Selling Your Business

Stephen DeAngelis

April 8, 2011

Entrepreneurs come in all flavors. Some entrepreneurs start a company with the intention of making it their life’s work. Others start businesses with the intention of making them profitable then selling them to the highest bidder. If you fall into the latter category, entrepreneur Luke Johnson writes, “Perhaps the most important question is: when do you want to sell?” [“Plan your exit to prevent a sticky end,” Financial Times, 22 February 2011]. “Some 77% of business brokers say 2011 will be a good year to sell a business,” reports Emily Maltby [“Is Now the Time to Sell a Business?Wall Street Journal, 2 March 2011]. Although that may sound promising, one needs to remember that these brokers only make money when they participate in the sale of a business. That may be the reason that Maltby writes, “What’s perhaps more compelling is that 23% believe this year will not be a good year to unload a business.”

If you have no intention of selling your business right now, eventually you are going to retire, pass your business along, or die. If you want the business to survive after your tenure at its helm, Johnson says that you need to plan in advance for that eventuality. Regardless of whether you are going to sell or intend to pass your business on, Johnson writes, “Preparation is a good idea – because a business is not an inanimate asset like a house, but a dynamic construct that is extremely vulnerable if neglected.” He continues:

“Most founders are proud of their creations, and would much prefer to see them prosper in the future, almost as a form of legacy. Entrepreneurs might pretend to have no emotional attachment to the business they spent perhaps decades building, but often I have found that impression to be false. These owners have strong bonds to their employees, customers and suppliers, and a passion for their products and markets. That intensity of involvement means making sure that if possible the business ends up in the hands of appropriate shareholders – rather than it being broken up, over-borrowed or run by the wrong management. I have frequently seen owners turn down higher offers from their obvious corporate rival because they cannot bear to sell out to a bitter competitor who will gut their business.”

Although Johnson discusses how businesses can be passed on to family members, the focus of his article (and this post) is on selling your business to a third party. If you are going to hire someone to help you sell the business, Johnson offers a few suggestions. He writes:

“When it comes to selling out to third parties, many owners seek the counsel of M&A advisers. Some of them are excellent, a few are rogues, but none works for free. I expect them to only bill on results – this motivates them to deliver. Do not choose a selling agent based only on the promise of a higher price; this can be a tactic to secure a mandate, without the necessary follow-through. If you want a broker, I recommend using one you trust, who has handled similar tasks before, and who can supply solid references.”

Whether you use an M&A advisor or not, Johnson recommends that you put some serious thought into who you think would be the preferred buyer of your business. He continues:

“If a business is to be sold to an outsider, then you should consider who the best buyer is, and what they might be willing to pay. Due diligence will be more onerous, and the whole affair is likely to take much longer, because the purchaser will assume caveat emptor applies. Usually when I receive prospectuses for private companies there are adjustments to the profit figures, adding back certain non-recurring items like the owner’s salary. The price is meant to be a multiple of this number. Such devices can cause disagreements. And if you overstate the profitability of your business, then unless you find a dumb buyer, there will be a price reduction once the truth comes out. Therefore the final piece of advice is to plan ahead, because you can take a business with you.”

Colleen DeBaise, author of The Wall Street Journal. Complete Small Business Guidebook, offers some advice in this area [“How to Sell a Small Business,” Wall Street Journal, 2 November 2010]. She writes that “many entrepreneurs dream of leaving the business they created to their offspring.” But, like Johnson, the focus of her article is selling a business to others. She continues:

“Selling a business is a lot like sprucing up your house for sale: you’ll want to make sure everything is neat, orderly and presented in the best light possible for maximum dollar. And much the way a home owner might use the services of a real estate agent, you’ll likely want to enlist the services of a business broker or a merger-and-acquisition specialist. That’s because unless you have started and sold many businesses, you likely are not familiar enough with the ins and outs of the process. You’ll want to make sure you deal with an expert who is well schooled in assigning a value, structuring a sale in the most tax-friendly manner and negotiating the best price, especially if there are multiple potential buyers. As a rule of thumb, businesses that post less than $1 million in annual revenues typically use a business broker; multimillion-dollar businesses often use the services of a merger-and-acquisition specialist. Ask your lawyer, banker, accountant or other business owners for a referral; sites such as BizBuySell.com provide more information on the process.”

