Complete Guide to Selling a Business

Complete Guide to Selling a Business By: Dan LoIacono, President of ABMI-Mergers and Acquisitions Introduction As the president of a business brokerage firm I am fortunate to have the opportunity to interact with literally hundreds of business owners each year. The business owner or entrepreneur is a unique and wonderful breed. Simply by the fact that you are taking the time to read this guide means you most likely fall into this elite category of individual. As business owners we learn, often by trial and error, how to operate our businesses in a way that generates a profit. Operating a profitable business takes a good deal of attention and effort. Thinking about selling the business usually does not come into a business owner’s mind during the daily challenge of operating the business. The idea to sell our business too often tends to coincide with our need or desire to exit the business or retire within 12 months. For many business owners, most of their net-worth is tied up in their business and selling the business is a method to access retirement funds. Selling a business is not like selling a house. There are a number of things associated with selling a business that can significantly impact the outcome and value generated from the sale. Understanding the process of selling your business, and planning for the sale will help increase the returns from the sale and minimize legal exposure. As mentioned earlier for most business owners the business represents a significant portion of their net worth and you only sell your business once…there are no second chances. This guide is intended to help create an understanding of the process and introduce some concepts that if applied can save you hundreds of thousands of dollars. Proper planning can help eliminate some of the painful and costly surprises. Here are a few things to consider as an “Exit Planning Roadmap”. Exit Planning Roadmap Step 1 – Preparation Set Your Exit Objectives o When do you want to retire? o What will it take- in cash- to generate the retirement income you need? Prepare financial statements and other business information. o Buyers will want to look at financial statements for at least three years, a list of assets, contracts with vendors, and other documentation related to the business. Consult your advisory board o Assemble a team of advisors to assist you with planning. This team should include a CPA/Accountant, Tax Advisor, Attorney, Estate Planner, and Business Broker. Explore strategies to minimize the tax impact of the gain. o Step 2 - Determine the Value of Your Business Step 3 - Prepare the business to maximize value. Step 4 – Market the business Step 5 – Negotiate terms Step 6 – Close the transaction We will dig a little deeper into these steps, providing more details on each. Step 1-Preparation Is Selling the right thing to do? The process of transferring ownership to your business is emotionally challenging for most business owners. Butterflies in your stomach are normal. There are always a series of ups and downs along the way that add fuel to the emotional roller coaster. Selling a business is not something you do every day and in fact, you may only sell one business in your lifetime. Therefore, having a team of professional advisors is extremely helpful. The ability to bounce your doubts or fears off someone who is experienced will be invaluable to you as you progress down this emotional journey. When you plan to transition out of the business, keep in mind that selling to a thirdparty is not the only option. There are other options such as transferring ownership to family members or employees. An ESOP (Employee Stock Ownership Plan) may be an alternative if you have a competent group of employees. It is possible to transfer some or all of the company stock to the employees of the company and receive compensation in return. Implementing an ESOP can be somewhat complex, but effective. An ESOP is basically a type of pension plan that allows the employees to invest in the company and purchase stock as they invest in their pension fund. As your employees invest in the company ESOP, they are, in essence, investing in your company. As they become vested shareholders, their interest in the success of the company will increase significantly. ESOPs offer some unique tax properties to business owners that can be quite attractive. If this type of business transition sounds appealing consult your CPA and attorney for additional guidance in understanding the impact to you and your business. Keep in mind that some attorneys and CPA’s are not qualified to give counsel on ESOPs. Make sure you consult qualified advisors. Timing is another key factor in the decision to sell. Market conditions fluctuate and the appeal of a business in your specific industry can ebb and flow. It is important for you to stay abreast of trends in your industry and keep your eye on shifts that could impact the marketability of your business. The traditional rule of “buy low sell high” applies to your business too. Different industries have different cycles and may not mirror the national economic cycles. The time to sell is not when the market is in a slump. The time to sell your business is when your industry is in a healthy position in the cycle. You will never know if you are on the peak or not but a good rule of thumb is two to three years of increasing sales in your industry is a solid trend and will increase the market appeal to potential buyers. If your industry is in a declining trend pattern a tough decision may need to be made. Do you sell now or wait it out? Some questions to help you assess this