Business Transition Options – Pros and Cons
Stephen L. Ferraro, CPA/ABV/CFF, CEBC, CVA, MAFF
In the world of private business transfers there are five (5) primary ways that a business can transition. They are listed below and detailed on the following pages:
- Selling the Business to a Competitor
- Selling the Majority of a Business to a Private Equity Group
- Employee Stock Ownership Plan
- Management Buyout [and/or Co-Owner Transfer]
- Gifting [to family members or others]
1. Selling Your Business
The sale of your business is one of the most intuitive and easiest to understand transfer options. In short, someone that you compete with (or someone who has a synergistic business to yours) may desire to purchase your company to either eliminate a competitor and / or expand the reach of their own business in a new direction.
The primary benefit of a sale is that these transactions likely produce the highest overall transfer value. And, getting the highest price for the sale of a business is something that is near and dear to the hearts of many owners. However, many owners who have a low mental readiness fear the thought of losing their jobs (and/or not being able to work with / for someone else). Owners should know the pros and cons of selling the business and consider them carefully. Some are listed below:
Pros of a Sale
- The highest price may be available under synergy value.
- The risk of profitably running the business into the future now belongs to someone else.
- The sale transaction likely produces the most cash at the point of the transfer of ownership.
Cons of a Sale
- A sale of the business takes away the possibility of transferring the business to top managers because you are selling financial and strategic control of the business.
- In all likelihood you will not continue working for the new owner after the sale, therefore you lose your job (and likely sign a non-compete agreement, precluding you from working in the industry).
- You will pay taxes and advisory fees on proceeds received.
- You lose the potential to participate in the future growth and increased value if you sell 100% to someone else.
2. Private Equity Group Recapitalization (PEG)
If a business owner is looking for some liquidity today, financing for the business and partners who have experience achieving these results, a private equity group recapitalization may be just the thing to begin considering in your exit strategy planning. Private equity is simply that: private, not public money that is invested in privately held businesses.
Private equity groups are groups of investors who purchase majority (and some minority) ownership stakes in privately held businesses with a high return expectation for their investments. Because these groups are comfortable with the risks these private businesses offer, they are formidable players in the private marketplace.
A private equity group recapitalizes the owner’s company purchasing a majority stake. The private equity group then becomes an owner of the business, executing, as partners, on the transitioning owner’s growth strategy.
Pros of a Private Equity Group Recapitalization
- Owner liquidates a portion, but not all, of their ownership in the business, holding onto some equity for future gain.
- Owner continues working in the business
- Results-oriented focus imposed by a leveraged capital structure
- Superior monitoring and strategic oversight by active investors
Cons of a Private Equity Group Recapitalization
- Owner loses strategic and financial control of business
- Most entrepreneurs struggle with new partners and sharing decisions after so many years of independence
- Organizational culture likely to change as performance metrics become more carefully managed
- Leverage placed on business alters certain flexibility
- PEGs often invest to ‘re-trade’ the company in five or so years.
3. Employee Stock Ownership Plan (ESOP)
An ESOP is a qualified retirement plan that is allowed to buy your company’s stock. ESOPs have been in existence for over 30 years and despite the many misconceptions about ESOPs, they are very flexible tools for assisting with the design of a transition strategy plan. ESOPs can be the right tool for the right company. However they do have a significant amount of complexity associated with them so the analysis can be rather in-depth to see if the ESOP is a good fit.
Pros of an ESOP
- Owners maintain control of their business and achieve personal diversification while keeping their job, salary and reasonable perks.
- The ESOP creates a buyer for the purchase of shares
- Flexibility to sell any number of shares to the ESOP at the timing of your choosing – can customize personal planning by selling some shares today and some at a later date.
- Opportunity to participate in the future growth of the company
- Potential to defer or avoid capital gains taxation on the sale of shares (under specific conditions).
- Potential to improve performance by instilling a culture of ownership among employees without having to disclose financial or other confidential company information to them.
Cons of an ESOP
- The ESOP is complex to install and administer.
- Typically a management team needs to be in place because the ESOP will not replace the owner to operate the company
- If bank debt is used to finance the ESOP then the leverage can impact the company’s performance.
- The owner may need to personally guarantee bank debt.
- Owner may need to adjust excess comp. and perks.
4. Management Buyout (MBO)
Many owners want to see their management teams participate in future ownership of their business. A management buyout (MBO) can be difficult for a number of reasons. However, if those challenges can be overcome, the MBO can be a very flexible option. The primary issue with MBOs is that, in most cases, employees do not have the money to buy your ownership. Therefore these transactions become highly dependent on the future success of the business and the management teams (sometimes a single person) to continue to profitably run the business into the future.
An owner will want to determine what they are most interested in getting out of their exit and then consider how much time and energy they are willing to commit to succeeding with this exit option. Again, since future payments likely depend on the continued success of the business, you, the exiting owner, cannot completely step away from watching over the business’s continued success. It is for these reasons that we recommend a high financial readiness is first in place before attempting a management buyout.
Pros of an MBO
- A controlled transition that can occur over many years, providing a flexible deal structure, including tax minimization for owners
- An internal transaction does not require an outside party
- Managers know the business, so value can be maintained through continuity of business operations
- There is a natural affinity toward rewarding this group
Cons of an MBO
- Owner cannot completely step away from the business
- Lack of financing from the managers may mean payments will be received over time, not right away as in a sale.
- Potential for a lack of leadership amongst managers
- Current culture of company may not be aligned for teamwork
Some owners want to gift the ownership interests in their business to family and other managers and key employees. The initial questions that transitioning owners need to ask prior to establishing a gifting program are: “To whom do I want to give my wealth?” and “Can I afford to give away this wealth to others?”
A transitioning owner can utilize a gifting program in conjunction with an MBO and/or an ESOP. Owners can gift away to any number of people, related or unrelated, in any given year, including employees. And there is no limit on the number of people to whom these annual gifts can be given. It is possible to gift some stock to the management team as part of the exit strategy plan under an MBO or an ESOP. Or you may want to gift stock to a charity to support a cause and receive a current deduction.
Sometimes the gifting of shares in the company can assist in creating a culture of ownership within a business. However, other times gifting of shares becomes an administrative and legal burden when an employee leaves (particularly if they leave and are unhappy).
Pros of Gifting
- Owners can fulfill their desires to transfer wealth and use their illiquid stock to accomplish this goal.
- Gifting can combine with advanced estate planning to achieve a number of tax-efficiencies in the overall planning.
Cons of Gifting
- Owners are counseled to avoid giving away wealth that they need to meet their basic financial needs.
- Owners are also counseled to be honest about the future leadership of the company and not to necessarily continue to tie ‘ownership’ of the company with its future ‘leadership’.
6. Grow Business, Increase Savings
A final option is to Grow Business and Increase Savings.
In short, our process for designing a transition highlights one key point – the more liquidity that you have saved outside of the business, the more options that you have for a transition because you are less dependent upon the proceeds of the transition to maintain your lifestyle. Therefore, if you have a Low Mental Readiness, you may feel like you can continue running the business profitably for many years. You may want to focus on your personal savings and bolstering your financial independence from the business in preparation for a future exit transaction that will have a lot more flexibility, particularly if you are going to try an internal transfer to management or family.
Pros of an Grow Business, Increase Savings
- You continue forward with running and owning the business, but you have a plan for a stronger future financial position (from a personal perspective).
- You discipline your saving and spending habits to have greater certainty of meeting your post-exit needs.
Cons of the Grow Business, Increase Savings
- There is no liquidity today for your transition
- The company profits and cash flow that is diverted to your personal savings may slow the growth of the business.