Selling Your Business to Employees

Regardless of the reason, know that such a large undertaking cannot be implemented overnight if you are thinking of selling your business. It requires a lot of thought, advice, planning, and effort to effect a successful transition.

Unless you’re an old hand at buying and selling businesses, don’t do this independently. Seek assistance from knowledgeable and experienced advisors because there are no do-overs after the transaction. If you do this right, then you can expect many advantages and new opportunities.

In many small- and medium-sized companies, business owners or shareholders will retire in the next few years. The business is your legacy: you want new management to keep it going strong. One way to ensure new management is invested emotionally and financially in the company and knows the business inside and out is to sell it to your employees.

Related: COVID-19 and Exit Planning. 

Management Buy-out (MBO)

The story of Michael Dell. One prime example of an MBO is when Michael Dell, the founder of Dell, the computer company, paid $25 billion in 2013 as part of a management buy-out, taking the company private to exert more control over the direction and operation of the company. This involved expanding the company’s product and service offerings to restore the company’s high ranking. As of January 2021, Dell was once again the third-largest computer vendor in the world.

For many companies, a sale to employees as part of a management buy-out presents an attractive option. Often, long-standing, good employees are interested in owning the company that employs them. The main benefit of a management buy-out is corporate stability.

The gradual transition to new management via the existing employees allows the company’s current owner to slowly and systematically introduce the future managing directors to ownership tasks. Because personnel won’t substantially change, management buy-out enables the company to show customers, suppliers, and employees consistently. Being already familiar with the company’s processes and procedures means employees can manage the company without significant start-up processes. New management knows the entire company and can analyze its strengths and weaknesses well.

Plan Ahead, Act with Intent

Having a well-planned concept for succession is a crucial business characteristic. The plan gives the business owner the security of knowing that they have prepared well and have long-term prospects for future success. Employees also enjoy a long-term perspective of continued employment and prosperity.

The MBO offers a suitable solution for many small and medium enterprise (SME) owners. Negotiation paths are short. The employee(s) and successor(s) know the company, its customers, and colleagues, making the due diligence check relatively easy. Tax issues, costs, profits, hidden reserves, provisions, etc., are often known mainly if the potential buyer(s) is(are) already part of the company’s management team.

MBO Disadvantages

Despite its advantages, an MBO is not a sure-fire success. Three factors are particularly important for entrepreneurs of medium-sized companies to decide regarding an MBO:

  1. Once negotiations start, the employees and existing owners become adversaries. Up until this point, they’ve been working towards common goals. But once negotiations start, goals diverge – namely, one wants the highest price available and the other the lowest! This can cause significant stife in the ongoing working relationship. This is acutely true in privately held companies.
  2. The employee(s) must be qualified to run a company. A good specialist or manager does not automatically a good entrepreneur.
  3. Can the employee(s) afford to buy the company? Prospective buyers within the company often have to finance the purchase price through a bank (or potentially a private equity partner). In turn, credit institutions demand a variety of covenants and collateral, and ultimately a very detailed due diligence check, which may have been overlooked beforehand.
  4. The employee(s) may not be ready to run the company. Sometimes, the owner must remain involved much longer than they would otherwise prefer if they are still not fully trained for corporate succession.

Incidentally, these questions also arise with management buy-ins. In such cases, prospective buyers depend on external financing when buying a company. The outgoing owner receives the capital for the purchase and steps in to optimize the company further and generate more profit.

When selling a company, sales agents should ensure that prospective buyers have enough experience and competence to lead the company successfully over the long term.

The Right Attitude Helps

Company sellers should remain calm, serene, and confident when choosing the right candidate for management buy-ins and management buy-outs. Working with a specialized transaction advisor to develop a catalog of requirements for the potential new owner helps build the assurance for a solid choice of candidate.

A competent consultant can analyze the profiles of interested parties and compare them with the requirements needed to run the company. Qualifying questions include:

  • Is the employee capable of running the company?
  • Does the company suit the employee’s personality and skills?
  • Is the company even suitable for this type of sale?
  • Will acquiring the company enable the employee to achieve their goals?
  • Does the employee have sufficient financial resources to acquire the company?

Explore these questions and answer them with an open mind. These qualifying questions are particularly important for an entrepreneur who has a strong emotional connection to the company and is interested in its successful management even after leaving it. Comprehensive checks and a realistic purchase price further reduce the risk of a failed sale.

A real-life example of success is when sold to the right employee. The revitalization of RST Instruments Limited in 2004 was due to its purchase by three employees via a management buy‑out. An expanded product line, employee base, facilities, international distribution, and a confident attitude contributed to uninterrupted growth until 2013. In July 2014, the three shareholders sold a majority stake of the business to private equity company Hammond, Kennedy, Whitney & Company, Inc., realizing a positive return on their investment in the company.

Types of Management Buy-outs

In general, there are four different MBO types:

  • Leveraged buy-out: Low equity and a high proportion of debt finance the corporate purchase with an LBO. LBOs are typical for company acquisitions by private equity companies.
  • Management buy-in: With an MBI, external management takes over the company. Typically, management buy-in is carried out in the form of an LBO.
  • Employee buy-out: With this type of buy-out, all or a large part of the workforce takes over the company. In practice, this form of buy-out rarely occurs.
  • Institutional buy-out: With this type of buy-out, an institutional investor, such as a fund company, becomes the new majority owner.

How Does a Management Buy-out Work?

Before MBO proceeds, the company’s current owner must believe that the company’s existing managers and executives have the professional and personal qualifications to lead the business successfully. If this requirement is met, the seller and management must agree upon the valuation of the company. Too large a gap in valuation can make a transaction impossible. Advisors who specialize in corporate takeovers can assist by mediating the interests of the seller and management.

If there is consensus on the company’s valuation, the seller and management team then draw up a joint letter of intent. A letter of intent is an agreement in which the two parties record the key points of the transaction and their commitment to conclude the transaction.

When writing the letter of intent, management should clarify financing the takeover and hold discussions with banks or negotiate a loan from the seller to finance the company takeover. If one or more banks have signaled their willingness to finance, the transaction should also be optimally designed to minimize the tax burden. This task benefits from the involvement of a tax advisor who specializes in M&A.

In contrast to a sale to external third parties, the company’s detailed examination (i.e., due diligence) when continuing operations by the existing management are either unnecessary or have a very manageable framework. Based on the letter of intent and with legal assistance, the contracting parties draw up the specific purchase agreement toward the end of the transaction process.

Once the due diligence has been completed, financing agreements are ready for signature, and the tax structure is set, both parties sign the purchase agreement.

Conclusion

A management buy-out confers many advantages upon both the seller and the management of a company. Based on the long-term relationship of trust between the two parties, selling a company as part of an MBO is, in practice, more straightforward and faster than selling to external parties, such as external managers or a private equity fund.

Even so, owners and managers should be aware of the pitfalls in an MBO. In particular, financing a higher purchase price or divergent interests between sellers and buyers can be significant hurdles.

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Alan Lambert

Alan Lambert

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