In the world of business, partnerships are common. Many entrepreneurs enter into business ventures with partners who may differ in age, vision, or long-term commitment. Over time, one partner may decide to leave due to retirement, shifting interests, or unforeseen circumstances. This makes business succession planning essential to ensure a smooth transition, protect business continuity, and establish fair and financially sound exit strategies for all involved.
The Challenges of Internal Succession
Unlike external sales, where business owners typically seek the highest possible price from an outside buyer, internal successions often prioritize fairness, financial feasibility, and the ongoing health of the company. Internal successions require striking a delicate balance—ensuring that the departing owner receives fair compensation while preventing the remaining owner from being burdened with an unsustainable buyout structure that jeopardizes the business’s future.
Additionally, tax implications play a crucial role in structuring these transactions. The tax consequences for both the departing and remaining owners must be carefully examined to optimize financial outcomes and avoid unnecessary tax burdens.
Establishing Business Value
Determining the value of a business in an internal succession often follows a different approach than an external sale. While external buyers negotiate aggressively to maximize their deal, internal transitions tend to be more collaborative. Business owners should begin with a professional valuation, considering factors like minority ownership discounts and lack of marketability for shares.
In cases where a partner exits early without much notice, applying discounts might be appropriate. Conversely, if a long-time partner exits with substantial notice, little to no discounts may be applied. Reviewing past transactions of similar businesses can also help establish a fair valuation framework.
Structuring the Deal: Terms and Payment Strategies
Once the valuation is agreed upon, structuring the buyout deal requires thoughtful planning. If real estate is involved, a real estate appraisal should be conducted separately. The remaining owner must ensure the financial feasibility of the buyout, considering factors such as:
- Upfront Payments vs. Seller Financing: While an external sale typically involves a significant upfront payment, internal transitions may allow for extended payment terms, benefiting both parties. The departing owner can benefit from interest on seller-financed agreements, while the remaining owner avoids excessive financial strain.
- Deferred Compensation & Consulting Agreements: These tools can create tax efficiencies for both the seller and the business. For example, allocating portions of the purchase price to consulting agreements allows the business to deduct the expense while providing the seller with income taxed at a lower rate.
- Bankability of the Transaction: Ensuring the transaction is financially viable and potentially bank-financed can ease the process and ensure stability.
The Tax Considerations of Internal Succession
Tax implications must be carefully analyzed to avoid unintended financial consequences. In external sales, buyers often prefer asset purchases to maximize depreciation deductions while minimizing liabilities. However, asset sales can create significant tax burdens for sellers due to depreciation recapture and higher tax rates on ordinary income.
In an internal succession, structuring the deal to balance tax advantages for both parties is critical. The first seller may benefit from capital gains treatment, while the second seller may face challenges when eventually selling to an external buyer. A mixed structure—incorporating both stock sales and consulting agreements—can help distribute tax liabilities more equitably across multiple transactions.
Additionally, separating business and real estate transactions can provide financial flexibility. A structured lease with a right of first refusal can allow the remaining owner to purchase the real estate at a later date, easing cash flow pressures while providing rental income to the departing owner.
The Role of Professional Advisors in Succession Planning
Navigating internal succession requires collaboration with experienced professionals. A comprehensive advisory team should include:
- Attorneys: To draft legal agreements, ensuring compliance and protecting all parties.
- CPAs: To analyze tax consequences and prevent unexpected liabilities, such as phantom taxes—where buyers may owe tax on business income without receiving corresponding cash flow. We recommend that our clients rely on a CPA with demonstrated experience in internal succession situations.
- A Trusted Financial Advisor: To structure the deal creatively, ensuring financial feasibility for both parties while optimizing tax benefits.
By involving a trusted financial advisor early in the process, business owners can uncover strategic opportunities that reduce legal fees, mitigate tax burdens, and create sustainable succession plans. The advisor can also play point and help ensure all parties understand the financial implications of each step of the internal succession process. At MPPL Financial, we work with many business owners and have guided a number of them through internal successions.
Conclusion
Internal business succession is a complex but critical process that requires careful planning and collaboration. By prioritizing fairness, tax efficiency, and financial sustainability, business owners can successfully transition ownership while preserving the company’s long-term viability. With the right valuation, structured deal terms, and expert guidance, an internal succession can be a win-win for all parties involved.
If you’re contemplating an internal succession, we encourage you to reach out to us at MPPL Financial for a complimentary consultation of how to get started in the process and assemble the right team of experts to sell your business.