Business owners often have the choice to sell equity interests to an outside buyer or to sell internally to employees. Unlike employee stock ownership plans (ESOPs), where there are many employees that will start to have ownership in a company, and there is a fiduciary responsibility had by the ESOP Trustees and management when commencing and managing an ESOP, there is also an opportunity to sell ownership to key employees who might be interested in acquiring equity in the company and ultimately taking over when the selling shareholder retires or wants to slow down. Here are some important considerations for CPAs to relate to clients or their organizations.
Internal Selling Pros and Cons
An employee looking to acquire an equity interest from the owner likely doesn’t have the financial wherewithal to pay a premium price for his or her equity interest. However, they may be able to:
- Take reduced compensation for a period to buy into the company.
- Take out bank financing to help buy out the owner.
- Have the seller take back a promissory note, with principal and interest payments determined.
The positives of doing a transaction like this is that the seller gets commitment and effort from a buyer who wants the company to be successful. Selling internally also allows the seller to plan an exit strategy for him or herself. The company will have a legacy beyond the current owner. It may also allow the seller to work a little longer, in an employee capacity, and to feel connected to the company if the buyer agrees.
The downside of selling internally versus externally is that the seller may get a lower purchase price when selling to an employee instead of an outside buyer. In valuation, the terms investment value and strategic value refer to a premium over fair market value that may be paid if an acquiror knows the advantages and synergies that may be obtained by owning the target company. The acquiror knows how it might leverage employees, customers, distribution, suppliers, systems, logistics and more, in a transaction. The buyer is willing to pay more because of the anticipated benefits it may receive.
The valuation standards of value, investment value and strategic value, are perceived as a premium value more than fair market value. For example, if there is a large medical practice with an ambulatory care center and multiple offices, a private equity (PE) firm might pay a premium for that practice because it is buying a substantial medical practice, with work force in place, doctors already on insurance plans, large captive patient base, IT systems in place, and more. The practice may receive a price of six to eight times EBITDA (earnings before interest, taxes, depreciation and amortization) for the whole practice because it is a “strategic” buy for the PE buyer. If the owner of the practice looks to sell it internally, physician employees looking to buy in will not pay this multiple of EBITDA for the practice. Typically, they don’t have the financial wherewithal, the expertise of private equity investors and the ability to achieve synergies and efficiencies with acquiring the practice. The PE group likely has synergies it will obtain because of other practices it has already or practices it will add onto the first “platform” practice it acquires.
In a perfect world, when an internal employee buys a minority interest in a company, his or her equity interest value should be discounted by a discount for lack of control and discount for lack of marketability because the employee cannot control the company and the equity interest is illiquid (not readily convertible to cash). However, owners want to get the highest price they can from an equity interest sale, and usually the value determined will not reflect discounts. When owners are looking to sell internally, they are not interested in discounts to equity interests. They are interested in the value of their company and then they will take a pro-rata percentage of that value as the buy-in price, or at least the starting price in a negotiation.
Thus, the best way to handle sales to internal employees is to be fair with them and fair to the owner. A reasonable fair market value calculation (or full valuation) should be performed by an appraiser to understand the 100-percent equity value of the company. Then the owner can consider what level of equity they are willing to sell initially. Discussions with employees are important to understand what their expectations are when buying in and when they may want to be a controlling shareholder. Setting proper expectations for everyone is important to making a deal happen and keeping relations positive.
The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment or tax advice or opinion provided by CliftonLarsonAllen LLP (CLA) to the reader. For more information, visit CLAconnect.com.
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