In our previous Value Maturity blogs, we followed the journey of ABC Company, a hypothetical family-owned plumbing equipment supply business. Having determined that he is ready to transition ownership and move into the next phase of his life, the owner has taken several subsequent actions:
- In our blog on Identify Value, he first identified the true value of his business, then measured that against his post-ownership income needs, quantified a potential gap, and worked with his team on strategies to narrow or eliminate the gap.
- In our blog on Protect Value, he proactively addressed existing issues of risk as best he could, and worked to identify and understand potential risks in the near and long term.
- In our blog on Build Value, he and his team acted on the strategies they devised to build business value – particularly intangible value – in order to increase the company’s multiple and enhance its attractiveness as a purchase target.
It’s likely you’ll face some of these same questions as you undertake your process of value maturity. If and when you transition through these first three phases of value maturity, then you’ll arrive – as our hypothetical ABC Company owner has – at the fourth stage: Harvest Value.
In our Owners’ Roundtable series, we often tell participants that exit readiness is not the decision to sell. It’s a state of fact, not of mind. Determining your exit readiness, therefore, comes down to two considerations:
- Are you as the owner ready?
- Is your business ready?
Assuming your answers to these questions based on the Exit Planning Readiness Assessment (see our Identify Value blog) is ‘yes,’ you then need to consider specific options by which you can transition your business. Transition options are categorized as either internal or external. A brief explanation of each option type follows.
Family, or intergenerational transfer (if applicable). As the name suggests, a family or intergenerational transition occurs when ownership is transferred to a family member or members. Often, direct heirs – usually children – are the transition beneficiaries.
- A transition to a family member or members keeps the business you’ve worked so hard to build in your family’s hands.
- Oftentimes, it’s a lower-cost transaction, meaning there are lower legal and professional expenses.
- Less disruption.
- Family dynamics may be a known variable to some degree, but they’re nonetheless unpredictable. How family members react before, during and after a transition could strengthen familial bonds—or break them entirely.
- Lower sales price.
- Tradition may outstrip good strategy.
Interestingly, research has found that 50 percent of business owners want to exercise this intergenerational option—yet in reality, only about 30 percent actually do. If a family transfer is your ultimate goal, then that is not an excuse to bypass the first three stages of value maturity. If nothing else, would you be comfortable passing on your current business risks to your family members? We think the likely answer is “No.”
Management buyout (MBO)
- MBOs are inherently designed to preserve human capital, at least in the short term.
- They can also be used in conjunction with a private equity purchase of a percentage of the company.
- A highly motivated buyer can access additional capital.
- Generally, management tends to be relatively illiquid and doesn’t have the requisite funds to purchase the company.
- The transaction could likely be a major distraction to the business, since management’s attention is drawn toward purchasing the business rather than operating it.
- Managers are not always good entrepreneurs.
Sale to existing partners (if applicable). With this option, success is closely linked to the existence and quality of a buy-sell agreement. A well-written agreement will include appropriate valuation language and terms of payment.
- Transactions are generally less disruptive.
- They’re planned.
- Buyers are well informed (or should be).
- The owners incur lower costs.
- They generally yield lower sales prices than a sale to an unrelated buyer.
- They can foster potential discord.
- The buy-sell agreement may restrict selling options.
- Realization of proceeds from the sale are often slower (and less).
Employee Stock Ownership Program (ESOP). In an ESOP, the company uses pre-tax borrowed funds to acquire shares from the owner
- The business stays within the “extended family.”
- Shares are purchased by the ESOP with dollars that are deductible by the company.
- The seller can defer the taxable gain on the sale of the shares if certain circumstances are met.
- ESOP ownership by employees may cause them to “think like owners”—always a good thing.
- ESOPs are expensive to implement and operate.
- The company or the ESOP has to buy the ESOP shares held by a departing employee.
- Some companies may find it difficult to obtain financing for a leveraged ESOP; there are a limited number of ESOP lenders.
- Without using a leveraged ESOP, it is difficult for a large shareholder to make an immediate exit from ownership.
Third-party sale. Under this scenario, an owner sells the business to a strategic buyer, financial buyer or private equity group through a negotiated sale, controlled auction or unsolicited offer.
- Third-party sales usually net the highest prices of any internal or external options
- More cash is included up front.
- The business is refreshed and can grow through new talent, new ideas and new energy.
- Third-party sales tend to be long in duration (e.g., 9-12 months), which can prove to be emotionally draining for owners.
- They can be a distraction to the business and can lead to a loss of focus.
- They raise privacy concerns.
- They carry the highest cost of options.
Recapitalization/Refinance. Under this scenario, the owner finds new ways to fund the company balance sheet. Essentially, this entails bringing in an equity investor or lender to act as a partner in the business. The owner can then sell a minority or majority position.
- It allows a partial exit.
- It reduces owner risk, and diversifies asset concentration.
- It provides capital for growth.
- It allows for a “second bite at the apple.”
- A recapitalization/refinancing is not a clean break; it compels continuing accountability from an owner to his/her partner(s).
- It often results in a loss of control.
- It causes a cultural shift.
Orderly liquidation. While this generally isn’t the first option for most sellers, it works when the asset value exceeds the going concern value, or when the sum of the parts exceeds the whole (i.e., when asset division nets value).
- Liquidations are usually pursued as an efficient means of selling off assets. When that’s the primary objective, it represents an effective option.
- They are generally less expensive than most other transition options.
- Liquidations usually net sellers less money than other options.
- They produce no money for goodwill.
- They can be difficult emotionally for the seller and also can carry stigmas that may or may not be of concern to the seller.
As you can see, an owner considering transition has big decisions to make when the time comes to Harvest Value. For your business, we encourage you to think through your options; consider the pros and cons of each; and weigh each option against your business, financial and personal goals.