decision include: Are the sales for your business following the industry declining trends? Do you expect the trend to reverse? Are there operational changes that can be made to maintain the profitability? Can you wait out the trend? Do you have the financial, physical, and emotional stamina to drive though the cycle? Are there other macrolevel economic factors that can offset the micro-level cycles experienced in your industry? This is one area that many business owners take lightly and it can create significant negative impact on value. Step 2- What is the value of your business? It may seem surprising that many business owners do not have a clear understanding of how much their business is worth. One of the most important things we can do as business owners is to understand how much our business is worth at any given time and how the value can be affected by operational and financial activities. This is an essential foundation for succession planning, exit planning, and operational or strategic planning. There are a number of methods to establish a range of value for a business. Some of the methods used include the Discounted Cash Flow Method, Market Multiple Method, and Asset Value Approach. Each of these methods or a combination of methods can be appropriate for different applications. The most widely used method for valuing small businesses is the Market Multiple Method and we will cover that method in more detail. Understanding how to interpret cash flow statements for small businesses is an important first step in valuing a business. IRS regulations related to small business expense guidelines allows a good deal of room for interpretation. The application of these regulations can vary significantly between one business owner and the next. As a result, financial statements for small, privately held businesses often reflect some expenses for items not traditionally considered businessrelated. In addition there may be other expenses or non-cash items, such as depreciation, that are not typically transferable to a new owner in an asset sale. In order to review financial data in a consistent manner, the industry has developed a standard process call Stabilization. This concept has been adopted by the appraisal industry, CPA’s, attorneys, and the International Business Brokerage Association (IBBA) as the accepted approach to standardizing financial information. Expenses that typically are adjusted out of the cash flow statement include owner’s salary (and related payroll taxes), owner’s benefits (life insurance, health insurance, pension plan), debt service (interest and principal payments), depreciation (non-cash expense), and charitable contributions. Other expenses may be adjusted based the business owner’s unique accounting methods. The adjusted (stabilized) expense information is applied to the original cash flow for the business to arrive at an adjusted cash flow. This is the actual net cash benefit to the business owner. This adjusted number is referred to as Net Owner Benefit (NOB) and/or Sellers Discretionary Cash Flow (SDC). In a manner very similar to appraising a single family residence, business appraisers continually solicit information on businesses sold across the country. Professionals are encouraged to submit transaction details (without disclosing the actual name of a business) to the database, and in exchange are awarded access to the database for professional reference. Multiples (or ratios) can be derived by comparing selected variables such as annual sales, gross profit and SDC to the Sales Price. Due in part to the volume of transaction information, applied to businesses in similar industries, these multiples can provide a very accurate picture of valuation (as defined by the marketplace). In practice, regardless of the formal approach to valuation, and the calculated value of a specific business, the business is only worth what it can produce in terms of current cash flow and future returns to the buyer. Buyers and lenders look at the ability to earn a realistic salary for operating the business while producing enough cash flow to comfortably cover debt service, and generating a fair return on invested capital (ROIC). Step 3- Preparing the business to maximize value Selling your business should not be a last minute or spontaneous decision. In order to maximize your return on the sale of your business you should spend some effort preparing for the sale. Waiting until the last minute to consider the sale of your business can be setting yourself up for an unpleasant surprise. At ABMI we are honored to have the opportunity to work with a number of business owners who are considering selling their business. Unfortunately, sometimes the sellers have waited until the last minute to think about selling, and want to exit the business quickly. Some comments from surprised business owners this year have been. “I thought my business was worth much more than that.” “I can’t believe I will have to pay that much in taxes.” “I never kept good financial records, does that really matter?” We do what we can to help the business owner work through these issues and improve the outcome. However with more time and planning the outcome could be much better. The truth is that preparation for the sale of your business should begin the day you bought or started the company. Here are some basic strategies that ideally should be implemented at least three years before you begin marketing your business for sale. • Here’s an example: o o o Unreported Income = $10,000 Taxes Saved Over 3 years (28% tax) = $8,400 Lost Value at Sale (based on a conservative multiple of 2) = $20,000 Net Cost/Gain