Anatomy of an Internal Transition
Typical Timeline of a Solid Internal Transition Strategy
A few weeks ago, I did a podcast and blog post on the steps to successfully sell a business. After several requests from our listeners who don’t want to sell their businesses but rather transition them to insiders, I want to focus on the steps for internal transitions. Like selling a business, transitioning to insiders typically takes some time - more time than most business owners realize. While internal transitions cut out many of the steps needed to transition the business to a 3rd party buyer, there are still things that need to be done to successfully transition the business.
There are 7 major steps to a successful internal buyer exit strategy:
Define the Exit Strategy/Date (Valuation)
Achieving Buy-In from all parties
Prepare the Buyer
Post Acquisition Integration
Let’s run through each of these and discuss the details and timeline.
Define the Exit Strategy (2 to 5 Years Before)
So you’ve decided that you want to sell the business internally to family, managers, or employees. Planning for an ESOP, Employee Stock Ownership Plan, where the business is sold to the employees, is slightly different than a sale to family or managers. We’ll cover that in a future podcast, so we won’t cover an ESOP today.
Like a business sale to a third party, internal transitions take more time than most business owners think. When owners ask me how long in advance they should start planning for an internal transition, I simply tell them - as soon as possible - at least 2 years before the planned transition - ideally much longer.
Surprisingly, the success rate of internal transitions is not much better than the success rate of external transitions. For external transitions, the success rate is 17%. For internal transitions, the success rate is a whopping 30% - which means that 70% of internal transitions fail to reach the finish line. And, the number one reason for the businesses that achieve success is advanced planning!
The first step is defining the exit, setting the timeline, and determining the valuation. It’s important to note that in most cases (not all, but most), the valuation for an internal transition is slightly less than a sale to a third party. The reason for this is that business owners typically want to reward family or managers for their years of service and loyalty, so they are willing to offer an advantaged purchase price. Therefore, internal transitions are best suited for owners who are more concerned about rewarding the buyers than they are about valuation.
Just like an external sale, unfortunately, most business owners don't know what their business is really worth or how businesses in their industry are valued. So a great starting point would be to get a valuation on the business. I don't recommend getting a certified valuation which is something that can be used in a dispute or in a court of law, rather, I strongly urge all business owners to get a valuation that would tell them what the business would be worth if they transitioned it now. You can get one of these for free right on our website - or you can engage with us for the first step in our 4 Step Process - the Transition Readiness Assessment or TRA. In it, we complete a 360-degree assessment of the business, identify things to work on and provide an opinion of enterprise value.
Once the business owner has a valuation, they should clearly articulate the ideal desired outcome and timeline for the internal transition, which includes the date, type of sale, and the buyer (or buyers).
Achieving Buy-In (at least 2 Years prior)
Now that you’ve defined the ideal desired outcome and know who your prospective buyers are, it’s time to share the plan with them. Of course, you might also include them in the prior step, but I think it’s ideal to get it straight in your own mind first, then share it with the team. Make sure to stay flexible, because they may also have thoughts about how to achieve the desired result.
There is always a risk of getting hurt feelings during this step in the process. The buyers may think you want too much for the business - or they may not want to own the business at all. Remember, not everyone is cut out to be a business owner. Some very good employees may not have a desire to take on the headaches of business ownership! But it’s way better to find out early rather than discover they don’t want it when you’re close to pulling the trigger!
I once talked to a business owner who was in his late 70s and was very excited that he was planning to leave the business to his children - who had been working in the business for many years. It looked like an ideal situation. Unfortunately, the children had no desire to own the business and planned to sell it as soon as the founder was gone. That’s a terrible situation because the value of the business would almost certainly begin to decline as soon as the founder was gone, and ultimately, the exit value for the family would be far less than it could have been if the business were sold while the founder was alive. That’s why it’s so important to talk about these things and gain agreement with the prospective buyers!
Prepare the Buyer (12 to 18 Months Before the Target Date)
OK - so you’ve defined the outcome and have buy-in from all parties. Now it’s time to prepare the buyer for their future role of business owner.
At this point, it would be a great idea to get a third-party assessment to develop a strategy to get the future owner or owners ready. That starts by understanding the skill set needed to assume the owner’s role, comparing that to the current skill set of the future owners, and determining a strategy to fill the gap. There is almost always a gap in skills and therefore careful planning needs to be done in order to fill that gap once the current owner transitions the business to the new owner. This can be accomplished by training or hiring others to fill the void.
