If you are an owner considering exiting your business and have the luxury of being able to choose between an external and internal transition, the following information will provide a valuable comparison. External and internal exit options can have very different financial transfer values and considerations, and can also have very different non-financial characteristics. Let’s look at some striking differences and what you will need to consider prior to making a choice on which exit strategy is best for you and your situation.
What You Need To Know About Selling Your Business to a Third Party or the External Transition
- Financial Structure – The sale of a business to a third party (external sale) is usually funded with third-party financing and buyer’s equity. In some cases, the seller may be required to or may choose to participate as the lender in the form of seller financing, thereby receiving payments over time as an installment sale. However, in most cases, the catalyst for an external sale is the seller’s desire to receive a majority of the net sale proceeds immediately upon the transfer, creating a liquidity event.
- Value Used for Transition – The business value used for an external sale will be “market value” or what the market dictates in an arm’s length transaction. This can vary from the higher value paid by a synergistic buyer to the lower investment or financial value paid by a private equity group or financial buyer seeking a return on their investment. This value is driven by the buyer’s perception of risk and reward in the business acquisition.
- Percentage of the Business Typically Sold – The normal scenario in an external sale is for the owner to sell 100% of the company. The exception to this would be the sale to a private equity group, which may require or allow the seller to retain ownership in the 20% to 30% range and remain involved for a specified time. This is known as a recapitalization. This can be beneficial to sellers since they may be able to get a “second bite of the apple” if the business is sold again in the future. Hopefully at that later date, the value of the company will have increased.
- Owner Perks – With the exception of the Private Equity Group Recapitalization, where the owner may remain involved, most external business sale options do not provide for the continuation of perks and benefits to the owner past the sale date.
- Owner Income Stream – With the exception of the Private Equity Group Recapitalization, the continuation of an owner’s income stream is usually in the form of consulting income for a short time (12‒24 months), payments from an installment sale, and/ or an earn-out where the owner will be paid based on the achievement of performance goals.
- Typical Tax Treatment – The external sale generally creates the largest tax burden since the owner is typically receiving the majority of the proceeds all at once. The tax burden can be in the form of ordinary income, capital gains, or both. In a sale of the assets owned by a C corporation, double taxation occurs, once at the corporate level and again at the personal level from the corporation distributes the net proceeds to the seller. These taxes can seriously erode the net proceeds received by the exiting owner and planning should be done in advance to minimize them.
- Fees – Other costs that can have a large impact on net proceeds are transaction fees and legal, accounting, due diligence, and brokerage fees, which can be substantial. While an external sale to a synergistic buyer may provide the highest gross selling price, it may also carry the highest fees.
- Preservation of Legacy – The preservation of legacy and the continued employment of the current employees cannot be controlled in the case of an external sale. Even the location of the business cannot be certain since the new owner may be looking at combining locations with an existing operation.
- Operational Control – The current owners’ operational control will normally cease on the day of transfer. Even in the case of a Private Equity Group Recapitalization, the selling owner may not maintain operational control over the day-to-day business activities post transaction. They may continue with a board position and employment, but the buyer will have the ultimate operational and legal control.
- Level of Seller Involvement – Seller involvement is usually limited and may be on a consulting basis only for 1‒3 years on average.
- Due Diligence – This is a very arduous process during which the buyer examines every aspect of the seller’s business. It requires a great deal of time, effort, and preparation. It can also be very costly in time and money. The due diligence period, depending on the business and complexity can require from 45 days to several months.
- Degree of Difficulty of Transition – The external sale is the most difficult to achieve since it involves parties that have their own interests and have not developed mutual trust. These transactions require the assistance of legal counsel, CPAs, and other advisors for both buyer and seller so that everyone’s interests are protected and can be adequately considered and protected. Many transactions are never consummated.
- Disruption to the Company – The external sale generally causes the most disruption to the company. There can be due diligence teams on site prior to a transfer, and post transfer there can be new management, procedures, and processes. The culture of the company is one of the things at greatest risk in an external sale.
