Rainier Group | The Big Decision – Internal vs. External Sale
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The Big Decision – Internal vs. External Sale

The Big Decision – Internal vs. External Sale

When business owners begin to contemplate transitioning out of a business, they usually have many interdependent, and sometimes conflicting, objectives they are attempting to satisfy. The business owner needs to get enough money from the sale to live off, or to meet some lifestyle standard, but beyond that there are a multitude of items to consider. Ultimately, despite the detail, the plan often boils down to two options: sell the company to existing employees, minority shareholders, and managers, or find an outside investor to purchase the company.

Internal Sale

An internal sale is often the more difficult to implement but potentially more satisfying of the two options. The owner has to have a ready, capable, and willing internal market for the shares, and the process of developing this market takes effort and time.
  • Is there proper management in place to run the company competently after the transition? If not, these skills will need to be developed or obtained through hiring.
  • Do your employees have the needed entrepreneurial spirit to run a company?
  • How will customers and suppliers react to the sale, and have the relationships with these entities been properly transferred to employees?
  • Who will get to participate in the purchase, and are there factors (age of the acquirers, resentments between them, disagreements on the direction of the business) that can complicate this decision?
  • Does the business have adequate access to capital without the personal guarantee of the current owner?
  • Are the key employees tied to the company for the long haul? Are there proper restrictions and enticements in place to dissuade and minimize the impact of their departure mid-transition?
In addition to the above, the business owner is taking on significant risk in an internal transition:
  • The purchase is often seller financed, or the transition is subject to significant deferred payments. This means the seller is tied to the financial fortunes of the company long after sale.
  • If not properly prepared, employees can fall into disruptive disagreements or spiteful argument once the “boss” is gone.
  • If access to debt is reduced by the departure of the owner, a minor downturn in the company’s fortunes can easily lead to a default on the purchase.
  • Can the company produce sufficient cash flow to fund the purchase?
All these factors can force the departed owner to return to the business and set things right, confounding his or her long-term objectives and retirement.

External Sale

An external sale seems, at first look, simpler and safer by far. The owner sells the company to a larger player in the industry or to private equity, and walks away with the proceeds. Usually, the proceeds generated by a third-party sale will be higher than in an internal transaction. However, there are many factors to consider:
  • Will employees be retained by the acquirer? The higher sales proceeds generated in an external sale have to come from somewhere, and often it is found in redundancies that can be eliminated in a larger entity. The seller must be prepared for many people he or she has worked with for years to lose their jobs.
  • Will key employees want to stay? For companies where a handful of key producers or managers generate the lion’s share of profits, their retention is paramount. Tying them to the company can be expensive, and usually the purchase will include a substantial holdback or earnout that will reduce the sales proceeds if they depart.
  • The structure of the deal can impact net proceeds significantly. Is the purchase a stock sale or an asset sale? If an asset sale, what assets and liabilities will be retained by the seller? How does all this affect taxes?
  • Because of the various forms the sale can take, and the details involved, the purchase agreement is often byzantine and requires that you have good professional legal and negotiation expertise on your side to ensure that the deal is an advantageous one.
  • In industries where relationships are very important, the seller must often continue working on a contract or consulting basis for a number of years after the sale to ensure business is retained. This may conflict with the seller’s goals.

Other Factors

Beyond the financial and management factors discussed above, the seller must be emotionally ready to give up control. The business he or she spent years building to its current form is being taken over, and if it’s by a third party, probably losing its identity as a separate entity.
In either case the business owner must be ok with putting his or her baby into others’ hands and walking away. With an external sale, little will be left of his or her legacy but the sales proceeds. With an internal sale, the owner will have the satisfaction of watching his or her handpicked team build upon the foundation developed during a lifetime of work.

Conclusion

Each approach, internal vs. external, can make sense depending on the type of business involved, the financial needs of the seller, the company’s management strength and dependence on the business owner, the commitment of the owner to developing a strong internal team, and the emotional readiness of the owner to release control and possibly see the company change beyond recognition.