of unreported income strategy = <$11,600> o The old “trust me ‘wink-wink,’ there is much more cash coming in than I am reporting on my taxes” approach does nothing but convince the buyer that you are willing to lie when you think it is in your best interest. You will loose the buyers trust and they will doubt everything you say from that point on. • Make yourself replaceable. Some businesses have been built around the owner. Essentially, if the owner leaves, it will leave a big gap in the company. This dynamic decreases the market appeal of the company and can result in a significant discount to the value. Hire your replacement or structure the operations of the company making your role easily replaceable for the new owner. Document your processes. There are most likely a number of processes that are followed at your company that you may know off the top of your head and take for granted. A new buyer will feel a sense of anxiety over the unknown. They will naturally be concerned with their ability to fill your shoes and learn the processes quickly. They are also most likely hoping that they can implement some improvements that will increase the profitability. Clearly documented processes will ease the anxiety of the unknown, and give the buyer a better sense for areas that can be • Get your business appraised now and update it every couple of years. This will allow you to plan accordingly and avoid unpleasant surprises. Report all income. The fundamentals of the Market Multiple Method make the math pretty simple. The value of your business is in part based on the cash generated. Applying a multiple to the cash flow from your business usually produces a value that will far exceed the money you save in taxes from not reporting income. • improved. Process documentation could literally be worth its weight in gold to you in increased sale price. • Have key personnel sign nocompete agreements. One concern many buyers will have is the risk that the talent in the company will walk out the door after the sale. While this is always a risk, the possibility can be reduced with no-compete agreements in place. While the enforceability of these agreements may be debatable, the fact is that buyers feel much more comfortable when they know key people are legally restricted from leaving and taking customers with them. Diversify your customer base. We all love big customer accounts. They give us stabilized income and help build our credibility as a company. While big customer accounts are valuable, their value can be diluted if a large percentage of the revenues for the company are generated from one account. In the event that customer account is lost, it could seriously impact the profitability and viability of the business. If more than twenty-five percent of your gross revenues come from one customer, attempt to pick up more smaller accounts to bring the revenue generated from any single customer below twenty-five percent. Implement an account contract or PO policy. The assurance of recurring income is an important point of consideration for most buyers. While account or service contracts that tie a customer to a business are not feasible in some business models such a system can have positive impact on the value of a business. Consider developing a system that helps a buyer have confidence of re-occurring income. Assemble a team of qualified advisors. Having the right team of advisors can save you significant money and headaches associated with the sale of your business. As an example, the accountant you have used for 20 years may have been a great friend and reliable resource with regards to doing your books. They may not be the best resource to help you plan to maximize your aftertax proceeds from the sale of your business. Our tax law allows for some very attractive ways to reduce or eliminate taxes from the sale of your business, but pre-planning is essential. Get a qualified tax accountant or attorney on your team. You will be glad you did. Step 4- Marketing Marketing your business is an important step in attracting the right buyer and maximizing the sales price. Buying a business can be one of the biggest decisions an individual will make in a lifetime. In many ways this will be very emotional for the buyer and will often involve a spouse or other family members. Presentation of the information on your business is a critical factor to attract and maintain the emotional attention of qualified buyers. Preparing marketing information Buyers will want to review information on your business thoroughly before proceeding with a decision. Most buyers are not experienced in buying businesses and in most cases will need to be educated on some of the facts about small business ownership financial statements. It is in your best interest to present information to qualified buyers in a comprehensive manner including financial statements (adjusted to reflect the cash flow in terms of SDC). Ensure the financial information provided match your tax returns, but refrain from providing tax returns until the due diligence process. In addition to adjusted financial statements it is helpful to provide buyers with a written overview of your business including description of goods and services, industry overview, customer base (in general terms…do not provide a detailed customer list), organizational chart, equipment list, pictures of facilities and equipment, and growth potential. Remember, this is your chance to highlight all of the reasons someone should buy your business. • • • A marketing package should be prepared in a way that it gives a positive impression on the business. Giving potential buyer a package with