Every exit path requires a solid planning and implementation foundation. At the cornerstone of a functional Exit Plan, your job as the business advisor is to help select the best-suited successor to the business owner so that the business can live on after the owner exits. 

In a Forbes article that discusses choosing a business successor, it’s noted that “The intent of succession planning is to “future-proof” the business - by developing a strategic guide that builds upon the leader’s vision with a focus on a sustainable scale and continual growth for the future.” 

However, it’s hard to guide an Exit Plan in one direction or another without taking the time to pick a target successor. Compared to the lists of possible departure dates or the variety of lifestyle needs at retirement, the list of possible successors may actually be quite short: 

• A child, children or other family member 
• A co-owner(s) 
• A key employee (or key employee group) 
• An unrelated third party 
• An ESOP (Employee Stock Ownership Plan)

For the purposes of this blog post, we are going to focus on the top three successor options - all Insider Transfers - to discuss the considerations needed to be made when choosing successors. 

How a Successor Honors Values-Based Goals 

For owners set on an insider transition, this path is usually considered due to convenience and trust. A transfer to insiders, especially family transfers, are typically a surefire way for a business to carry on a legacy if that is something that the owner is looking to do. 

The appeal of an insider transfer is frequently due to the aspiration to reach any of the following goals at the time of their business exit: 

• Keeping the business in the community 
• Maintaining existing company culture
• Ensuring the owner’s legacy and/or family tradition remains 
• Owner maintaining a desirable amount of control and flexibility while transitioning 
• Encourages employees to stay with and grow with the company 
• Business continuity may be easier to preserve

An Advisor’s Role in Choosing a Successor 

As an advisor, it is your job to explain to your clients how each insider transfer option can help reach their ownership objectives. Further, helping them identify the appropriate choice is crucial in ensuring they are able to set aside sentiment and emotions to make the smart choice and avoid common mistakes. 

Three tips for business advisors: 

1. Refer back to the financial needs analysis and the company’s preliminary valuation that will provide logical and rational facts for an emotionally charged decision.
2. Relate each successor choice to your owner’s values-based goals (like the ones listed above) to evaluate if the chosen successor will ultimately help reach those objectives and how.  
3. Remind business owners that taking the time to make certain you have made the right choice is better than proceeding down the path with the wrong successor and having to eventually change paths or delay an exit.

Questions for Advisors to Ask Business Owners 

It is one thing for a business owner to select a successor who they’d like to take over their business. However, a successful business transfer is very dependent on the willingness of the successor to put forth time, money, and energy to the transition plan, and the overall business. 

As the advisor to business owners, you must ask questions of your owner clients that will get them to think about the feasibility and reality of the successor they have in mind. Such questions might include: 

1. Is the successor capable of being an owner? 

Owners should be able to explain to you why their chosen successor(s) can run the business without them. Even the best employees do not necessarily make good owners. 

2. Does the successor desire to be an owner? 

A common mistake that owners often make is to assume their chosen successor wants to become an owner. This misstep is often made in situations where owners want to pass down their business to a child or family member. While it might be easy to assume that one day their child or family member will take over for the sake of keeping the business in the family, ultimately successors must possess the same spark that motivated the owner to start the business in the first place. 

3. Does the successor understand the risk involved in business ownership? 

Many times even if a successor is interested and/or capable, it’s important that they also understand the risk involved in business ownership. For example, many employees might be willing to become owners until they learn that most times they will have to put their own personal funds in (depending on the structure of the buy-in) to pay for initial ownership interest and fund ongoing business operations. 

Final Takeaway - Tips for Successor Search

When it comes to selecting a successor that is not a strategic outside buyer, there can be more personal attachments and history to consider. In addition to the tips and questions mentioned above, keep in mind some of the following thoughts during these discussions with your clients: 

1. Keep an open mind. The future of any company relies on new ideas and opportunities, so being headstrong or inflexible will not make for a healthy transition. 
2. Avoid micromanagement. Regardless of successor selection, it is important to allow for the next leader to find their own way. Giving them responsibility and time and space to learn from before the owner’s exit will increase a successor’s readiness. 
3. Prepare and be inclusive. The transition should be an open and inviting process for the entire team. Regardless of the assigned successor, having open communication, both internally and externally, allows for the opportunity for feedback and a productive transition period.

BEI believes that some of the best insights and advice come from peers who are actively using Exit Planning strategies in their daily work. For this reason, we welcome content from our members, niche guests, and our strategic partners, as additional ways to provide high-quality advice and resources for you and your planning practice. 

This week, one of our newest partners, CSG Partners, gives a high-level overview of multiple M&A transaction types and the pros and cons of each. Reviewing these M&A options, as well as how they relate to a business owner’s goals will prepare you for conversations with your owner clients.   

 

Choosing the Right M&A Option for your Clients

By David Blauzvern, CSG Partners 

The difference between a positive liquidity event and seller’s remorse often comes down to strategic alignment. Deal terms and pricing are important, but the right structure often matters more. The "right" transaction generally reflects a business owner's distinct goals and needs.