- Impact on Employee Morale – The impact on morale can also be greatly impacted since a pending sale can lead to uncertainty about continued employment. Employees can become fearful for their future and may even seek new employment prior to a transfer if they feel their jobs may be in jeopardy. Top-level management, unless included in the process, can be most concerned in these types of transfers. The company is at the greatest risk of losing key people during these transactions.
What You Need To Know about Selling Your Business to an Insider or the Internal Transition
- Financial Structure – The internal sale of a business usually will be structured as seller financing, the redemption of the owner’s shares over time, or in the case of a leveraged buy-out, third-party financing. Generally, in an internal sale, the seller does not receive a large amount of cash up front.
- Value Used for Transfer – Some internal transitions and are governed by strict IRS guidelines, such as Employee Stock Ownership Plans and gifting. The value normally associated with these types of transfers is known as the “fair market value.” This value tends to be substantially less than market value derived from an external sale. Other internal transfers such as management buyouts may be transacted at a negotiated market value that could be higher or lower than what might be received in an external sale but should be transacted at a minimum of fair market value to avoid tax issues.
- Percentage of Business Typically Sold – Internal transfer options generally allow for a more flexible transfer structure than their external counterparts, offering sellers the ability to sell a small percentage of their ownership up to and including 100%, all at once or over time.
- Owner Perks - Depending on the time and percentage of ownership sold or transferred, the perks to an owner can continue during a sale period and be phased out over time. This provides the most flexibility for an owner to continue his or her existing benefits.
- Owner Income Stream – The internal sale option provides the most flexibility and possible continuity for compensation to the owner that is often prorated based on the owner’s level of involvement over time.
- Typical Tax Treatment – Some internal transfer options, such as the Employee Stock Ownership Plan and the stock redemption plan, can provide significant tax savings. Other forms of internal transfers can result in minimal taxes if structured correctly thereby limiting ordinary income tax and resulting in the more favorable capital gains tax treatment.
- Fees – With the exception of the ESOP, which can incur substantial setup fees due to its complex nature and IRS requirements, most internal transfers do not trigger substantial fees. The majority of the fees incurred will be legal, accounting, and advisory in nature.
- Preservation of Legacy – The preservation of legacy and the continued employment of current employees and management in these types of transitions is typical.
- Operational Control – The business may continue to be under the control of the transitioning owner for a time or it may pass to the insiders at the time of the transaction but the owner may be able to retain legal control until they are fully paid.
- Level of Seller Involvement – Seller involvement can vary and may diminish over time, depending on what is most advantageous for the business and for the exiting business owner.
- Due Diligence – Due diligence is usually quite limited since the incoming buyer is very familiar with the business and most likely has been involved with the company in a senior position for quite some time.
- Degree of Difficulty of Transition – The internal sale is typically easier to consummate than a sale to an external party although it can still take time to negotiate all aspects of the deal. The buyer is known to the seller but they must be strong enough to run the business in order for true succession to occur. Planning for the training, education, and development of incoming leaders takes time and effort. Adequately assessing the skills, abilities, talents, and desires of the incoming team, are critical to the continued success of the company.
- Disruption to the Company – The internal sale is generally less disruptive to the company as long as the successors are respected by the employees and communication about the transition is clear. The culture of the company is generally maintained.
- Impact on Employee Morale – If planned well, the internal sale can have a positive impact on employee morale. Employees who might have been fearful for their future when employed by an aging owner can now be reassured of business continuity. If the successors are strong and resourceful, their new leadership can reenergize a company.
As you can see, by examining these business sale options even at this high level, there’s a lot to consider when making an informed decision about how to sell your business. There are numerous variables that need to be identified, assessed, addressed, and integrated to achieve the best possible outcome. Each transition is unique, as unique as every business and every owner. The time and effort required to prepare adequately for a sale, whether internal or external, should not be underestimated.
You will typically need 3-5 years to adequately develop and implement your exit strategy and achieve a successful sale. It will most likely be the single largest financial event of your lifetime, and you must be prepared. Don’t procrastinate. Seek the assistance of highly trained exit planning experts to protect your financial future and fully understand your best transition option.