information to reference later will help keep the excitement level high. Advertising Advertising your business is an important and sensitive step in selling your business. The advertising should be done in a way that keeps the identity of you and your business confidential while providing enough information about the business to attract interested parties. Consider using a phone line or e-mail address in the advertisement that is dedicated and separate from your business contact information. This will help keep your business anonymous until you have had a chance to qualify the buyer and choose to release more information. The advertising strategy will vary slightly for different businesses. Businesses in certain industries may be more effectively marketed to specific buyer pools including competitors or companies in complimentary industries. Businesses with sales revenue over $2,000,000 will attract a different pool of buyers and direct marketing may be a more effective approach. In general, there are a number of advertising platforms that can attract qualified traffic. A blend of various forms of advertising is usually the best approach. Some potential advertising medium include local newspaper, Internet, trade publications, and direct mail. Put yourself in the place of a potential buyer. If you were interested in buying a business like yours, how would you look for it? Once you have a few ideas, do a little homework and start advertising. Qualifying Buyers Qualifying buyers can be a little awkward at first but could save you a great deal of heartache and frustration down the road. Business ownership is the “American Dream” and there are a number of people out there that are dreaming about being a business owner. Some will realize their dream…but for multiple reasons the majority of people currently dreaming about buying a business will not be able to make their dream come true. Business ownership, as you know is tough and is not for everyone. In addition to personality and talent factors, many people are not financially prepared or capable of buying a business. These truths do not keep people from exploring the concept of business ownership. Often their exploration involves contacting people selling businesses (like you). If you are implementing a comprehensive advertising campaign you could easily receive a hundred inquiries from potential buyers. It is assumed that up to the point that you are now interacting with a potential buyer, you have kept the name of the business confidential. The first step in qualifying a buyer is to ask them a few questions regarding their interest, background, income requirements, and resources. While there is not a magic formula to determine after a few brief questions if someone is qualified to buy your business, it will give you an opportunity to filter out some of the obvious people that are clearly not qualified. Once you have a good sense that they sound qualified, you should get them to sign a confidentiality agreement. This helps protect you and discourages them from telling the market your business is for sale and disclosing confidential information. You should fax the confidentiality agreement or e-mail it to them in a non-changeable digital format (i.e. pdf file format). The agreement should be signed and returned to you before you provide them with any detailed information on your business. Showing the business Once you have a signed confidentiality agreement in hand the next step will be to provide the potential buyer with more detailed information on the business, including the name, type of business, overview of the business (i.e. financial performance), etc. This can often be done over the phone or in person at a neutral location. They will most likely have a number of questions that you should be prepared to answer. After gauging their interest, it may be appropriate to provide them a copy of the marketing package prepared for your business. This will help reinforce some of the things you discussed initially and give them a point of reference to review after the conversation. If a buyer is interested in moving ahead with discussions, it won’t be long before they will want to tour the physical location of the business. If you have a production process that would be helpful to see in action and your employees are used to seeing you walk people through the facility, a tour during business hours may be valuable. Carefully consider how you will introduce the potential buyer if that becomes an issue. If you think your employees may be suspicious or alarmed at the stranger walking through the business, make arrangements to tour the potential buyer after business hours. Whether you are talking to a prospective buyer during the initial meetings or during the on-site tour, it is important to remember to be positive. Highlight the benefits associated with your existing processes and equipment and point out the opportunities for future growth. This is not a time to share war stories about how you made it through a challenging situation. These stories may be very impressive, but they will cause the buyer to wonder how many challenging situations remain unresolved or question their ability to handle those situations as well as you. Remember to keep the information you are sharing as positive as possible without misrepresenting the facts. of an art than a science. There is a delicate balance between being too aggressive and too generous. Keep in mind that price is only one component of the negotiation. Other very important factors worthy of consideration include financing terms, earn-outs, and contingencies. All of these factors can impact the ultimate