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Few things are as mystifying and exasperating as selling a business – especially if it is yours. After years of worrying about the most intimate details, owners are often perplexed by the sale process, which requires a significant investment of both time and money. Sellers typically make this journey once, and without the right level of professional support, critical, costly and common mistakes can interrupt what should be the penultimate event in the life of an entrepreneur.
Although the rewards can be substantial, the sale process may be controlled by professionals who buy and sell companies on a repetitive basis. As such, a lack of preparation may put you at a disadvantage. The value of the sleepless nights spent worrying about payroll, pitching to larger customers, and dealing with difficult employees can be quickly dismissed in the weeks leading up to a sale.
Sellers should know that most professional investors specialize in contributing transformational capital and skilled resources to achieve scale and create durable earnings. However, questions remain - why does hard-won owner equity seem to slip away as the terms of a sale are hammered out with a prospective buyer? How can owners bring negotiating leverage to their side of the table? Although each deal is different, a few general rules apply to most selling situations.
Define the shape of a fair deal and what that means to you and your partners. Do you hope to survive the transaction, or are you motivated to monetize the value of your company and move on? How about the management team? Perhaps your team is younger with the energy to take the company to a different place. Talk openly to key leaders and understand their desires. Employees are more than an expense – they are perhaps a seller’s most valued asset and should be central to any sale decision. Although voting stock may be concentrated, key employees play an important role and contribute significant implied value in any sale. Understanding the desire of key employees before identifying a potential buyer can make the process cohesive and well-coordinated. As a routine matter, management should develop a plan identifying risks, opportunities, and likely outcomes. Remember that roughly 40 percent of transactions of less than $50 million value never close. Sellers must clearly and objectively identify transactions thresholds that go beyond the agreed upon sale price.
The sale process typically starts with a buyer presenting a Letter of Intent (LOI) as an expression of formalized interest. The LOI outlines terms and conditions including value, general deal structure (purchase of stock or assets) and specific payment terms, which include the amount of cash presented at close and possible contingent or deferred cash consideration which take the shape of rolled equity into the “newco” or “earn- outs” based on future performance.
Sellers are advised to keep buyers on their collective toes and maintain a degree of energy around the transaction. To help a deal move along, sellers should ask for a well-defined LOI expiration date – a period typically used for diligence. Although transactions in heavily regulated industries, such as healthcare and government, are complex and take months to close, asking questions about the life of the LOI will expose the seriousness of the buyer. Buyers often ask for exclusivity where the company cannot be marketed once the LOI is executed. Unreasonable exclusivity must be balanced against other elements of the deal, such as a breakup fee, no financing contingency, accelerated close and deal terms. Sellers should know the LOI is the “dating stage.” As you might expect, buyers and sellers will have detailed conversations in the weeks and months following the LOI.
First and foremost, sellers should do all they can to control the transaction narrative. A detailed review of one’s business, completed in the language of the buyer, allows sellers to close gaps in perceived value and possibly uncover value inhibitors that cause the best of deals to jump the tracks. A sell-side quality of earnings (QoE) report will give buyers (and sellers) a clear idea of the normalized earnings of a business. The term EBITDA (earnings before interest, taxes, depreciation, amortization) – is commonly used as a measure of cash flow generated by the business. What is less understood by sellers is that EBITDA should be expressed in post deal terms in which unique or non-recurring items (largely expenses) that do not survive the close are isolated (normalized) and added or subtracted from the operating results. Non-recurring expenses such as personal expenses, legal and consulting expenses are added back to the trailing 12-month period so that buyers have a clear idea as to the true earnings power of a target.
The report also untangles personal and business assets, provides for a proof of cash (correlates collected cash to claims of revenue) and includes an extensive review of ongoing working capital needs. Most deals are completed on a “no cash/no debt” basis, meaning that the seller retains company cash at close and is also responsible for certain debts (e.g., bank debt). It is generally better to preemptively understand issues such as customer concentration, working capital imbalances and negative inputs to EBITDA. The report allows you to repair or defend such shortcomings or emphasize items not correctly expressed within the context of the financial statements.
Sellers should expect buyers to conduct their own “buy-side” QoE. As a seller, it is important to get there first to maintain the “narrative” advantage. In doing this type of work for many years, we have seen about every type of unique expense from country club memberships, personal travel and even dog grooming. The best strategy is to inventory and present these items early in the process. Support initial negotiations with a normalized EBITDA calculation - the cornerstone of a QoE report.
Well-organized sellers simply get better deal terms. And, more importantly, the probability for a timely close significantly increases with an organized “data room” to be used as a repository of diligence items including financial statements, operating forecasts, regulatory and compliance items, and legal agreements.
Ensure that your company can be recognized as an investable entity and can successfully onboard capital and transact. Do you have appropriate legal protection around intellectual property (IP)? Do the rights of minority shareholders need to be considered? Is the corporation duly organized and registered? Preemptively work with counsel to review the legal foundation supporting your company. Relationships with tangential assets such as real estate that will serve the company post-deal should be well documented. Document the completeness of employment agreements, contracts, and shareholder understandings. Unsolicited offers are a deliberate strategy of professional buyers. Too many sellers fall in love with headline numbers and ignore the building blocks of a successful sale. Companies not ready for diligence are prime targets as buyers seek to capitalize on companies not dedicated to the process. If an unsolicited offer arrives, be thankful, but ask for time to prepare for the rigors of diligence prior to signing an LOI.
Buyers are required to provide rationale supporting the investment to their own sources of capital. Is the industry particularly attractive? Has your company enjoyed above market growth rates or robust margins? Will your company serve as a platform where successive acquisitions are “bolted” onto your company? (Platform companies tend to fetch higher purchase multiples - more reason to create the administrative foundation in advance of a deal.) Are new buyers attaching your company to a previously purchased platform company in which future managerial contributions can be muted? Practice your responses to such questions so you can articulate the true value of your company.
The first question I ask a selling shareholder is straight forward – As a seller, what do you want? Are you the person to lead the company to its next stage? Are you willing to miss family events, work the crazy hours, accept the risk of going this alone? The rewards can be spectacular, but the risk and responsibility can weigh on owners over the long term. Sure, getting paid for your efforts form the basis of any deal. However, the thrill of a deal is often offset by unhappy working roles and increased corporate responsibility. One must address the role of the management team post-deal. What will be your relationship to the board? What is the composition of the board? What type of reporting responsibility will the company have to those now involved in the capital structure, which may include banks, private equity sponsors and strategic partners? We often find that key managers get stuck in an endless loop of post-transaction reporting, which can create creeping deficiencies in the business and a general sense of management disenfranchisement.
The adage, “It’s not what you make, it is what you keep,” is never truer than in the context of the sale of your company. Proper tax planning, including tax elections, play a critical role in enabling sellers to retain higher percentages of sale proceeds. A tax professional will proactively review elections status of the entities under purchase consideration and create strategies to make the sale tax efficient (e.g., transferring pre-sale shares to a grantor trust). Along with the lawyers and financial professionals, make time to work with a transaction tax professional as this single element can easily translate significantly higher retained sale proceeds.
All transactions are different, but none are as important as the one in which you have decided to sell a majority stake in your business – and few sellers can respond advantageously to a pre-emptive and unsolicited sale without proper planning. It is imperative to engage the right team to guide a seller through a dizzying myriad of choices and strategies. The advisory professionals at Elliott Davis will facilitate a comprehensive approach to a successful sale. Contact us to get started.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.
