Selling to Key Employees or ManagementJan 14, 2018
This article kicks off our series describing the advantages and disadvantages of the five primary Exit Paths that business owners might choose. Our goal is to introduce important issues so that business owners, Exit Advisors and Advisory Teams can communicate and strategize on the same terms.
A transfer to key employees or management the most common Exit Path used by business owners who have undertaken comprehensive Exit Planning. According to The BEI 2016 Business Owner Exit Survey, 31% of business owners indicated that they were interested in pursuing a transfer to key employees or management. In our experience, many more owners pursue this Exit Path. What are some aspects that make a transfer to key employees or management so attractive to business owners, and how can advisors to business owners articulate and address those aspects for their business-owning clients? This article provides an overview of the advantages of an ownership transfer to key employees or management.
Advantages of a Transfer to Key Employees or Management for Business Owners
The following list covers the primary advantages of a transfer to key employees or management. It discusses the most popular reasons for why business owners express interest in transferring ownership to key employees or management. As you peruse this list, it’s important to note that all of these advantages exist under the umbrella of the three fundamental goals that all BEI Exit Plans aim for:
- Maximizing the value the business owner receives for ownership transfer.
- Keeping the business owner in control until he or she receives all sale proceeds.
- Minimizing the business owner’s risk.
Advantage 1: Financial Security
The allure of financial security is often the primary reason for why business owners look to transfer their businesses to key employees or management. With proper planning, business owners gain four distinct advantages in terms of financial security by transferring to key employees or management.
4 Financial Security Advantages of Transferring a Business to Insiders:
- In choosing to transfer ownership to key employees or management, business owners, with help from their Exit Planning Advisors and Advisor Teams, can structure an ownership transfer to suit their particular wants and needs, rather than the whims of an outside buyer.
- Key employees or managers who know they’re being considered for future ownership are as interested in building value; training future owners; and making the business more profitable, stable, and better managed as the owners they’d succeed. This gives current business owners a strong foundation on which to build their Exit Plans, since the goals of everyone involved harmonize.
- Transfers to key employees or management can yield more income over time than a sale to a third party or ESOP. During the multi-year transition period, the business owner’s salary, distributions, and perks typically continue. This continuous distribution of free cash flow to owners is a major source of asset accumulation.
- Business owners continue to share in the growth of the company. When they ultimately cash out, they not only receive the initial business value but also enjoy the proceeds from any growth in value.
Advantage 2: The Time Factor
Business owners who choose to transfer ownership to key employees or management afford themselves the luxury of extra planning time. It normally takes longer for owners to phase themselves out of ownership through a sale to key employees or management than it does through a sale to a third party or ESOP. Having extra time to prepare gives owners options if something unexpected were to happen, such as disability or receipt of a huge inheritance. When correctly designed with help from an Exit Planning Advisor, this type of transfer permits owners to switch to another Exit Path—specifically, a sale to a third party—at any time and for any reason.
Advantage 3: The Time Margin
According to Jeff Spadafora, Director of Global Coaching Services for The Halftime Institute, the time margin is the time that owners spend developing interests outside of the business. An ownership transfer to key employees or management gives owners a sizable time margin, usually 5–10 years, to pursue those interests while receiving income and maintaining control. This is especially important if an owner is not yet sure what he or she will do after exiting.
Additionally, the staged and protracted nature of a transfer to key employees or management gives successive owners time to gain experience running the business without the owner. If those successors fall short in ability or ambition, the original owner is still in control and can redesign his or her exit accordingly.
Advantage 4: Tax Consequences
The design of a transfer to key employees or management can significantly minimize income tax consequences. For example, BEI has developed an insider sale process that typically reduces the cash flow needed to achieve the owner’s financial security goal by 30–40%, compared to traditional techniques.
Advantage 5: Values-Based Goals
A transfer to key employees often gives business owners the best chance at fulfilling their values-based goals, which are personal goals that business owners have outside of the financial realm. The top three values-based goals that a transfer to key employees or management facilitates are:
- Legacy and Culture. Existing management is more likely to maintain the culture, legacy, and mission of the business.
- Benefits to Employees. The employees who helped build the business keep their jobs and have a future with the company.
- Family Harmony. Owners can treat all children equally by (eventually) providing them equal amounts of cash. This appeals to owners who would rather not worry about which child will run the business and which children will receive other assets (or not) to compensate for their not owning the business.
Advantage 6: Successor
In these transfers, buyers are prequalified through on-the-job training and observation. Management is motivated to stay with and grow the company just like any other owner.
In our next article, we’ll look at the primary disadvantages this path presents to business owners.