How to Sell Your Engineer-to-Order Service Business to an Employee

The professional service firm is the classic engineer-to-order service business. Consultants, legal, accounting and technical consultants are people-heavy. Mikel calls these companies, “smart people who can type.” Selling these companies is often quite difficult and rarely produces a large, single payday. The reason? Lack of repeatable processes.

However, rather than belabor the problems with the engineer-to-order (“ETO”) service business, or convince you that you should change the company into a make-to-order service company, I will instead walk through how I would go about selling an ETO service business.

First off, I believe a business is a gathering of people around an idea. In no other company type is this more apparent than in a ETO business. Usually there is a founder or two that are lords of their land. Their vision, if well articulated is why others have joined. When selling your company, be sure to repeat an articulated vision to prospective buyers from within your team. Remind them why you started. Remind them why this or that niche is promising on a go-forward basis. Repeat this over and over. Worst case scenario, you bolster moral as you work on a deal.

Many sellers assume the employees are the best option because they are the most bought into your ideals. I don’t think this is a bad line of reasoning. Look to them first; maybe they will be the last and final owner.

Most ETO business are very light on tangible assets. They provide the market with rare specialists. It is precisely this specialization that drives clients to select your firm over the alternatives that provide a more templated experience and/or a less specialized talent pool from which to draw upon. Know precisely where your specialization lies. Has it drifted from the vision? What is it today? Be honest. Many ETO firms started with a very narrow niche but expanded their lineup after exhausting their local market. Where are you best? Remind your team of this, and remind them that they can trim areas that you were unwilling to trim, once they become the owner. This will help your employees think as an owner thinks.

Now, with all your employees paired with your core specialization, consider who will stay. Who possess the value? Is it in the minds of the individuals that are selling? Is it in a person that may leave post closing? What of the customers? Are they loyal to a particular teammate? To their particular skill?

How often have your customers experienced staff changes? Have you had low turn over or high turn over on an account by account basis? If the turn over of your employees to a particular account has been low, there have likely been larger profits scraped off the ETO business over time. Your exit price will likely be lower despite a higher profit margin along the journey. If the turn over experience per client has been higher –and client retention has been high– the loyalty may be associated with the brand, and the value as a going-concern may be higher to your staff. If you have had a high turnover in staff generally, its likely your value as a going-concern with an engineer-to-order service model is likely to be very low. It may be risk-wise to make a soft landing and close it in an orderly fashion; wrapping up work with a smaller team and not taking in any new work.

Assuming you are not in this final category, and you want to look deeper at your employees as a prospective pool, be careful looking only at your leadership team. This pool of professionals are most loyal and most bought into the vision. That’s good. However, as a prospective buyer, they may be more risk-averse than others in your organization. Do not limit your scope to just this inner circle. The leaders probably enjoy the status quo more than the newer teammates. In many cases the long held senior leadership has settled into the idea that they are not the owner –and they like it. In other cases, you may find your senior leaders willing to buy you out through a sense of loyalty and desire to sustain the business continuity. This can setup horrific relationship breakdowns late in negotiations. Or, it can put you in a position of selling to a close friend, knowing they may not be able to handle it.

However, there may be fast rising Allstars lower in your ranks. If you are pitching the vision and willing to share your desire for an exit plan, you may attract some young hotshot who has not been with you for very long. This is also the path to get a competitor to buy you. Because this young hotshot probably considers himself or herself a prospective competitor and figures they might skip a step and just buy you out.

Usually there is the matter of capital. In my 20’s I asked to buy out several consulting firms. One particularly memorable seller had his advisor ask me if I was “all hat and no cattle.” I laughed and said, “No. My cattle are on his property” and pointed to the seller. Needless to say I did not get the business purchased.

The reality is, most employees need to be of this level of ambition to successfully buy your company. The reality is you are going to strap them and your company with your debt and you are going to walk away with some cash and retain some risk. Most sellers don’t love this path. And, most employees don’t love it either. Most employees are unequally yoked with the owner. It’s largely why they work “for” the other person. It’s extremely rare that an employee would be wealthier than their boss. The most common instance where this might happen is if the boss is a lot younger than the employee. In that case the net worth relative to the ambition and earning capacity is usually neutralized in the minds of the people. So, it’s unlikely the buyers are coming at you with lots of cash.