Also - the current owner should get busy documenting everything that resides only in his or her head - you know, the things that you’re the only one who knows what to do and how to do it - so the new owner won’t skip a beat. By the way, it’s always a good idea to do that anyway just in case something happens to you… By going through that sometimes painful exercise of documenting everything, you can reduce owner dependency, and increase business value (something very dear to my heart)!
This step takes time. Don’t rush it, but also don’t delay it. Agree to the strategy at the beginning, and then work through it on a regular basis (at least monthly) so the future owner will be ready when the time comes. Too many times, business owners delay this step, preferring to kick the can down the street until it’s either too late or the future owner gets tired of waiting and moves on. Don’t let that happen to you! Make a plan and stick to it!
Secure Funding (As early as possible!)
Now comes the tricky part - securing financing. So, at the outset, realize that in most cases, the new owner will not be as “financially healed” as the current owner - meaning that they probably won’t have enough reserves to buy the company outright and will need financing to do it.
There are three primary paths to doing that. The first, which is the easiest but probably the least desirable path, would be for the current owner to finance the transaction after taking some sort of down payment from the buyer. I call this the least desirable because in some cases, the buyer defaults after some period of time, and the seller winds up either taking the business back or worse, there’s nothing to take back.
The second path would be to secure bank or SBA financing on the deal. If the business has operated for many years, the bank may be willing to take a chance on the buyer because of the long history - but don’t automatically expect that to happen. Remember, the bank relationship is with the seller, and if they don’t know the buyer, although they have been a long-time employee, they may not be willing to take a chance. If that’s the case, SBA financing may be the best option - and I suggest you go back and listen to two of our recent podcasts on securing funding with guests Joshua Kim and Bill King. Two excellent podcasts that can help you position for the funding you’ll need.
By the way, if the bank is willing to finance it, your bank may also require you to guarantee the note, so don’t be surprised if they ask… Push back, if you can.
The third path is securing equity or financing from a third party. Although I’ve used this method in some of my businesses, many times investors prefer to have control in the business which could be a deal killer for the buyer.
When securing the financing - explore all of the appropriate avenues and choose the path that best fits your specific needs.
Due Diligence (3 months before closing)
Yes, even though the buyer is internal or a family member you’ll still need to make time for due diligence. Now, typically in an internal transition, the due diligence is not as rigorous as an external transition - but it’s still important to allow the buyer to inspect everything before closing. By the way, if the financing is provided by the bank or investors, expect them to take a moderate to rigorous due diligence stance depending on the size of the deal. By the way, you’ll still need to have some of the formal documents in place at the beginning of this transition like a letter of intent or a memorandum of understanding, and ultimately you’ll have to agree on a final purchase agreement.
The Closing (Hopefully on Target!)
Now that the final purchase agreement is in place it's time to close the deal. Just like external transitions, this will be an emotional day for the seller. Be ready for it! Make the closing the best day of your business life - and you can do that by really preparing in advance!
Post Acquisition Integration (Short Term or Open-Ended)
Now, this may be the most critical part - especially if you’re financing the transition. Many business owners who sell to internal buyers remain with the business for some period of time, if not long-term. This can give you a smooth transition to retirement, and also ensure that the business will be able to make its financial obligations to service the debt! Regardless - it’s important to remember to let the new owner BE the owner, and be willing to take a back seat. This may be uncomfortable at first, but learn to settle into your new role of being the trusted business advisor, coach, and cheerleader to help the buyer transition to their new role as owner!
So - there you have it - seven steps to a successful internal business transition! Again, if you’re looking for information on the ten steps to a successful external sale, check out this blog post.
If you’re planning to sell the business to family or employees, start today! Call me for a FREE consultation, get started on our 4-step process, or join our MasterYclass today!
The sooner you get started, the smoother the transition will be!
Prepare like your business value depends on it… because it does!
Want to learn more? Check out our podcast:
ABOUT THE AUTHOR
Tom Bronson is the founder and President of Mastery Partners, a company that helps business owners maximize business value, design exit strategy, and transition their business on their terms. Mastery utilizes proven techniques and strategies that dramatically improve business value that was developed during Tom’s career 100 business transactions as either a business buyer or seller. As a business owner himself, he has been in your situation a hundred times, and he knows what it takes to craft the right strategy. Bronson is passionate about helping business owners and has the experience to do it. Want to chat more or think Tom can help you? Reach out at firstname.lastname@example.org or check out his book, Maximize Business Value, Begin with The Exit in Mind (2020).
Mastery Partners, where our mission is to equip business owners to Maximize Business Value so they can transition their business on their terms. Our mission was born from the lessons we’ve learned from over 100 business transactions, which fuels our desire to share our experiences and wisdom so you can succeed.