In order to provide entrepreneurs who are thinking about selling their ventures some idea of what is involved, DeBaise interviewed “Barry Evans, owner of Acquisition Services Group, a La Jolla, California, merger-and-acquisition firm that assists individuals who want to sell privately owned companies with market values between $1 million and $20 million.” Evans stated that process begins with the accumulation of required documents. Those documents include:

• Tax returns from the past five years

• Internal financial statements from the past five years

• Year-to-date financial information

• Year-to-date financial information for the year-ago period

• Minutes of board meetings and annual meetings (if a corporation)

Evans states that once those documents are assembled, the real work begins. DeBaise explains:

“Most businesses will need to adjust financial statements to better reflect actual earning power—a process called recasting, which is widely accepted in the industry. Essentially, while operating the company, you may have employed tactics—such as giving yourself perks, putting family members on the payroll, or steering profits into capital improvements—designed to keep the company’s profits low, for tax purposes. When you recast, you add those expenses back in to present a picture of the company’s normal operation. Another piece of the valuation is an analysis of risk. For instance, a company that relies heavily on one big customer for the bulk of its revenues would be considered high-risk, while a business that has hundreds of customers, a long-term lease and noncompete agreements already in place with its employees would be lower risk.”

All of that effort is designed to help you establish a valuation for your company. With that behind you, you have to start worrying about finer grained details associated with your business and getting it sold. DeBaise continues:

“According to Mr. Evans, … you’ll need to disclose the nittygritty details of your business in a selling memorandum that would be confidentially marketed to potential buyers. Some typical information it might contain:

“• A history of when you started the business, hired employees and (if applicable) secured patents

“• A roster of employees (including yourself) outlining job descriptions, levels of experience, salaries and whether they are unionized

“• A description of your customer base, detailing customers’ size, location and the amount of business you conduct with them

“• A review of your location, such as whether you own or lease the space (If it’s a lease, indicate if it’s assumable by a new owner.)

“• A listing of all owned or leased equipment, trucks or trailers, with a description of their condition

“A special note: You’ll also want to disclose any litigation or regulatory hurdles you’ve dealt with in past years—and any other negatives that may become a headache for the new owner. By disclosing that information, you’ll help protect yourself from a lawsuit down the road, Mr. Evans says. You’ll also want to outline any improvements that the new business owner might make to the business.”

DeBaise notes that a lot of entrepreneurs simply believe that “preparing financial statements and getting your documents in order” is all that is required. Even if you do everything mentioned above, DeBaise indicates that “you may need to renegotiate lease, vendor and employee agreements and pay all back taxes or other outstanding debt.” That still may not be enough. She explains:

“In a tough economy, you’ll want to take steps to maximize revenues and minimize operating expenses, Mr. Evans says. After all, it’s your profits that will undoubtedly attract buyers to your business. That might require some cutbacks, such as trimming staff if need be. You may also need to tighten up any operating problems, such as investigating why inventory routinely goes lost or missing. And you might want to reexamine your credit-granting procedures, especially if you’re worried about customers missing payments. Once you’ve got your business’s financial and operational houses in order, your broker or specialist should actively market that information to potential buyers.”

One important caveat that DeBaise raises is: “Potential buyers, who may be competitors, should be required to sign a confidentiality agreement before reviewing the information.” She also recommends holding your plans close to the chest since revealing them might cause vendors, employees, and customers to take flight. The best time to reveal the takeover to them, she claims, is “when you’re announcing the new owner.” She concludes:

“In the best of circumstances, you’ll get offers from numerous buyers—and a critical next step will be deciding how to structure the deal in the most tax-advantaged way possible. Most small businesses are sold through either a stock sale or an asset sale, and there are various tax consequences depending on your company’s legal entity, your personal investment and other factors. If your company is valued at $1 million, you might end up with after-tax proceeds in the range of $450,000 to $850,000, depending on those variables, according to Mr. Evans. To ensure the most profits, he says, plan the sale far in advance so you can eke out as much tax savings as possible.”

