesses with at least $3 million in EBITDA, recapitalization may be an opportunity to bring in outside capital, allowing employees to acquire a partial stake alongside new investors.
• Working Capital Needs: In an internal sale, it’s natural to think about taking cash that has been built up in the business. However, it is essential to consider the working capital needed to sustain operations post-sale. Leaving adequate liquidity will help ensure the new owner(s) can cover immediate expenses and keep the business running smoothly. Think of it as leaving fuel in the tank – retaining cash to help sustain the business during the transition. This will require conversations with tax advisors and incoming owners to determine an appropriate amount.
• Timing and Tax Efficiency: Timing can play an important role in optimizing the financial and tax outcomes of the sale. Working with tax and financial advisors early on allows you to align the various factors that affect tax treatment and structure. For example, a phased ownership transition may allow you to spread payments over several years, potentially recognizing capital gains over time instead of all at once. However, installment income and capital gains are taxed at different rates, and understanding these distinctions can guide the timing and structure of the sale. It is also important to note that the SBA also allows for partial changes of ownership, meaning you are no longer required to sell your entire stake up front. SBA-backed loans can support a gradual sale, although they often require the outgoing owner to guarantee the debt. In ESOP transactions, similar nuances apply with tax benefits available if at least 30% of the equity is sold to the ESOP trust.
• Governance and Control Considerations: If you plan to sell less than 100% of your equity, governance and decision-making factors become important. In many cases, bank-financing arrangements will have percentage ownership thresholds that can trigger guarantee requirements. Legal documentation will be necessary for shareholder provisions, and you may want to set performance triggers so that you can retain certain rights if key targets aren’t met. Overall, phased ownership can offer both you and the incoming owner(s) the opportunity to assess capabilities and potentially reduce the risk of decreased company performance.

Ownership Culture OR Ownership Transfer?

Having the desire to transition ownership to your employees is a noble goal, often rooted in a genuine interest in seeing them benefit from their hard work. However, it’s worth asking yourself if your primary aim is to transfer ownership as part of an exit plan, or if your focus is on building loyalty and rewarding performance through an incentive plan. While this might seem like a simple distinction, it’s an important one. Building an ownership culture doesn’t necessarily require selling or transferring equity – it can be achieved through cash-based incentive structures that foster commitment and reward performance. 

The visual below may be helpful to further distinguish between building an ownership culture and transferring ownership. It may help clarify whether your objective is to share financial success with employees, or if you are looking to structure an actual ownership transfer.