These questions often vex business owners as they first consider a potential sale. While there is no one-size-fits-all approach, there are basic precepts to consider before beginning a sales process. Preparation for a sale will certainly have associated costs, and there is no simple way to know beforehand exactly which costs will translate (directly or indirectly) into future deal value. But, everyone with any substantial transactional experience has seen too many deals that failed to close or suffered price reductions because of avoidable legal or business issues.
So, what makes a successful sale of business transaction for a seller? Put simply, it is one that closes, generates an acceptable after tax payout to the business owners and has an acceptable risk allocation. With time and attention, a business owner can get his or her business in shape for a sale well before a deal is on the table to improve not only the chances of success but to redefine “success” and move it to another level. Houses that are move-in ready can command a premium. The same can be true of businesses.
While this list is far from exhaustive, here are some basic things a business owner should consider before putting the business on the sale block:
1. Nothing kills more deal value than having to sell before a company is ripe. Deciding when to sell is often very difficult, but every business owner would rather make that decision than have it dictated by others. For example, liquidity crises, ownership disputes, estate planning deficiencies or a lack of a shared vision among the owners can often force a business to sell prematurely at a sometimes shocking cost.
Most businesses are valued on a multiple of earnings or cash flow and buyers pay higher multiples for larger businesses. As a result, when a growing company sells too soon, it loses value in both aspects of the valuation equation – lower earnings and a lower multiple. As a result, it is critical that the owners of a business have a clear, shared vision for its future and potential sale triggers are addressed by, among other things, having good conflict resolution options, developing strong succession plans, maintaining access to capital and minimizing excessive distributions.
2. Mismatched tax structure. While a business owner should consider many things when choosing the right kind of business entity through which to operate, tax efficiency is usually the most significant consideration. But tax efficiency is also critical in structuring a company for a sale. A company in an industry where asset sales are the most common sale structure should focus on a flow-through structure (e.g., limited liability company or S-corporation), which enables an entity to sell its assets without incurring a double tax (at the entity level and again upon distribution of the net proceeds). For companies with long-term growth plans to be funded by organic growth in industries where stock sales are the more common sale structure, the regular C-corporation is usually the better choice. For some companies, it may be advantageous to begin as a flow-through entity and convert once a level of consistent profitability is achieved.
Of course, in selecting an initial tax structure a business owner must also weigh other considerations. One often overlooked is whether the structure will complicate future capital raising needs. For example, while an S-corporation has certain advantages over other types of entities in some circumstances, it is restricted from having certain types of shareholders and it may only issue a single class of stock. Business owners often underestimate the difficulties those restrictions can cause when it comes time to raise capital in the future.
Do not assume choice of entity is a one-time consideration, made when a business is first formed. It will always be a critical issue for any business while it is operating, but do not allow it to be the issue when you prepare to sell.
3. Accounting credibility is paramount. Most successful companies have very strong cost controls and do not spend any dollars that do not affect the bottom line. In a sale of business transaction, very little affects the bottom line more than accounting concerns or mistakes. The more confidence a buyer has in the accuracy of a seller’s financial statements, the quicker the deal will move from discussions to completion. Consider upgrading the internal accounting capability, if needed, as well as the level of external accounting services received – e.g., from compilation to review or from review to audit. This is not without cost, but a history of high quality accounting reports can be very valuable when selling.
4. Know your GAAP numbers. Most buyers (particularly larger companies) insist on making pricing decisions based on accounting information determined in accordance with generally
accepted accounting principles (“GAAP”) rather than tax books. If business books are kept using very conservative accounting policies or aggressive policies designed to reduce or delay tax liabilities, a seller may be surprised at how much its non-GAAP numbers will cost at the bargaining table. Know the numbers that will count most when the sales price is decided.
5. Manage Critical Risks. Identifying critical risks and addressing them before a sales process begins can be important to maintaining deal momentum. The longer the time period from term sheet to definitive agreement or from definitive agreement to closing, the greater the chance a problem could impact the deal. Solving problems late in a process is more costly than solving them early. Many business owners are surprised to learn that their business, which has operated without incident for years or even decades, has potentially serious latent risk exposure in areas like taxes, environmental law, retirement plans and employee benefits or intellectual property. A business seller may also be surprised at how much it costs to resolve risk concerns while the deal is active. If the buyer finds a major problem after the deal has closed, it may be even more expensive.
In sports, coaches often self-scout to make sure they know their weaknesses and address them before the next big game. Likewise, business owners do that every day regarding operating risks. However, business sellers should consider taking a similar approach to the sales process.
6. Protect the Value Drivers. In a business sale, the buyer wants to acquire the key elements of the seller that have made it successful. Those keys to success, or “value drivers,” may include physical assets, intellectual property, key personnel, key relationships or unique business strategies. Most businesses are quick to protect the obvious things but slow to protect those key elements that are less obvious and which may be most at risk of predation in the marketplace. In a sale of business transaction, third parties will be undertaking a close inspection of the seller, looking to identify all of the seller’s key value drivers and major risks. A strong non-disclosure agreement with non-hire protections is critical, but will that provide enough protection? Don’t wait. Identify your value drivers and make sure you have a good plan to protect them from your competition and those who may bid on your company – whether a deal is imminent or not.
7. Manage Critical Documents. When a company is sold, many of its most valuable assets are documents. Buyers want to see and confirm all critical patents and trademarks, sales or supply agreements, essential licenses and permits, corporate and shareholder records, executive employment agreements and employee confidentiality agreements and other critical asset or business records. A seller that has these documents in good order can move quickly when an opportunity presents itself and avoid self-inflicted wounds. Also, managing critical documents can often uncover the critical risks that have been neglected and key value drivers that have been left unprotected.
In conclusion, it is important to note that many of the steps in preparing a company for sale are not necessarily difficult, costly or time-consuming, particularly if addressed before the sales process begins. Managing the basic items of structure, accounting and corporate records is a must for every business. The same can be said for protecting a company’s most important value drivers.
It is equally important to identify and minimize the kinds of risks that can slow down or derail a transaction once it has begun. Everyone benefits from a cleaner, quicker deal. Getting ready to sell and staying in “sale shape” can be a challenge, but speed can be critical to a successful deal. Be prepared before the time is right for a sales process, before the opportunity to make a deal presents itself. No business owner will regret being too prepared when that time comes.
» Law Elevated explores the latest trends, issues and perspectives facing the legal industry and is written by the attorneys of Butler | Snow. For more information, visit www.butlersnow.com or follow Butler | Snow on Twitter @Butler_Snow. By Kap Primos and Sai Ireland
BEFORE YOU GO…
… we’d like to ask for your support. More people are reading the Mississippi Business Journal than ever before, but advertising revenues for all conventional media are falling fast. Unlike many, we do not use a pay wall, because we want to continue providing Mississippi’s most comprehensive business news each and every day. But that takes time, money and hard work. We do it because it is important to us … and equally important to you, if you value the flow of trustworthy news and information which have always kept America strong and free for more than 200 years.
If those who read our content will help fund it, we can continue to bring you the very best in news and information. Please consider joining us as a valued member, or if you prefer, make a one-time contribution.Click for more info