Posted: April 29, 2011

Selling the business to your favorite employee

Why it might not work out

By David Tolson

Successful business owners have been successful because of hard work, a great staff and a little bit of luck. As a result, some business owners want to consider transitioning their business to a key employee as a reward and out of a sense of loyalty.

While this notion is initially attractive; pragmatically, there are some significant limiting factors that make the chances of successful sale to a key employee very low. From our experience in having worked with business owners to facilitate transitions, there are three primary issues when attempting the transition to the key employee: the employee's general aversion to risk, a lack of money, and a lack of skills required to run a business.

Risk aversion

When first approached by the business owner to consider "taking over" the reins, the key employee inevitably answers "I'd love to." After all, they know the business, enjoy working there, and have seen all inner machinations of the business, and often have the impression that they have contributed to the significant amount of money the business has made for the owner over the years.

What they fail to see, are the risks that the business owner has taken to get to the business to the position it is in. This issue can be significantly understated in the mind of the employee. Three questions that should be asked of the key employee are:

• Are you ready to put your entire life savings on the line for you to own this business?
• Is your spouse ready to risk their investment(s) as well?
• Would you be willing to risk bankruptcy for success?

In essence, is the key employee willing to put everything on the line?

When faced with this stark reality, the key employee will often start to think hard about the prospect of owning the business. Until they are truly confronted with the risk of losing everything, it is something that is not recognized. Unfortunately this issue is rarely vetted early on in the process. As a result, the plans for the transition will start to proceed and as the owner and the key employee get deeper into the transition process, the employee suddenly recognizes this risk and decides that they are not interested in "writing that check."

Assuming the key employee says yes to these questions referenced above, at least initially, there remain two additional significant hurdles that have to be cleared.

Lack of money

Unless you have been paying your key employees well above market rates, they most likely do not have the money to invest and buy the business outright. As a result, the typical key employee transition requires future business cash flow to generate the dollars for the employee to buy the owner out. This can be put together a number of different ways but any way you look at it, the business must continue to perform and generate cash.

That excess cash then goes to buying the owner out over a period of several years. This is where many business owners suddenly realize that this deal may not be in their best interest. If the business owner is planning on retiring and needs the money from the sale to retire, then this type of transition rarely works. As many of these earn-outs will take at least five years to complete, the key employee will struggle with the thought of having to write very large checks for the earn-out to someone who is long gone, while the owner will be on pins and needles wondering if they are going to get their money. Both parties often feel like the deal is not attractive to them because of this issue.

Lack of talent

Most often, the key employee selected to be the successor to the business owner is not the most talented, but the most loyal and the one with the longest tenure. Unfortunately, this is a recipe for disaster. In many cases the key employee has a unique set of talents that have served that person, as well as the business, well over the years.

Many of these skills have been honed during their tenure and the key employee is generally an expert in his/her area of the business. Faced with the significant challenge of running a business and understanding the sometimes tough decisions required to manage employees, vendors, and cash flow, the key employee rarely has the skill set to meet these challenges. Some of these skills can be learned and taught, but it takes time and experience to get there.

After all, remember how. as business owners, we learned our best lessons? We learned them through the School of Hard Knocks! Our best lessons have come from our learning experiences, which is consistent with our ability and willingness to take risks. If the key employee doesn't have the right risk profile, they will be more likely to crumble under the pressure of these lessons.

Transitions to key employees do happen, and they can be successful to all parties involved. Through proper planning and recognition of key issues early on in the process, business owners can increase the likelihood of making such a transaction successful!
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David Tolson is the co-author of Harvest: The Definitive Guide to Selling Your Company and Managing Director of CapitalValue Advisors (www.capitalvalue.net). He can be reached at david@capitalvalue.net . Visit www.harvestthebook.com for further information.