Never Too Early to Begin Transition Planning--Part 3

The final parts of the process are internal and external exit strategies
By Tom Doyal and Andrew Duncan, P&M Corporate Finance
August 15, 2007

This article is the third in a three-part series about business transition planning and options.

You’ve heard the old saying, “An ounce of prevention is worth a pound of cure.” Well, it’s true, which is why it’s important to stress the planning component of business transition.

Who will ultimately run the business? Does a family member currently involved in the business have the requisite leadership or management skills to run the company? Have you, as the owner, really listened to their interests and communicated your desires? Have you been fair to all parties involved? Do you want to have a role in the company in the future? How important is preserving the company culture? Have you planned for a seamless transition for customers, staff and vendors? What kind of legacy do you want to leave behind?

Those are heady questions, and their importance cannot be overstated. Only once you’ve given these questions thorough consideration are you ready to move on to the next parts of the process—evaluating exit alternatives and beginning the sale process.

There are five internal transition strategies and three external processes. Let’s begin with the internal strategies:

Gift to a Family Member. In this strategy, stock ownership is gifted to family member(s) over a long-term transition period. The major benefit is obvious: continuity and transfer of wealth within the family, perpetuating long-term financial support.

It’s important to realize that this is not a liquidity event, and proper tax planning is crucial—you don’t want to trigger cash outlays.

Equally important is developing a clear understanding between each generation regarding the near- and long-term employment status of the current owner. How will decisions be made? By whom? How will customers and employees be managed? At what point will the new generation assume control?

Sale to a Family Member. As the name indicates, this strategy involves selling stock ownership to family member(s) over a mutually agreed-upon transition period. Like gifting, the company can be sold in its entirety or in smaller segments.

Also like gifting, the major benefits are the opportunity for long-term legacy, a seamless transition for customers and employees, and costs to execute the deal are typically less. What becomes complicated, however, is negotiating the value. This can be the most difficult part of the transaction and has the opportunity to cause friction, particularly if non-active family members are selling to active family members. Generally, if a 100 percent sale is contemplated, the current owner is not concerned with maximizing value and may be more concerned with legacy and transition issues. It can be difficult in these instances for the owner to step away. An intermediary may be helpful here to sort through these issues.

Sale to Employees. An employee stock ownership plan borrows money from a bank to buy the seller’s shares at fair market value. The company makes annual retirement contributions to the ESOP to repay debt. As the ESOP repays the debt, shares of the company are allocated to plan participants.

There is a variety of advantages to selecting an ESOP. It can be a powerful motivational tool for employees, ownership and control can transfer on the principal shareholder’s schedule, the owner may be able to defer capital gains tax, and it allows the owner to diversify wealth and reduce overall risk.

However, the same issues of valuation tend to emerge. In addition, ESOPs have higher administration costs, must maintain large capital reserves to liquidate a participant who leaves the company, and third-party appraisals must be conducted annually to determine the value of the shares.

Sale to Management. In a management buy out, the management team borrows against company assets and cash flow, or joins with equity sponsors to redeem the principal shareholder’s value. This can be attractive when the team has been instrumental to the growth and well-being of the company.

In some instances, a sale to management over time can be more lucrative than an outside sale. For example, a contractor with limited assets may find the company is worth more to mid-level management, who’ve always wanted to own it, than a competitor who will value the company on its assets and current backlog.

Other advantages include avoiding imposition of an arbitrary future sale date in favor of a “planned transition period,” which lays out in advance the understanding around who controls what at what time. In addition, the original owner can maintain contact with the business through an advisory agreement with new management.

However, with an MBO, the owner is less likely to receive all proceeds in cash. It also highly leverages the company, limits company flexibility to pursue capital-intensive growth opportunities and the company becomes more sensitive to economic cycles.

Leveraged Recapitalization. The final “insider” transaction, a leveraged buy out, involves the use of senior bank debt or other debt vehicles to generate sufficient funds to distribute to the owners. The company borrows the money and then dividends it to the owner. The other owner then reinvests the proceeds of the distribution in alternative investment opportunities that are unrelated to the company, diversifying risk away from the company.

One major advantage to the LBO is that the owner isn’t required to sell any ownership interest in the company; the value of the company stays intact with the current shareholder. The downside is the incremental debt that’s incurred by the company, which will need to be repaid over three to five years.

This completes the five internal strategies, however, three other external strategies may merit consideration. These include equity recapitalization, sale to a financial buyer (leveraged buyout), and sale to a strategic buyer (sale to a competitor or similar company).

