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Key Idea: Sell to Your Employees (6)

Use an Employee Stock Ownership Plan as the instrument to sell your company to your  employees.  More...   Related...

Key Question:


n this episode we are talking about employees buying the business and that is an option.  To sell your business to anyone or any group, you must find the value of your business  and calculate your EBITDA.

This is a little technical but understanding this concept and why it matters is critical to your ultimate exit strategy. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Calculating your EBITDA is easy. Take the bottom line of your income statement and add back all those items (interest, taxes, depreciation, and amortization). Simple, right? But understanding EBITDA and why it's important is what matters to you.

Why the focus on EBITDA?

The EBITDA is probably the single most important factor in the buyer's evaluation of the acquisition target because it represents cash flow from operations. The purchase of your business is an investment from the buyer's point of view, and he or she will calculate the return on that investment. This return is generally calculated in the traditional percentage manner as well as in terms of the "payback period."

The payback period is calculated based on how many years it takes to recoup the cash and/or stock investment.

The more profitable the business, the higher the price the buyer will pay because the business will provide an economic return justifying a larger investment. EBITDA isn't the only thing the buyer will evaluate. If your business operates with a significant investment in equipment, the buyer will have the equipment appraised. What kind of capital investment will be required beyond the purchase price? If your equipment is aging and needs to be replaced, this could have a big impact on the purchase price.

Necessary capital improvements are considered separately by the buyer, that's why depreciation and amortization are not included in EBITDA.

Q: Why add back taxes to calculate EBITDA? Isn't that a cost paid from cash flow? Won't the buyer have to pay the same taxes you did?

A: You bet! There's an old Yiddish proverb, "You make your money; you pay your taxes." CPAs like to say that you can't let the tax tail wag the economic dog. Yes, the buyer will pay taxes on the profits of your business and yes those taxes will come out of the cash flow of the business. The reason taxes are not considered in the valuation of your business is because the buyer is considering your business as an alternative investment.

The same is true of interest. The buyer will take into consideration the cost of money, to be sure, but as with the capital improvements that may be required; the buyer's cost of money is independent from your cost of money. So just as the buyer will "add back" the depreciation and amortization you have recorded each year, he or she will similarly add back interest and take into account his or her own cost of financing the transaction.

If you pay yourself above industry standard, don't worry. Buyers realize this and will deduct from your overhead the salary and benefits you have been paying yourself. A new buyer will use what is called recasted numbers to determine the value your company holds for them.

Q: What is the fundamental reason a person starts a business in the first place?

A: The simple answer is to first create something of value, and then sell it to someone at a price that is greater than your costs again and again.

A "first principles" answer looks more deeply at the value creation component, then at the very nature of the agreements with the buyer, then at the leveragability of both. And both "answers" fully reflect every aspect of the mantra.

Questions for this clip: 1 | 2 | 3

Think about it

Do you think that this option could be an employee motivation tool? Does this option intrigue you? Should you learn more?

Clip from: From Equity to Exit Strategies - 8 Possible Paths

The world:  Most of us small business owners do OK competing with the big businesses in our industries or we don't survive. But when it comes to our exit strategy and succession planning, most of us fall on our face.

This episode is to explore business valuation and exit strategies.

An exit strategy is just like doing a will, but here you try to maximize the dollars you get out of your life's work.   Nobody wants to see you liquidate. That's getting pennies on your dollars. Tangible assets get sold (fire sales) and the intangibles are lost forever. Liquidation is the worst kind of liquidity.  

Most of us will sell our business through merger or acquisition. But, if we get much over two-to-three times sales or six times earnings, we all think we've done very well. Yet, when big business sells, they usually begin at six times earnings. Then we see 40 times and even 300 times earnings on the open markets. Why should we be satisfied with so little?

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former Director, Beyster Institute

Ray Smilor, CEO

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Sell to Your Employees (6)

HATTIE: Number six. Sell to your employees. These last three roads are the least understood and the reason we are doing this episode.

HATTIE: So tell me about where we are.

RAY: This is a little bit of paradise -- La Jolla Cove.

HATTIE: It’s a gorgeous day.

HATTIE: (Voiceover) Dr. Ray Smilor is President of the Beyster Institute and he’s an expert on ESOPs.

RAY: An employee's stock ownership program is a way to get employees engaged and involved in the company so they think and act like owners. But also a way for the owner to sell the company in a very effective way so he or she gets liquid as effectively as possible. So it helps the founder, the original owner of the company, and if it's done right, it helps the employees succeed as well.

FREDDIE THODE: ESOPs are a fabulous vehicle.

RICK VALENCIA: We do have a stock option plan and we do reward people very generously with stock options right off the bat.

FREDDIE: Your employees are what carry you on.

NED LESTER: The ownership is what will entice people to come.

FREDDIE: Founders get things rolling, but employees are the people that really are the implementers.

NED: To be able to offer a part of the company and part of the ownership of the company is a very significant to attract good quality personnel.

RAY: What are the reasons that motivate an entrepreneur, a founder to want to set up an ESOP so his employees can buy the company from him or her? And the reasons may be three or four key ones, Hattie.

One is because you think it's the right thing to do because people who build the company should own it and you want them to have some ownership stake in it. That's one reason.

Second, it may be to prevent the company from disappearing. Because if the owner wants to sell the company on the open market, and a large company comes in to buy it, the company in effect may "disappear." Gets a different name. It gets subsumed into the larger firm. Or the company may actually be shut down where a competitor buys it and closes it. So you may want to prevent the company from disappearing.

A third reason may be the owner sees this as an effective way to get liquid, to get money out of the company that he or she has built. And to get liquid, there are some terrific tax advantages that benefit the owner. So you can get liquid, you can prevent it from disappearing and you can help give the company to the people who helped build it.

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