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Employee Stock Ownership Plans Come with Both Risks and Rewards

Maybe you’re thinking that your business is not valuable to a third-party buyer. Maybe you don’t want to deal with the sales process, or perhaps you don’t have the next generation to pass it to. So, what are your options?

Maybe you’re thinking that your business is not valuable to a third-party buyer. Maybe you don’t want to deal with the sales process, or perhaps you don’t have the next generation to pass it to. So, what are your options?

Many owners wonder about the options, risks, and rewards of selling their business to a key employee, a group of key employees, or even an employee stock ownership plan (ESOP). The idea of an inside sale has made for very successful transition strategies for many construction companies and may also be the right solution for you. Here are some considerations to take into account when evaluating the ESOP option.

An Inside Sale
Owners typically prefer to sell to someone they know and someone who wants to continue their legacy by running the business in a similar fashion with the people who helped build it. They often want to see their company go to a person who has been with them for a long time, someone who knows the employees, understands the company’s culture, and has the relationships and trust of the employees, vendors, and customers.

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This type of transaction is called an inside sale. The process is more about facilitating a transition within the company than negotiating a transaction with an outside buyer. The reality is these types of sales take more time to execute, but provide the most creative deal structure options for both parties. The parties still need to negotiate, and they still transact a deal, just in a very different way.

Selling to a key employee means that there is only one buyer, so the process focuses more on deal structure than sales price. Price is always important, but tax consequences, payment plans, retirement plans and continuation agreements all provide different ways to pull money out of the company. The business only generates so much cash, so the more creative the parties are the better deal that can be facilitated. Typically, the terms of this type of sale require more seller financing and have little security. The payment plan is contingent on future profits, and both parties will have to share the risk.

The number one challenge in this type of deal is that this buyer has no money. In addition to having no cash at close, they have no bonding availability, no CEO experience and have not been trained to take over the role.

This shouldn’t stop you.

Just be aware that post-close involvement by the owner requires significant financing, mentoring and continued operational support by you for years.

Typically, neither the owner nor the employee has ever sold/bought a business before. This type of deal puts more risk on the seller than a typical outside third-party sale. Owners think this type of sale will be easier and save them in transaction costs, legal fees and convenience.  All of this can be true if owners think ahead and have good advisors to help them plan, communicate and support a mutually beneficial deal. 

Control is another hurdle for the owner to get over in an inside sale. Owners do not want to give control over to the employee without getting paid. Employees cannot make a commitment without the control of the company. So you need to ask yourself these three questions:

  1. Do your key employee(s) have the experience, leadership, street smarts, loyalty, work ethic, integrity and grit to generate enough profits to pay for the business over the next 7 to 10 years?

  2. Are you prepared to finance, coach, mentor and put your personal wealth at risk until the new owners can accumulate enough wealth to cover the bond, A/R, and line of credit needed to operate the business?

  3. Do you (and especially your spouse) have the patience, faith, trust and confidence that once you give them the control, that they will make their debt payments over the next 7 to 10 years without you being involved?

An inside sale to a key employee (or employees) or an ESOP can be your best exit strategy. The process allows for more creativity, continues your legacy and facilitates a win-win. The reality is that an inside sale takes much more time, requires extensive planning and more continued involvement after the sale. You also have the satisfaction of mentoring good, smart employees, providing wealth transfer to the next generation of workers, and watching your employees and the business flourish.  

John Ovrom
John Ovrom

John Ovrom is the founder and CEO of Exit Consulting Group.