Reducing the Risk of an Employee Buyout

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Here’s one of the “dirty little secrets” of selling a business: In most cases the efforts will fail.

When teaching on business succession I introduce the “35-20-7 Rule”: only 35% of all companies reviewed by mergers and acquisition professionals are viable for sale, only 20% of all companies listed will actually sell, and as a result of these only 7% of all businesses will actually be sold as an ongoing venture.

Others have called me an optimist.

Why is this important? Because more than seventy percent (70%) of all business owners have most of their personal wealth tied to the value of their company or firm. And without effective preparation that wealth will be reduced or lost at the time when the owner needs it most.

The lack of buyers are creating transition solutions similar to the one taken by Richard (not his real name). He owns a successful professional service firm with a national reputation and few hard assets. After discussing different options – including strategic buyers, investment buyers and family succession – he decided his best option would be an employee buyout. He would give his key managers an opportunity to own what they helped grow.

On our part, we first determined the interest, willingness and capabilities of the buying group. The managers were excited about the possibility of ownership and were willing to make an initial financial investment as a part of their buy-in. So far so good. But there is more to an employee buyout than willingness.

Richard agreed to finance a part of the purchase. And then the plan came to an abrupt halt. He realized that his managers, though capable in their current role, did not have the skills needed to keep the firm growing. If they failed he would have to come back and re-start the succession process. For Richard, the risk was too great.

After transitioning to new owners, a business can fail for a number of reasons. Usually, however, the cause can be found in one or more of the following areas: General Business, Financial, Marketing or Human Resources.

Having managers-to-owners with proven experience in these critical areas increases the likelihood of transition success; the goal of everyone involved. Especially in an employee buyout.

Together, they provide a framework upon which potential owners can be assessed early in the transition process.

General Business Factors Contributing to Business Failure

Why businesses fail: New owners attributed the failure of the business to the following General Business Factors:

1.      The lack of a well-developed business plan, including insufficient research on the business, its market and its competition (78%)

2.      Being overly optimistic about achievable sales, money required and what it takes to be successful (73%_

3.      Not recognizing or ignoring what they don’t do well and not seeking help from those who do (70%)

4.      Insufficient relevant and applicable business experience (63%)


Every business decision carries some risk. This is minimized grounding decisions in reality. After all, today’s inspiration have more to do with last night’s pizza than a well thought out business solution.

I don’t watch South Park. Even so, I was introduced to the dangers of blind optimism through one of their shows (find it here

After having their underwear stolen the boys follow a gnome to an underground cavern filled with piles of stolen underpants. When asked, the gnome told the boys they are stockpiling underpants as a part of a larger business enterprise. Their business plan was straight forward and easily understood: “Phase 1, Collect Underpants. … Phase 3, Profits.”

The obvious question – both in the show and in real life – is frequently unanswered: “What’s Phase 2?”

To be successful, owners – no matter how optimistic – must develop “Phase 2.”

Too often new owners will attempt to accomplish too much, too soon. Their energy, though welcomed, keeps them from studying the strategic issues that lead to sound decisions about budget, people and market; the nuts and bolts of business success.

Before agreeing to sell to an employee buyout, owners must be confident in their ability to grow the business. If missing, look for an outside buyer.

Financial Factors Contributing to Business Failure

 Why businesses fail: New owners attributed the failure of the business to the following Financial Factors:

1.      Poor cash flow management skills (82%)

2.      Too little money (79%)

3.      Poor pricing strategies (77%)


A few years ago a friend sold his successful hydroponics operation. He had built his company through the familiar combination of hard work, good fortune, customer care and determination. But he was growing weary of being a wholesaler with high receivables and inconsistent cash flows.

Prospective successors – whether they are employees, managers or family members – should be asked, “How do you pay rent? Salaries? Supplies?” The answer of course, is with cash. Not profits.

If they are not careful, new owners can burn through a lot of cash. Or, conversely, fail to invest in areas that will generate additional cash. If, for example, old computer system needs to be upgraded, what is the best way to do so? Business loan? Cash? Lease? And what is the benefit (savings or new efficiencies) to the company?

Owners need to take a hard look at the experience internal successors have in managing budgets, projecting cash flow and recommending capital investments. Otherwise, it will only be a matter of time before the business experiences a cash crunch that can put the entire operation at risk.

Marketing Factors Contributing to Business Failures

Why businesses fail: New owners attributed the failure of the business to the following Marketing Factors:

1.      Minimizing the importance of promoting the business properly (64%)

2.      Not understanding or ignoring the competition (55%)

3.      Too much focus or reliance on a single customer (47%)


I was looking at company a client wanted to sell. For the previous threes year the business had shown a profit, strengthened its balance sheet and improved its workforce. The owner had been taking a high salary. He thought he was sitting on a goldmine and was now ready to retire.

In our due diligence we peaked under the covers and contacted the business’ largest customer (representing more than 65% of the company’s annual revenue). They had just signed an agreement to have parts manufactured overseas, putting my client’s business at risk.

Because of its income, the business had been lulled into an unhealthy sense of success. They had stopped marketing. The one sales person was ineffective. The competition had been growing.

To succeed, prospective internal owners must prove their ability to grow all or a part of the business. If they can’t, then find another buyer. The lack of business development is too much of risk to carry.

Human Resource Factors Contributing to Business Failure

 Why businesses fail: New owners attributed the failure of the business to the following Human Resource Factors:

1.      Inability to delegate properly (micro-managing) or over delegating and abdicating key management responsibilities (58%)

2.      Hiring the wrong people and not people with complementary skills, or hiring friends or relatives (56%)


The late Peter Drucker wrote, “The ability to make good decisions regarding people represents one of the last reliable sources of competitive advantage, since very few organizations are very good at it.” At the very least, having the wrong people hurt a company’s ability to compete. Unfortunately it can also bring a business down. Micro-management, abdication and poor hiring will quickly undermine years of business success.

Frequently managers are given limited responsibility when it comes to hiring. And if they are, they are not held accountable for the results.

In his book, Top Grading, Bradford Smart writes about the poor job leaders do when hiring. He believes that a company will only hire the best available person for the job in 3 out of 10 attempts. The remaining 70% represent a costly mistake for the business.

Unless managers prove their ability to hire and retain a strong team of employees they should not be given an opportunity to become an owner.

With a limited number of buyers creating an internal market for a business or practice should be considered if, and that is a huge qualifier, the owner is capable of turning his or her managers or successors into owners. With proven experience in the areas of general business, financial management, marketing and human resources the new owners have a good chance of succeeding.

Without that same experience, however, they have an even better chance of failing.


© 2005, 2014 to present Paul R. Brown. All rights reserved.


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