Equity Recapitalization. In an equity recapitalization, a private equity fund acquires a majority interest in the company; the owner/management typically retains a minority interest (15-40 percent) and is responsible for day-to-day operations while the board supervises long-term strategy. In addition, the management team usually receives stock options that offer the team the opportunity to participate in the future value of the company.

Private equity groups have been aggressive in the marketplace, and they have much to offer, such as access to growth capital and the ability to optimize synergies between other portfolio companies. In addition, they bring perspective and experience beyond the constraints of the specific industry focus of the management team. These opportunities are most effective with companies who have a solid growth history and a clear vision for future expansion.

The major downside of a recapitalization is the knowledge that the company will be sold again in the future, usually within five to seven years.

Sale to a Financial Buyer. In contrast to an equity recapitalization, a sale to a financial buyer involves an entrepreneur who acquires 100 percent of the business. He then owns and runs it as the former owner did.

This allows the seller to exit the business quickly—usually between 3 and 12 months. In addition, the owner is often allowed to stay active in the company via a long-term consulting agreement. Finally, entrepreneurial buyers may perceive greater opportunity in the sale, driving up the value of the business.

On the other hand, this requires significant buyer prequalification to determine his/her ability to raise sufficient capital to close the transaction. The risk of a seller note default may result in lower recognition of value while a lack of synergies may affect the value the buyer is willing to pay.

Sale to a Strategic Buyer. In this scenario, the buyer is typically a competitor or a company in a similar industry. The strategic sale provides an opportunity to generate synergies, including combining purchasing agreements, sharing of sales and marketing resources, and leveraging complementary distribution channels, that can have positive effects on value. The strategic buyer typically provides management team depth and experience. In addition, this scenario affords sellers the likelihood of significant up-front cash payments.

A sale to a strategic buyer, however, may mean employment for the current management team is uncertain, and company culture is more at risk. In addition, prior battles with a competitor can make discussions regarding value and opportunities difficult. Consulting with an intermediary can alleviate the stress inherent in negotiating with a direct competitor.

When it comes to selecting an exit strategy, there’s no right answer. There is, however, a best answer. By planning ahead, you can assess the pros and cons associated with each option to determine which is the best for you.

Some final thoughts, before we discuss the sale process. Market timing, especially if selling to an outside party, is crucial. The ability of an owner to control the situation and pick the right moment to enter the market can be worth 25 percent to 75 percent or more.

In addition, you can’t go it alone. It’s important to involve the right legal, tax and financial professionals to guide you through the process. The most important advisor may be the investment banker.

The investment banker will be your guide and advocate through the sale process and play a number of roles. Their primary responsibility is to give fair and unbiased financial advice on timing, value and transaction feasibility. They’ll ensure that the right value, structure and new owner have been determined. They’ll manage the process on your behalf, market your company, act as your representative in determining value and negotiate on your behalf with potential purchasers. The banker also has relationships with numerous investors and strategic buyers that can bring valuable insight to the appropriateness of the transaction for both parties, keeping the transaction on track. In situations where the company is transitioned internally, the investment banker can provide a third-party perspective of the value of the company, help the new owners raise the appropriate capital to complete the transaction and ensure the legal documents reflect the spirit of the deal.

Regardless of the exit strategy selected, it’s important to plan on six to 12 months to complete the sale process. The process includes five major activities: preparing materials and completing financial analysis; the initial marketing of the company to selected buyers or investors; selecting a small group of buyers to proceed through on-site presentations and company visits; selecting a final buyer after negotiating the deal; and working through buyer due diligence and closing process.

Throughout this three-part series on business transition plans, we’ve discussed the importance of personal and business planning and how that planning affords owners the ability to assess opportunities for investing in new activities that create value and improve communication between the owner and those around him/her. We’ve also discussed how assessing multiple exit alternatives can aid in making the best decision that meets the needs of owners and their families, customers, and employees.

Selling one’s business can be a daunting prospect; there’s much to consider. However, if there’s one piece of advice, that we’d like to impart, it’s this: never lose sight of the ultimate goal—to align the expected transition results with your personal goals and objectives. As long as you keep that in mind, you’re halfway there.

G. Thomas Doyal is a managing director of P&M Corporate Finance, and has been with the firm since 2001. His responsibilities include managing the firm’s Chicago office, leading the group’s construction and building products industry team, as well as participating as a member of the firm’s board of directors. He is available to answer questions or comments at 312/602-3604 or 

Andrew J. Duncan is vice president at PMCF. He is available at 312/602-3607 or