Overcoming Obstacles to Employee Ownership:
Lessons Learned Over 20 Years
guest column by
Tomas Duran and Bruce Dobb
Partners at Concerned Capital
Many new employee ownership advocates and ‘social impact’ investors have emerged to address the risk of job loss caused by the ‘Silver Tsunami’ – aging baby boomers all selling their closely held small businesses at the same time. They often ask us to share our experience with difficulties we face transitioning company to employee ownership. Concerned Capital has successfully facilitated the transfer seven companies to their employees and we’re working on 4 of these deals currently. Dozens more are in our pipeline across the country and we’re working with owners and employees to get transactions to work.
We launched our ‘transfer of ownership’ initiative in 2003 after serving as consultant to the Valley Economic Development Center (non-profit lender). There we developed a ‘transfer of ownership’ initiative designed to mitigate the effects of thousands of business closures following the 1994 Northridge Earthquake. The federal needed to keep the doors open at hundreds of major employers in the San Fernando Valley following the quake. Aging owners decided it was time to ‘get out’, collect insurance money and close, rather than risk re-starting after this major business disruption. One solution was to transfer ownership to qualified employees.
Employee ownership is being tried across the country to mitigate the consequences of aging ‘baby boomer’ owners exiting their companies (they own 75% of all small business) due to retirement. The following are some of the most common obstacles to overcome in transitioning companies to employee ownership along with some suggested solutions:
Lesson #1: It is a highly competitive marketplace.
Employee groups need to identify these opportunities early and quickly secure their spot at the table. . For every viable, profitable company there are dozens of professional buyers who buy to ‘flip’ and exploit a company or strip the firm of assets and liquidate. Two of the most common phone calls a company owner receive are from brokers looking to buy the company and equipment dealers looking to sell used equipment from a purchased company. It’s increasingly difficult to ‘flip’ residential real estate, so small business has become the next speculator magnet.
Speculators have crowded the market. They have no social mission to save jobs; in fact, one of the first things they do after buying a company is to cut costs by firing workers before they look to resell it. A profitable on-going business with a recognizable trade name and highly trained workforce is worth far more than the valuation CPA’s give them. A typical valuation will discount ‘goodwill’ as an asset. For this reason, valuations rarely reflect a company’s true value. This has created the perfect storm for rampant speculation.
We recommend uncovering the better deals through unconventional means – not business listing. Less than 1/3 of all listed companies sell. The reason is that the better ones are never listed. Employee groups bring these companies to us and we help them draw up a “Letter of Intent” (LOI) as quickly as possible. The LOI takes the company ‘off the market’ for 30 to 60 days while we test out the books, check with creditors, and assess strengths and weaknesses – a process known as due diligence. We also line up purchase debt and working capital during that period.
Lesson # 2: Employees don’t know they can buy the company or even that it is for sale.
The saddest call we get is when we hear from an employee AFTER his/her company has been sold and the purchase price was affordable to an interested group of employees. No one reaches out to tell that the company is ‘for sale’. The best candidates for employee take-over have the following profile:
- Main company asset is its undervalued; highly skilled workforce.
- Many long-term employees (5 years and longer). This is often true of older manufacturing or industrial companies with high paying jobs that require skill and training. Many of these firms have less than 75 employees.
- Absentee management – owner comes in once or twice a week and only handles crisis or new sales. Most customers are the repeating kind.
- Owner is being forced to transition – age, sickness, family upheaval and lack of heir apparent – Heirs are all doctors, lawyers or white collar workers not interested in the family business.
- Niche players who have carved out a meaningful market for their goods or services based on verifiable market demand.
Lesson #3 – Exiting owners deplete a company of value as they wind down their involvement and head for the door.
The reality is that exiting owners don’t invest when they don’t know how long it may take to re-coup their money. Exiting owners are building assets outside of a place where they already have an over concentration. This could mean that the company hasn’t kept competitive with its market; hasn’t updated production or purchasing system; and, has little or no inventory. It needs to be‘re-invented’ if it’s to survive.
The successful employee groups we deal with know what is needed and what’s missing. That’s the first reason they give as for wanting to take over. The business future success requires re-investment and fresh management.
The trick is to get in before it’s too late to keep the company viable. We only do deals where the employee buyers are hungry to make the company work and then reap the benefits. Identifying how the seller has neglected the company or created an opportunity of growth is key to understanding the deal correctly. Retiring owners often seek to take as much of their investment ‘off the table’ as possible even before they sell.
Lesson #4 – Tax consequences can make or break a deal.
Sellers do care about long-term employees and would like to protect them – if it’s in their best interest to do that. There are a lot of tax laws involved with selling a long-held privately owned company. Technical stuff such as ‘allocation of purchase price’ and ‘stepped up bases and estate taxes all enter into the decision as to how to best sell a company. It’s not as important how much you sell the company for as it is how much you get to keep. Tax consequences are one area where employee purchasers have very strong advantages.
We try and sell a company ‘lock stock and barrel’ so employees take over not just assets but the entire corporate shell as well (after that shell has been studied and scrubbed for problems). This allows the owner to treat sales proceeds as ‘capital gains’ which are taxed at a lower rate. There are other tax favorable consequences possible when selling to employees that sellers need to understand. It can tip the scale in favor of an insider deal.
One practical consideration is that many transactions are financed with ‘seller carry’ because of favorable tax treatment. Owners often feel better about carrying paper for someone they share a history with. (Yet another benefit of selling to employees; it keeps the company intact just in case the owner does have to come back in for a rescue.)
Lesson # 5 – Bank finance is difficult for employee buyers.
Banks don’t understand business loan requests from new business owners UNLESS they fully understand the successful history of the company and the role the employee(s) had in that success. The advent of social impact investors and the growth of worker co-op financing have been strong in the last 5 years and lots of resources are now available other than conventional banks. The company’s existing bank of account is still that best place to start a search because they understand the history of the company and will want to keep it as a depository client.
Employee takeovers need to be accompanied with projections that the new owners devise. Repayment must be demonstrated. Key is often showing savings when the all of the owners wages, benefits and related family costs are added back. Hopefully, the new employee/ owners will need less compensation after the take-over.
Because a bank may have more faith in the company’s track record than the new buyer, a working capital loan after close is easier to obtain than money to purchase the company. Lenders want to see that borrowers are first in and have ‘skin in the game’.
The above rules of thumb don’t apply in every case and you don’t need a lawyer’s disclaimer to make that statement obvious. What is true is that small business acquisitions are done in an under-regulated market place where good intentions and B-school training don’t count for much. Helping employees buy a company doesn’t always save the day; some companies don’t make it even after an employee take-over. All our deals have been successful in keeping the target company opened but, that’s because we are experienced lenders who learned many lessons the hard way. It takes years of experience to assess risk and gage sustainability. We’ve been at it a long time and we’re still learning. We wanted to share some of what we’ve learned in hopes that it helps more companies become employee owned.
Tomas Duran is President, and Bruce Dobb is Founder and CEO, of Concerned Capital, a social benefit company dedicated to saving and creating living wage jobs in low to moderate income communities. For more information on Concerned Capital, go to http://www.concernedcapital.org/