Key Employee Buy-In Transition: A Case Study

By Lara Copeland, contributing editor
The American Mold Builder

John Carter, principal at JVMC Transitions Group, LLC, works with business owners to prepare their companies for sale to outside buyers or internal transition to family members/key employees in a manner that works for all parties involved. Recently, Carter collaborated with John Hill, president and owner at Midwest Mold Services located in Roseville, Michigan, to help him transition his business to two key employees.

Preparing for transition

In the last 20 years, Hill has taken the company, an injection mold builder and plastic part manufacturer for high/low volumes and prototypes, “to a highly profitable company with strong growth prospects,” Carter remarked. “He built a great organization with loyal employees with a strong work ethic while facilitating a friendly culture,” a crucial prelude to the kind of work Carter does. When Hill came to Carter a couple of years ago as the sole shareholder of the company, he wanted to transition the company to two key employees over time but didn’t know how to structure the deal. Each of the key employees had been with the business for a long time, and they represented operations and business development. Carter noted that it is important for key employees to come from different functions of the business because they will need each other’s skills and strengths to continue growing the business through the owner’s transition process.

As opposed to trying to prepare the business for a third-party sale to a larger organization, “where you lose control in the process and you really have no say in the end result,” Carter explained that Hill wanted to continue the company legacy by passing it on to his key employees. He felt these key employees would be able to successfully maintain the culture while also continuing to build the infrastructure of the business he carefully created. “A lot of his decision was based on maintaining the legacy of the company and managing the process and financial outcome of his transition plan, unlike in a third-party sale.” Hill already had invested five years in grooming both employees to handle key operations of the business before Carter entered the scene. “Then when I got involved, we looked at creating what is known as a two-phased key employee buy-in, where the key employees first buy the non-voting equity over a period of time and then ultimately acquire the voting equity when the owner is ready to leave the business.”

The idea behind this type of transaction is that the money used to buy Hill’s stock from him is predicated on the profitability of the business. As a result, the money does not come directly out of Hill’s successors’ pockets; rather, it comes from the business, which in turn pays the successors, who then pay Hill. This is a typical succession plan for smaller manufacturing companies when the owner has retained the business for a long time and invested time in developing good key employee successors.

Transaction phases

“We can think of this transaction in two major phases, and the first phase is the prep phase,” Carter said. The purpose of this phase is to restructure the governance of the corporation, so that the key employees handle more key strategic decisions in the business. “We put them on the board of directors so they could sit with Hill and be a part of all key strategic decisions in the business,” he said. This was done 18 months to two years before the actual transition plan kicked in. In this case, Hill retained his final decision-making authority as chairman of the board while also retaining all the stock.

The second phase is the actual transition process, which also can be broken into two main processes. First, a valuation, or estimated value, of the stock was conducted. Because the goal was to sell to the two successors a minority of the shares over a seven-year period, the parties needed to understand and agree to what the value of those shares was. Second, Carter worked to figure out the appropriate “lack of marketability” discount to be added to that valuation.

“Essentially this reduced the value by another 20 to 25%. The reason we do that is because we want to come up with what we think the real value of the stock is worth, but we also are trying to minimize the value so we can then minimize the purchase price requirements that are going to have to be met by the successors,” Carter explained. This reinforces the idea that the purpose is not to maximize the price for Hill initially but to try to minimize the actual amount of money the key employees have to pay for the stock over the next seven years. “Our goal in this transition is to maximize the value of the company by reinvesting the business, and we also want to pay as much money out to Hill by way of other mechanisms over the course of the seven years before he retires,” he added.

Once the numbers were figured out, Carter created a series of stock purchase agreements and other legal transaction documents. These documents stated that, for the successors to be eligible to buy a percentage of the 49% minority shares each of the next seven years, the company had to obtain a minimum percentage of EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) that increased from year one to year seven. “By showing that increase in EBITDA, that tells us that the company is making money and its level of free cash flow is increasing enough that the company can afford to pay these guys money that they would then turn around and use to buy Hill out,” Carter said. The takeaway here is that the “triggering event” that would allow the successors to purchase up to a certain percent of the non-voting stock each of the seven years was the company reaching a minimum threshold amount of EBITDA for each of those seven years.

“Additionally, the purchase process was not a given,” Carter stated. “Once the parties signed the agreement, it didn’t mean they automatically bought 49% of the stock.” This only occurs if the company was increasing in value each of the seven years. “So, if there’s a recession in the middle years and the company’s not cash-flowing, then these guys are not buying equity those years,” he said. This would then extend the seven years. Furthermore, the stock is revalued each year, and presumably it will cost more each year because it will be worth more.

This transaction was structured so that if the company had a level of free cash flow through enough EBITDA, the company would bonus the successors, paying them the money needed to buy out Hill’s stock. “But instead of writing a check outright, that money would be held in an escrow account in their names. At the beginning of the following year, the escrow agent would then take that money and pay it directly to Hill for that percentage of stock that’s being allocated to each successor.” Those successors still are responsible for paying income taxes on that money. Carter made clear that this is not a charity opportunity and not a guarantee for the successors, but the upside is nobody is borrowing money from a bank, and the successors are not contractually obligated to make these payments to buy Hill out if the company is not profitable. “So, it’s a win/win,” he concluded.

Looking ahead

At the end of the seven years, Hill’s successors will have acquired all 49% of the non-voting stock. Along the way, when the company is profitable and pays dividends, the successors also get paid dividends. A portion of the dividends, or the performance bonuses, always will be earmarked to make sure there is enough money in escrow each year to buy out Hill’s succeeding interest. At the conclusion of year seven, the parties will reevaluate and follow through on one of two options. If the company continues to grow and the economy does well, all three parties could come together and sell to a large strategic buyer or private equity-funded buyer to completely cash out. The other option is that Hill would revalue the profitability at the end of year seven and revalue the stock’s worth, and then he’d set up a final transaction to sell that 51% equally between his successors. They would then do a leveraged buyout and go to the bank to borrow whatever was needed to buy Hill’s voting share.

“We like that transaction because the successors at that point in time have control of the business, and they are the ones who should be responsible for the debt service in buying Hill out.” Furthermore, it is quite likely the successors also would provide some form of personal guarantee when borrowing that money, which is fair because they now own the business.

Carter said this kind of transition will work for 60 to 70% of the businesses under $20 million that belong to AMBA. The obvious caveat is that the company must continue to grow. It serves as a layer of protection, too, because the successors are vested.