This article continues our series describing the advantages and disadvantages of the five primary Exit Paths that business owners might choose. In our last article, we showed you the primary benefits of a third-party sale for business owners. Today, we’ll show you why so many business owners initially choose a third-party sale as their preferred Exit Path. As always, our goal is to introduce important issues so that business owners, Exit Planning Advisors, and Advisor Teams can communicate and strategize on the same terms.
Last week, we discussed the fact that 59% of business owners initially intend to pursue a third-party sale as their Exit Path. However, many of those same owners end up choosing a different Path—typically, a sale to key employees or management—more often than not. What makes owners change their minds? Let’s look at some of the challenges inherent to third-party sales to find out.
The challenges we’ll discuss exist in the context of the three fundamental goals of all BEI Exit Plan designs:
- Maximize the amount of money the owner receives.
- Keep the owner in control until he or she receives all monies.
- Minimize the owner’s risk.
Challenges in Sales to Third Parties
Challenge 1: Financial Security
While one of the benefits of a third-party sale is that it typically has the highest ceiling in terms of sale price, there’s a caveat. In a sale to a third party, owners lose control of their companies at closing. If they do not receive the entire purchase price in cash at closing, they significantly increase their risk of receiving the balance in the form of earn-outs or a secured promissory note that they hold for the balance of the purchase price. This means that the price they get is subject to future company performance after the sale.
Challenge 2: The Time Factor
With properly planned third-party sales, there are no disadvantages related to the time factor. However, that’s only if an owner is personally and emotionally prepared for a future without the business. Without a proper plan, business owners can find themselves falling prey to the rolling five-year plan or spend more time than they want in the business.
Challenge 3: The Time Margin
One of the downsides of a third-party sale is that owners need to have their time margins set before they dive in (recall that time margin is the period in which business owners develop interests outside the business while still receiving income from it). If an owner has no time margin now, this path won’t create it until he or she has sold the company. Without an established time margin—which results from proper pre-sale planning—business owners can face seller’s remorse, which can destroy a sale.
Challenge 4: Tax Consequences
Third-party sales can create severe tax consequences for the unprepared owner. For example, many owners start their companies as C corporations and never convert them to S corporations. In these cases, owners of C corporations who sell their ownership shares can be taxed twice on the final sale price (one tax at the corporate level and a second tax at the personal level). The combined tax rate can exceed 50%.
Challenge 5: Values-Based Goals
Regardless of what buyers say, a sale to a third party runs the risk of a radical change in the personality or culture of a business. Buyers don’t buy businesses unless they are convinced that they can make changes to improve them, which can lead to extreme changes in the business’ culture. For owners who place a premium on maintaining culture, third-party sales tend to be risky enterprises.
Challenge 6: Successor
Similar to values-based goals, third-party sales often limit a business owner’s choice of successor. If the best offer comes from a buyer who will change the business in ways that the selling owner cannot live with, the selling owner needs to know how to respond in ways that won’t damage the sale prospect or the business’ value. Proper pre-sale planning helps business owners do this, but too often, owners only realize this after they’ve damaged their sale prospects.
Addressing Challenges in Third-Party Sales
You probably noticed that most of the challenges inherent to a third-party sale result from improper pre-sale planning. That’s why BEI has developed a variety of bespoke designs and tools to minimize or eliminate the challenges in sales to third parties. These designs and tools are part of the pre-sale planning and execution process that focuses on achieving all of an owner’s goals and aspirations.
Remember that the actions required to mitigate the challenges described here may take years. If owners push their third-party sale planning until when they are ready to exit, there is little advisors can do for them to assure that their businesses are ready for their exits. Because most owners would like to exit within five years, advisors must speak with owners about the advantages and disadvantages of this Exit Path immediately.
In our next two articles, we’ll discuss the advantages of business transfers to family members and disadvantages business transfers to family members.