 

Common M&A Options

To illustrate, let's explore three transaction types: strategic sales, private equity deals, and leveraged ESOPs. Each carries its own unique attributes, pros, and cons. While "perfect fit" is an elusive M&A concept, certain options may offer greater situational utility. With that in mind, we'll also look at each strategy through the lens of common shareholder priorities.

Strategic Sale

When business owners envision an M&A exit, this option is usually top of mind. Generally speaking, a larger player or deep-pocketed upstart will purchase a seller's company to gain assets, intellectual property, customers, and/or sales territory.

Pros

• Widely understood process
• Transaction valuations may exceed fair market value
• Strategic buyers often have a greater appreciation of market dynamics and nuances
• That familiarity may facilitate a smoother, post-transaction integration process

Cons

• Confidential company information is shared with potential competitors throughout process
• Sale proceeds are fully taxable
• Employees, including tenured staff and top talent, may not be retained 
• Departing staff are often left with hard feelings and little to show for their efforts

Private Equity

Most private equity (PE) deals are leveraged buyouts. To complete an acquisition, a financial buyer will lever-up a company’s balance sheet with private debt. Once in charge, the acquirer may seek to professionalize operations and drive future efficiencies. 

Pros

• Selling shareholders will often receive a substantial portion of the purchase price upfront
• PE firms generally have the means and expertise to grow and/or scale a business
• Sellers may also financially benefit from future add-on acquisitions and M&A activities 

Cons

• Sale proceeds are fully taxable
• Sellers usually reinvest a portion of their proceeds in the post-transaction structure
• PE firms often have final say in future operational, strategic, and M&A decisions
• Risk of putting excessive leverage on the company

Leveraged ESOP

Similar to a management buyout, a company finances the purchase of an owner’s stock. But in this instance, the buyer is an employee trust, rather than a management team.

Pros

• Sellers can eliminate capital gains taxes on sale proceeds and maintain potential upside
• Company receives tax deductions equivalent to the sale value
• Company can become a tax-free entity as a 100% S Corp ESOP
• Board of directors continues to oversee operations

Cons

• Employee trust cannot pay more than fair market value
• Highly structured deal process
• Regulatory oversight by Department of Labor and IRS
• Outside lenders often provide non-recourse financing, but this may only cover a portion of the transaction (seller notes fund the remainder)
•  

Evaluating M&A Options Vis-a-Vis Owners' Goals

So, let’s consider these transaction types in light of common shareholder priorities. 

Seeking Complete Business Exit

Owners that want to cash out and not look back should give serious consideration to a strategic sale. This option likely represents the cleanest of breaks – free of continuing management duties and most other ongoing entanglements.

Of course, a third-party sale is subject to capital gains taxes, so a premium valuation can take on outsized importance.

Looking to Gradually Step Back

For shareholders seeking to pare back their day-to-day involvement while diversifying their personal portfolio, a private equity or ESOP sale may be the right option. Both can provide a partial liquidity event with potential upside. Ongoing “skin in the game” takes the form of rolled equity in a PE sale and retained stock and/or stock warrants in an employee stock ownership plan transaction.

Businesses seeking an infusion of outside talent could be well-served by a private equity buyer. These firms often specialize in industry-specific transactions and provide operational know-how and human capital to scale their portfolio companies. The common trade-off is a loss of independence. While selling shareholders may play a role in the restructured entity, day-to-day control is generally assumed by the PE firm.

If a company already has the bench strength to facilitate a gradual leadership transition, an ESOP may be an attractive PE alternative. Sellers and their companies can reap the associated tax benefits with only a 30% sale to an employee trust. Even in the event of a majority or 100% ESOP sale, the company’s board of directors will continue to operate the business, and sellers can continue to earn a salary and a maintain meaningful role, without being obligated to stay. 

Solely Focused on Financial Diversification

While certain owners may be fully invested in their business, it could be the right time to take chips off the table. The case for an ESOP is compelling under these circumstances. Selling shareholders can complete a partial, fair market value sale to an employee trust and still maintain a majority stake. 

Under a minority ESOP, operations and leadership remain largely unchanged, while the company benefits from increased cash flow, thanks to the ESOP’s tax incentives. Employee-owned companies, on average, are also more stable and productive than their non-ESOP equivalents. The stock incentive can help foster increased employee engagement and provide a unique incentive for attracting and retaining top talent.

An employee-owned company also has significant flexibility to accommodate evolving stakeholder goals and future growth. Partial ESOP sales can be followed by a range of transactions including secondary sales, M&A or PE deals, and ESOP plan terminations. As a result, owners have the latitude to actively shape their business legacies even after a minority employee stock ownership plan sale.

 

In Conclusion

The sale of a company is one of the most significant transactions a business owner will face, and it can have a huge impact on their future and the legacy they leave behind. An educated seller will almost always end up with the best possible outcome among available options. Taking the time to explore the full impact of transaction alternatives, on all stakeholders, puts business owners in a position to avoid surprises while choosing the best path forward.