If you are an owner considering a transition away from 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 transition options can have very different financial transfer values and considerations, which may not be surprising, but can also have very different non-financial characteristics as well. The following outlines some striking differences to consider prior to making a choice.
The External Transition
- Financial Structure – The sale of a business to a third party or an external sale usually requires a substantial portion of the sale price be funded with third-party financing and buyer’s equity. In some cases, the seller may be required to or chooses to participate as the lender in the form of seller financing, receiving payments over time as an installment sale. However, in most cases, the catalyst for an external sale is the seller wanting 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 would dictate the price to be created by 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 other 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 the seller to retain ownership in the 20% range and remain involved for a specified time. This is known as a recapitalization. This can offer a benefit to sellers since they may be able to reap the rewards of a “second bite of the apple,” as it is referred to in the industry, when they sell their retained ownership 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 transfer 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.
- Typical Tax Treatment – The external sale generally creates the largest tax burden since the owner is 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 corporate distribution. These taxes can seriously erode the net proceeds received by the exiting owner and should be carefully calculated and planned for.
- 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 should 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 will generally not maintain operational control over the day-to-day business activities post transaction. They may continue with a board position and employment but not from a majority perspective.
- Level of Seller Involvement – Seller involvement is usually limited and may be on a consulting basis only, generally 1‒3 years on average.
- Due Diligence – This is a very arduous process and 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 construct since you have 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.
- 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.
The Internal Transition
- Financial Structure – The internal sale of a business usually will be funded through 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 – Since many internal transitions and are governed by strict IRS guidelines, such as Employee Stock Ownership Plans, management buyouts, or gifting techniques, the value normally associated with these types of transfers is known as the “fair value.” The fair value tends to be substantially less than market value derived from an external sale.
- 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 to an owner for the continuation of his or her existing benefits.
- Owner Income Stream – The internal sale option provides the most flexibility and possible continuity for the income stream to the owner. An owner can choose to remain involved at his or her same or different level of involvement and over a varying time periods.
- Typical Tax Treatment – Some internal transfer options, such as the Employee Stock Ownership Plan and the stock redemption plan, can provide dramatic tax savings. Other forms of internal transfers can minimize taxes if structured correctly limiting the ordinary income tax and resulting in the more favorable capital gains tax treatment. Also, since the value of the transfer internally is usually less than a third-party sale, the tax burden is generally lessened.
- Fees – With the exception of the ESOP, which can have substantial fees due to its complex nature and IRS requirements, most internal transfer options do not have substantial fees associated with the transfers. The majority of the fees incurred will be legal, accounting, and consulting in nature. Rarely will brokerage or sell side fees be incurred in these types of transfers since the buyer is already identified.
- Preservation of Legacy – The preservation of legacy and the continued employment of current employees can be under a seller’s control in an internal sale. There is also usually continuity of management in these types of transitions.
- Operational Control – Operational control of the business will normally continue and is under the control of the transitioning owner. In the case of an Employee Stock Ownership Plan or a stock redemption plan, the owner can maintain complete operational control of the business for as long as desired if structured correctly.
- Level of Seller Involvement – Seller involvement can vary and is at the discretion of the owner and can be diminished over time as is most advantageous for the business and for the exiting owner.
- Due Diligence – Due diligence is usually 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 the easiest to achieve. There is a built-in buyer created in the case of an employee stock ownership plan, but a strong management team must be in place for succession to occur. Planning for the training, education, and development of incoming leaders takes time, planning and effort. Adequately assessing the skills, abilities, and talents, including understanding the desires of the incoming team, are critical to the continued success of the company.
- Disruption to the Company – The internal sale generally creates the least disruption to the company, typically appearing as a rather seamless occurrence to employees. The culture of the company is generally maintained.
- Impact on Employee Morale – The internal sale can produce a significant positive impact on employee morale. Employees who might have been fearful for their future when employed by a company owned by an aging owner can now be reassured of business continuity. Top-level management is generally involved in an internal sale, and their new leadership role can reenergize a company.
Reviewing these differences at even this high level illustrate there is a lot to consider in making an informed decision regarding the best ownership transition option. Transitioning is a very complex topic. It includes many variables that need to be identified, assessed, addressed, coordinated, and integrated into a holistic process to achieve the best possible transition outcome. Each transition is unique, as unique as every business and every owner. The time and effort required to prepare adequately for a transition, whether internal or external, should not be underestimated.
Typically 3‒5 years are needed to adequately plan and implement a successful transition, yet most owners mistakenly believe planning is not even necessary. When considering that an owner’s business transition will most likely create the single largest financial event in his or her lifetime, being correctly prepared is mandatory. Don’t procrastinate. Seek the assistance of highly trained transition planning experts to protect your financial future and fully understand your best transition option.
Want to maximize business value while minimizing costs? A dedicated business ownership transition planning process is essential. Read our free guide for more.