Pui-Wing Tam asserts that selling a business is getting more complicated and reaping rewards is becoming more difficult [“Cashing Out Start-Ups Gets More Complicated,” Wall Street Journal, 16 February 2011]. She writes:

“For acquisitions of private companies backed by venture capital, it’s becoming increasingly complicated to collect cash after the deal has been signed. In contrast to a decade ago, when many such deals went through with little trouble, today’s venture-backed acquisitions are fraught with landmines that can result in delayed payments and reduced purchase prices long after the deal has been struck, say venture capitalists, entrepreneurs and deal attorneys.”

Tam anecdotally refers to a mid-2008 deal in which SRA International Inc. acquired Era Systems Corp. She notes that “Era’s shareholders took a haircut on their purchase price and didn’t collect their reduced amount until last year, partly because of a disagreement during the escrow period.” She continues:

“More venture-backed acquisitions are subject to contentious escrow periods—where 10% to 20% of a deal’s proceeds are held back to protect a buyer in case of a contract breach—with buyers and sellers dickering over the pot of money being held, sometimes leading to legal fights, they say. Many of the deals also now include earnouts—where part of the deal’s value is pegged to the purchased company hitting a performance milestone later—some of which never end up being paid out. As a result, investors and entrepreneurs are in some cases ending up with far less of the purchase price than the number upon which they originally agreed. That’s having a knock-on effect on entrepreneurial wealth and venture-capital returns and distributions, among other things.”

Tam reports that “two thirds of private companies that are acquired now go through post-closing purchase price adjustments, according to a study by Shareholder Representative Services LLC, a San Francisco firm that helps companies navigate post-close issues.” She indicates that “a quarter of the deals had earnouts attached.” In a recessed economy, that really shouldn’t come as a surprise. It should make seller wary, however, of including earnouts in sales agreements. Tam continues:

“Driving the rise of post-deal complications is the increasing clout of many acquirers. With initial public offerings of venture-backed companies—which were once the main source of profits for the venture industry—now happening less frequently, more companies are now sold instead. That gives buyers more sway in picking and choosing acquisition targets and imposing harsher post-close terms.”

As long as buyers hold most of the cards, don’t expect to see conditions easing — because “no matter how good or thorough the due diligence is, there’s still opportunity for unknown things to happen.” One interesting development that has taken place as a result of the recession is that entrepreneurs who once sold their businesses are now buying them back [“Sell the Store, Then Buy It Back,” by Emily Maltby, Wall Street Journal, 11 November 2010]. Maltby reports that “a handful of entrepreneurs who sold during flush times are repurchasing their old companies for cheaper prices, hoping they can resuscitate the now ailing businesses.” She continues:

“It’s unclear how many business owners buy back their companies, though sale prices are at temptingly low levels. According to BizBuySell.com, an online marketplace for small-business acquisitions that tracks market activity, the median selling price for a business is down 30% compared with early 2008. Still, buy-backs are rare because ‘virtually every owner has emotional and personal reasons for selling,’ says Barry Evans, a partner at Acquisition Services Group Inc. a business brokerage firm in San Diego. ‘When they get out, it’s a major step in their life—a burden off their shoulders.'”

With global economy continuing to recover from the Great Recession, some companies are sitting on large piles of cash and many of them are eager to start using it for mergers and acquisitions. I suspect that the next few years will witness a flurry of such activity. For entrepreneurs this means that the coming years represent an opportunity to sell that has been missing for the past couple of years. As Luke Johnson noted at the beginning of this post, “the most important question is: when do you want to sell?” To learn more about this topic read the Buying and Selling a Business section of The Wall Street Journal‘s “How-to Guide for Small Business” and “All in the detail: how to prime, prepare and sell,” by Jonathan Moules [Financial Times, 18 October 2010].