Employee Transfer Scenario
What is a Key Employee Buy-In?
Key Employee Buy-Ins (KEBIs) are a form of internal transfer which occurs when an owner sells or bonuses some or all of their ownership interest to one or more key employees over a defined period for an agreed upon value.
KEBIs allow owners to select their successor(s), determine how much money they will receive, what financial or organization requirements need to be satisfied before awarding any equity and decide when the selected key employees will “buy-in” to the business.
Assuming the business has enough free cash flow, and the selected key employees have been properly vested and prepared, this is one of the best Transfer Scenarios– truly a “win-win” for the key employees and owner.
How Do Key Employee Buy-Ins Work?
KEBIs generally occur through some form of equity sale or equity bonus, both of which are detailed below.
In the world of equity sales, there are two primary sale structures – direct sales and equity options. Both require the eligible key employees to meet or exceed their performance standards and for the company to meet its financial and growth goals.
Key Employee Direct Sales
Direct sales are transactions between the eligible key employees and the existing owner or the key employees and the company. There are two primary direct sale structures – Installment and Cash.
- Installment Sales. These equity sales enable key employees to purchase a certain amount of equity over a defined period at the then fair market value at the time each installment is purchased. This structure allows key employees to “buy-in” and for owners to transition out of the business over time.
- Cash Sales. These equity sales occur when eligible key employees are able and willing to purchase a specific amount of equity at one time for the full purchase price, which is paid in full at the time of the sale.
There are pros and cons to each sale structure but both need to require that the seller/owner gets the money they need out of the business within their desired timeframe. Also, each structure needs to be tied to meeting the company’s financial goals, key employee’s performance standards and must allow the seller/owner to “regain” the equity in the event the deal goes south or something happens to the key employees.
Key Employee Equity Options
Equity options (non-qualified) are another way to sell and transfer equity to key employees. Options provide eligible key employees an opportunity to purchase a specific amount of equity (non-voting or voting) at a predetermined price over a specific period. The option to purchase the specific amount of equity is based on the company achieving its goals and the key employees meeting their performance standards and any other vesting requirements. Options are great for fast growing companies or businesses which are expected to grow exponentially in the short run.
Non-Qualified Equity Bonuses
Unlike sales or options (which are transactions), equity bonuses are “grants” of specific amounts of equity to eligible key employees. They are structured so that the company, not the owner, bonuses or transfers some amount of equity (usually non-voting) to an eligible key employee who has continuously met their defined performance standards and increased the value of the business. The goal is to bonus or grant the equity over a defined period of time and to motivate the key employee to continue meeting their performance standards, remain committed to the business and continue increasing its value.
All equity bonus plans should contain “minimum vesting” and “forfeiture protections” to protect the business in the event the employee leaves the business, becomes deceased, or violates any of the restrictive covenants.
Equity bonuses are treated as ordinary income to the employee upon their receipt or when the forfeiture restrictions expire. As a result, key employees may elect to be taxed on the current value of the bonus when it’s granted (when the value is lower) rather than waiting until the forfeiture restrictions expire (when the value is presumably higher).
Key Employee Buy-In Benefits & Concerns
Assuming the selected key employees are properly vested and developed over time, and the company is poised for growth, this Transfer Scenario is one of the best to consider.
It allows owners:
- To determine the value they will receive
- To determine who their successors will be
- To determine the terms & conditions related to their transition
- To determine their timeline for departure
- To “take back” or regain their ownership if things don’t work out as planned
It also provides key employees with a great opportunity to own a business, but not just any business – one for which they have been groomed to own and manage, without having to come up with lots of money. It truly is a “win-win” scenario.
The primary concerns in any KEBI are that the key employee(s) fail to continue meeting their performance standards, cannot grow the business, or it is discovered that the key employees don’t possess the necessary “intangible qualities” for being an owner.
Other concerns relate to their inability to build rapport with the company’s existing customers, suppliers, contractors and other non-successor employees. The new owners will have to convince those third parties that they are as capable as the previous owner and have the ability to deliver the same quality products and services and maintain those important relationships.
“Engaged, enthusiastic, and loyal employees are pivotal
drivers of growth and health in any organization.”
Preparing Key Employees for the Ownership Role
It’s critical that key employee successors understand what it takes to lead and grow the business, and that they are willing and capable to increase its overall value. It’s also important that key employee succession occurs over time to ensure that the owner’s goals and objectives are achieved and that the company can generate the required cash flow (over that period) since these Transfer Scenarios generally require the use of company funds for the owner’s buy-out.
KEBIs allow owners to properly vest and develop each key employee over a period of time and to delegate all owner-related tasks and responsibilities. This enables the key employees to learn how to run the business without the owner (creating sustainability) while allowing the owner to evaluate whether the key employees possess the ability to run the business. All of these issues will impact the culture and productivity of the business and increase or decrease the overall value of the business.
Considering a Key Employee Buy-In?
If you are interested in implementing a KEBI, there are a few things to consider:
First, determine who, if anyone, is a key employee. Make sure that you have an objective definition for determining the qualifications of each key employee. For instance, they may need to possess:
- Unique, valuable experiences and skills that can’t be found in other employees.
- The “IT factor” – the intangible and noticeable ability to act like an entrepreneur.
- The business acumen and instincts to run and ultimately own the business.
Second, be patient and open-minded. Understand that most employees don’t possess the required intangibles to run the business, regardless of how important they are to the business. These generally need to be developed overtime.
Third, define an objective process for evaluating, developing, and/or releasing your key employees from contention if they don’t pass the test. This process should involve non-owner employees as part of their evaluation.
Finally, make sure that when you commit to transferring equity, that you commit enough equity that signals your willingness to make sure the key employees are successful as the company’s new owners.