What to do about employee owners in target business?

July 20, 2021

by a searcher from Georgia Institute of Technology in Durango, CO, USA

Hi all,

I'm currently looking at an opportunity where 3 employees are also owners in the business totaling just over 20% ownership between the 3 of them. The owner does this with all 5 businesses he owns where he provides equity to key employees. The owner was planning to sell to those employees but has lost patience with that transaction due to some issues with the employees getting things in order to arrange financing. This is related to their personal finances and ability to secure financing and not the business. The deal recently came to me through the broker after the owner made the decision to look at other options. I won't go in to details on the business but I like it and am planning to get an offer together.

The current owner's preference is to keep the employees on board as owners in the business and to sell is ~80%. Because the current owner has 4 other business and some of those larger he mostly relies on these employees to run the business and spends around 10hr / week dedicated to this business. If I go this route, an SBA loan would be off the table to keep the other owners on and I would use a large seller note coupled with as much non-SBA bank financing as I could arrange.

Alternatively I could go the SBA route and buy 100% of the company. The trick here then is how to keep the key employees after they are no longer owners. One issue is the SBA 12 month rule which I think there are ways to get around. The main issue I'm concerned about is how to keep them engaged and wanting to be there once they are no longer owners.

In general I'm not in favor of partners I don't really know but am leaning in this case towards going with Option 1 to ensure continuity of the business as long as I have full control. Not the ideal situation but nothing is perfect and it's a strong business that ticks a lot of boxes for me. Would love any thoughts on things I should be thinking about here.

Cheers!

Reply by a searcher
from Harvard University in San Francisco, CA, USA

First, I’d want to get a read on the 3 key employees’ personal motivations, preferably by talking to them directly. Are they still trying the buy the company even though the seller is looking at other options? Would they prefer to roll their equity or cash out? What happens to each employee in those scenarios? Do they even want to stay on post-change of control and what would the org chart look like if one or more exited? Is their payout going to motivate them to do something else? If they wanted to stay, how would they feel about a new boss / majority partner that they don’t know? Then after you get a sense for what you’re dealing with from the 3 key employees’ POV, I’d double-check if the SBA loan is truly off the table if they roll their equity into the new entity as they only hold a minority interest. If you went the 100% SBA route and were looking for ways to motivate those employees post-close, I think there are many routes - various ways to mirror the mechanics of esops, phantom stock, and stuff like profits interests or other profit sharing plans.

Reply by an investor
from New York University in New York, NY, USA

Very interesting situation. As long as you can get attractive financing in place and you are in full control, I actually like Option 1 a lot. You have 3 employees that (I assume) are critical to the business and that have a natural owner's mentality. That said, even if they remain owners, there might be some disappointment that they only own a collective 20% vs. owning the entire business like they intended. I have seen this on a larger scale, and it did not end well, so I agree with the other comments that you need to get a sense of their motivations. How excited are they to move forward with their current minority ownership stake? I would imagine that if they stay on that this stake is meaningful enough to them that they want to make a go of it. If you pursue Option 2 and buy them out, you could replicate economic ownership in the other ways mentioned, those might not "feel" as tangible as their current situation as actual owners. In Option 2, I would definitely be prepared for some turnover - they might not want to commit to X years to build up enough equity value.

+7 more replies.

Join the discussion