value of your business. In order to help minimize the challenges in the negotiation process it is a good idea to have the offers and counter-offers communicated in writing. This will avoid misunderstandings that could sabotage the transaction before closing. The offering agreement can take the form of a Letter of Intent (LOI), Offer to Purchase, or Purchase Agreement. The form used to communicate negotiated terms should have standard language regarding the proposed closing date, and any contingencies that are expected to apply. Some typical contingencies may include financing, detailed review of financial information, and the ability to obtain an assignment of your lease with acceptable terms. There should be specific timeframes built into the agreement allowing enough time to fulfill the contingencies but creating a sense of urgency for the buyer to move toward closing in an acceptable timeframe. It is not unusual for the buyer to have some language in the offering document that obligates you to take the business off the market for the period during due diligence. While this condition is fair to the buyer since they will be incurring expenses associated with professional review of the records and applying for financing, this will limit your access to other potential qualified buyers. You should not lock up your business unless you have a strong level of comfort in the buyer’s ability to close. It is reasonable to request an earnest money deposit from the buyer as a sign of confidence. The offering agreement should address the conditions under which the deposit will be refundable or forfeited. Most business brokerage firms have a library of standard forms that have been reviewed and approved by legal counsel. It is advisable for you to use an attorney to create or review any agreement before signing. Step 5- Negotiating the terms Negotiating the terms of a transaction can be one of the most challenging aspects of the selling process and arguably one of the areas that can be most costly if not handled properly. By the time you are talking to a potential buyer about price and terms you have most likely started to develop a relationship. It is always difficult to say no to someone and our natural tendency is to be polite and avoid uncomfortable conflict or disagreements. The fact is that negotiating terms on a decision this big will most likely be emotional and involve some uncomfortable dialog regarding a settlement that is acceptable for all parties. Negotiating is more Due Diligence Due Diligence refers to the period between the offer or LOI and the closing. This is a period in which the buyer will be verifying the information you have previously provided and digging for additional information to confirm or discredit assumptions. The offering agreement should be referenced as a guide to provide the standards for the due diligence process. It is not unusual for buyers to want to review details on customers to verify the source and reliability of the income. Buyers may want to meet with employees. This is a difficult situation for the person selling a business because it can expose the business to unreasonable or unacceptable risks. Once your employees know about a pending sale, you have passed the figurative point of no return giving the buyer an excessive amount of leverage. This situation should be carefully considered on a “case by case” basis. Financing will be one of the biggest challenges the buyer will need to overcome. The market is full of lenders that say they are willing to lend on small business acquisitions, however in practice most lenders have aggressive collateral requirements that put unrealistic requirements on small business borrowers. “Preferred SBA Lenders” are often the best lenders for a buyer to partner with on an acquisition loan. The SBA will guarantee a percentage of the loan (typically seventy percent), reducing the exposure to the local lender in the event of default. Lenders will be driving part of the due diligence process with their review of information for the approval. Providing information requested by the lender in a timely, efficient manner will help the financing process move along smoothly. You will most likely be asked to sign an IRS Form 4506-T giving the IRS authorization to provide certified copies of business related tax returns directly to the lender for validation. If you are operating in a leased facility, you should be prepared to assist the buyer in obtaining a new lease or getting an assignment of your lease. The timing of this process is delicate. Depending on the corporate structure and internal processes followed by your landlord, this process can be time consuming. You should start the communication with your landlord as soon as you are relatively certain that the buyer’s financing will go through and other contingencies are met. Unless you are working with a broker, you will most likely act as the primary facilitator between your landlord and the buyer. It is not unusual for the landlord to require that you stay on the lease as a secondary guarantor through the term of your lease. They rarely have an obligation or incentive to reduce their security position and will almost always take the opportunity to increase it. Step 6- Closing the Transaction Closing the transaction refers to the completion of final components and formal signing of the final closing documents including Purchase Agreement, Bill of Sale, Promissory Note and Security Agreement if applicable, and closing statement. A notary should be present at the closing to notarize all signatures. The closing also involves the official payment of sales proceeds. Payment should