If the business is very conservatively capitalized (lots of cash, high current ratio, no debt) then the buyer’s ability to borrow against your company is higher. In some rare instances you might be able to dump your debt on the buyer but that’s more akin to a turn around situation, and employees are foolish to do that, and if you’re thinking of that and reading this blog, I invite you to mosey along.

Some teams go in together and buy out the owner. This is common of many professional service firms, although they do it asynchronously by “making partner.” One new, rising star takes ownership, whilst a retiring partner gets paid. So long as not everyone leaves at once, you can make this work in an ETO service company, too. Start this very early and be very mindful of making partners regularly so the timing is spread out amongst your group of buyers.

If the group goes at you in one swoop, the equity pool is divided amongst the many and everyone is asked to take on some risk and recapitalize the business with a continuity plan. This sometimes takes the shape of a formal employee stock ownership plan. And, other times its simply a buy out of the membership interests in an LLC or stock in a s-corp. The company takes on the debt and the seller walks away with the cash. This usually takes a very strong finance person to coordinate and convince the team that it’s fair and a good idea. Plan on this taking a very long time and requiring experts to get involved. I have a friend who is running an ESOP holdco model that is super fascinating. Chris calls it “ESOP in a box.” He can make your team employee-owners in one foul swoop.

(I’m skipping over selling to a competitor and staying on the sale to an employee.)

Usually there are one or two key employees that have risen up quickly from lower ranks at younger ages that are willing to take on more risk than the balance of the team. They probably joined your firm because they wanted to do the type of work on their own and couldn’t yet justify it. They are probably a lot younger than you imagined. At this point, this one or two person sub-team will likely inquire about ownership in round about ways already. They will need the seller to setup the structure for them because they are going to try and take it from you. This is healthy and normal and good. There is conflict that can arise as the parties have to remain in employee-employer relationship while navigating a possible departure of the rising star when the deal falls apart. They will always leave you if your negotiations culminate with them as the point person and you do not close. It’s simply too awkward for them to stay. They will become a competitor and they will likely take a few of your employees with them. Rare is the case they do not. Anyways, this pathway requires a heavy hand by the seller, an aggressive buyer, and a swift closure by a single point of contact who is willing to take on loads of debt. Don’t accidentally start down this path. It’s a steep hill to climb back out of.

Ideally, the seller can get 25% to 33% cash down, and a large senior debt bank loan on the price, held by the buyer, based on your strong cash flow. The seller will usually carry an interest-only note or an earn-out connected to the retention of clients and/or staff, depending upon the health of the reputation and the skills of the staff. Most times the down payment is <10% and the bank note is <50% of the price and the seller carries a huge note. Then, most businesses go sideways under the young, ambitious leader within the first 18 months and the seller has to repossess a floundering situation. Compare this to a methodically setup ESOP and the probability of a disastrous outcome makes the seller financing pathway troublesome to start.

An alternative means to solve the heavy seller financing is to get the buyers to come up with cash from friends and family. Plan on this to take 6 months or more. Lenders will likely want the largest shareholder to personally guarantee the note, which will still be required. Encourage your employees to take on equity partners and/or very long term, interest only notes to ease cash flow and improve senior debt position. This should help you drive the price up on your employee, and lower the amount of debt you will retain. It also provides your employee(s) with an alternate source of cash when things hit rough patches post closing. Starting those relationships earlier than needed is smarter on your part. It improves your odds all around. However, it will take many months and might not work. Again, it comes back to the leader.

This brings me to my final point when selling an engineer to order service business to employees. The business is likely to be strapped with debt for some time. The debt coverage ratios will limit your upside price point and dramatically increase the probability of problems for the new owners. This reduces the odds that your company will continue long after you are gone. If you push the price and debt too hard, be prepared to see it fail, and for the source of that failure to be shared by your aggression.

My final suggestion (not advice) is to take on a huge earn out schema and participate with the buyer. In this way you bring on a partner who enjoys working with you, but instead of getting out, you join them in the future endeavors. But, I think it’s important that you flip flop roles. Make yourself the junior partner and make them the senior partner. By this manner, you can help without controlling. And, the financial terms of such a plan can become less urgent and more pungent in the marketplace.

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