always be made in the form of certified funds. When purchase funds are coming from a lender the payment will most likely be made directly from the lender to the seller. It is important to account for any prorated expenses that may be due to either party. Examples of some prorated expenses that may apply are personal property taxes, rent, or lease payments on equipment. Most businesses are expected to be transferred free and clear of all encumbrances unless the buyer is buying stock or has specifically agreed in writing to accept defined liabilities. As the seller you should be prepared to provide validation that all vendors are paid in full prior to closing. Some states require a Notice of Bulk Transfer to be sent to all active vendors allowing vendors or creditors to present any outstanding balances to the closer. The Notice of Bulk Transfer process would then require all vendors with confirmed outstanding balances to be paid at time of closing using sales proceeds before final distribution of funds to the seller. Even in states that do not require a formal Notice of Bulk Transfer, it is important to ensure all payables are satisfied prior to closing unless otherwise agreed with buyer. A Uniform Commercial Code (UCC) lien search may be run on you as the seller and the business entity to confirm that there are no creditors that have filed a lien on the business assets. It is not unusual for there to be one or more liens filed on businesses assets for things such as a business loan. If there are any liens from existing creditors, a payoff letter should be requested from the creditor containing conditional release language. This creditor should be paid in full at time of closing before the seller receives any proceeds from the sale. In the event your business has inventory, an inventory should be conducted immediately prior to the time of closing. This can be done by a third-party inventory company for a nominal cost or the buyer and seller can count inventory themselves if preferred. Usually the value of inventory is extended based on retail price and an average mark up is calculated to determine actual cost value of the inventory. The buyer may want to spot check a few recent invoices to confirm that the selected mark up percentage is realistic. In preparation for the inventory it is a good idea to either remove all outdated or unsellable items from the inventory or agree in advance with buyer that the inventory will be bought in its entirety. Any payment adjustments associated with the variable cost of inventory should be documented and accounted for as needed in the final closing documents. The Purchase Agreement should clearly outline the agreement related to payables and receivables. Since these items fluctuate, it is normal to have last minute updates. We have discussed the process to handle payables. Receivables should be documented in detail as of the day of closing. The list of receivables should include customer name, invoice number, date billed, and amount owed. If you will be retaining rights to the receivables on goods or services previously provided, you should have a process defined in the Purchase Agreement to describe how you intend to be paid. There are a number of moving pieces associated with preparing to close a business transaction and frankly there are a number of potential landmines along the way. It is advisable for you to use a qualified third-party to facilitate the process and keep your attorney close. Ideally the transaction should be closed by a third-party. After the sale Your hard work has paid off and the money is in the bank. Congratulations! The new owner will most likely need you around to assist in the transition and train them on the business. The parameters of your role during this transition period should be clearly outlined in the closing documents. This can be an emotional time for you. The joy of successfully completing the sale may be tempered by the emotions of letting go of one of your most valuable possessions. There is a good deal of pride in what you have built and handing off the baton is not always easy. Without over dramatizing the event, it is advisable to simply prepare yourself for some mixed emotions. During the transition period the new owner (with your assistance) will be notifying vendors and employees of the change of ownership. Utilities and other credit accounts should be transferred to the new owner. You will most likely want to keep your business bank account open for a month or so to allow for checks to clear and provide an easy way to deposit any checks received from the defined list of receivables. If there were liens that are now satisfied on your business the buyer may request your assistance to work with the lien holders to confirm all liens are removed after the sale. If you agreed to finance a portion of the sales price you should have a signed promissory note and security agreement giving you a security interest in the assets of the business. Remember to file the security agreement with the county to give public notice of your secured position. Enjoy yourself…you earned it. Dan LoIacono is the president of ABMI-Mergers and Acquisitions based in Overland Park, Kansas. ABMI has been bringing buyers and sellers of businesses together in the Midwest since 1983. Dan is a respected speaker for various well-know organizations in the Midwest. ABMI has won a number of awards for their best-in-class business practices including one of the top 25 businesses in Kansas City with under 25 employees in 2006 (“25 Under 25”). For more information on ABMI visit their website at WWW.ABMI.NET or call toll free- 1-913-381-5974. HTU UTH