Executing a successful sale of your business
Entrepreneurs may decide to sell their business for any one of a number of reasons: they have reached retirement age, they want to change their lifestyle, they are burnt out, or they are uncertain about the future of their business. If you are considering such a sale, keep in mind that, financially and emotionally, this transaction will be one of the most important events of your life and it will draw a line under years of your hard work and investment. To maximise your outcome and minimise your risk, you should understand the sales process before you jump in. This article will provide a practical guide for entrepreneurs looking to sell their business. It will also point out common pitfalls that should be avoided during the selling process.
The sale or acquisition of a typical business can take several months. During this period, you will have to prepare several important documents that describe your business, hire consultants who will assist you in finding suitable buyers and negotiate with them to arrive at mutually acceptable terms.
Prepare Yourself
Purchase of a business typically involves a substantial amount of due diligence by the buyer. Before committing to the transaction, the buyer will want to ensure that it knows what it is buying and what obligations it is assuming, the nature and extent of the target company’s contingent liabilities, problematic contracts, litigation risks and intellectual property issues, and much more. This is particularly true in private company acquisitions, where the target company has not been subject to the scrutiny of the public markets, and where the buyer has little (if any) ability to obtain the information it requires from public sources.
Understand your Business’s Financials
First and foremost, as part of the due diligence process, the buyers are going to spend a lot of time looking into your business’ finances. Therefore, you should be well prepared to answer any question they raise.
The three years of financial records that you show to the buyer should be in perfect shape:
Ensure that the assets and liabilities on your balance sheet are classified correctly and with correct valuations.
Your revenue recognition policies should be conservative and simple to understand.
To avoid errors of omission and being sued for fraud, report all your expenses and make sure that inventories are adjusted to reflect their current level.
You should be able to show contractual agreements (such as equipment purchase agreements, customer agreements, lease agreements, etc.) for the major line items on your financial statements.
Paying a qualified outside accounting professional familiar with M&A transactions to look over your books can be an excellent investment.
At the macro-level, you should be able to explain your business model and its underlying drivers of your revenue. In most businesses, profit is driven by four factors: price, variable costs, fixed costs and sales volume. Be ready to explain the figures and the interaction between these factors for your business. Does your business have a significant repeat customer base? Are your sales seasonal? Are they driven by partners, affiliates or advertising? Do you sell directly to the customer, or through an intermediary such as Amazon? Why would a customer purchase from your business rather than from a competitor? Having answers to these questions at your fingertips will greatly increase your trust and credibility with buyers.
Hire a Good Law Firm
As this will be one of the most important financial transactions of your life, it is important to hire the right law firm for your needs. Do not just hire your brother-in-law’s cousin (unless he happens to be an expert in business sale transactions!) You should be working with a senior partner in a respected law firm who understands your industry and has experience in transactions of similar size. Be sure to interview a handful of firms before making a decision.
Larger firms might be more expensive as a rule, but selling a business is a complicated legal task and a sole proprietor or a small firm is unlikely to have the breadth of experience that you need.
Look for domain expertise; if you are selling a technology business, ensure that your chosen firm has prior experience in the technology M&A market. Again, you are more likely to find this expertise at larger firms.
If your business is international in scope, make certain that your deal is not the first time your chosen lawyer has dealt with the legal and financial challenges associated with cross-border trade.
Consider the size of the business you are selling and the amount of money that is expected to change hands, and look for a firm with experience in selling businesses of a similar scale.
Checking references can be a great way to assess the capabilities of both the firm and its individual lawyers.
To limit costs, ask the firm for an estimate of how many hours they will bill you for, and consider setting a maximum fee that you are prepared to pay for the whole project. Many law firms will agree to a not-to-exceed cap on their fees with some reasonable caveats; push for such a cap. A good lawyer will keep you up to date about the fees used up; but make sure that you receive this information along the way and are not surprised at the end.
Finally, don’t underestimate the importance of interpersonal chemistry during your law firm selection. A business sale requires many intense and emotionally charged hours of discussions and negotiations; your lawyer should be your trusted general in these. It can be frustrating to work with person who doesn’t share your sense of urgency, or someone who speaks in dry legalese. As you will be spending a large amount of time with your chosen legal team, select the one with whom you will be able to develop good rapport.
Find Multiple Buyers
Often entrepreneurs initiate the sale process in response to unsolicited interest from a potential buyer. Even if you already have a buyer lined up, you can benefit from increased exposure to a larger pool of potential buyers.
If you are negotiating with only one party, the buyer will have lot of power in the discussions. The buyer knows that you will have to start negotiations again from scratch if they walk away. This situation can lead to businesses being underpriced, with unfavourable terms for the seller. The buyer can use this leverage to force seller’s compromise on demands.
Having multiple buyers gives the seller some leverage in negotiations. If a buyer wishes to purchase your business, they will have to outbid the others and provide you with their most favourable terms. In the event that you accept an offer and find that the buyer renegotiates the terms of the deal, you will have the option to reintroduce one or more underbidders back into the negotiations. This incentivizes bidders to accept your terms and avoids negotiations that result in your disadvantage.
It is essential to hire a good broker or investment banker to identify possible buyers. Interview several brokers and ask them how they will generate demand for your business and identify potential buyers. Due to the size of their network, larger firms (50+ brokers) are in the best position to find the largest market of qualified buyers for your company. Alternatively, a boutique firm that specializes in your industry segment may also be a good choice. Note that some serious buyers may shy away from a business where they are bidding against competing buyers; a good broker can guide and navigate you through these choices while protecting your interest.
Understand the Deal Structure
There are several important concepts that relate to the structure of a business sale. You should have a very good understanding of these as you will have to make many important decisions that are undergirded by these concepts.
Asset sale vs stock sale
Buyers of a business typically want to acquire its assets, while sellers usually prefer a stock sale. To avoid legal complications, it’s essential to address deal structure early in the negotiations process and involve both your CPA and your legal team from the outset.
In an asset sale, the buyer purchases some or all of the assets of the business but the corporate entity remains with the original shareholders, albeit as an empty shell with no assets except for the cash received from the asset sale. This cash is then distributed to the shareholders and the corporate entity can either be shut down or kept alive. In a stock sale, the buyer buys the stock of the corporate entity from the selling shareholders. The ownership of the corporate entity itself transfers from the buyers to the sellers.
If the buyer purchases assets, the buyer’s tax basis for the purchased assets will equal the purchase price. In most situations this will benefit the buyer when it comes to making deductions for depreciation or amortisation, or if the buyer were to sell the business to someone else in the future. In the case of a stock sale, the buyer will not be able to amortize the buyer’s basis in the purchased stock.
By contrast, any financial gains made by the seller as a result of an asset sale may be subject to double taxation; for instance in the case of US C corporations, any gains on the asset sale are first taxed at the corporate level. The after tax amount is then paid out to the shareholders as dividend which is subject to a further dividend tax. This double taxation can be avoided by the sellers in a stock sale where the proceeds are only subject to capital gains tax on the sold stock.
With an asset purchase, the seller normally retains responsibility for the business’ liabilities, including product liability claims, contract claims, employee lawsuits, pensions and benefit plans. Stock sales transfer these liabilities to the buyer, which is advantageous for the sellers.
Seller financing
Sometimes, sale of a business includes seller financing as part of the deal structure. Under seller financing, a portion of the purchase price is paid to the seller through issuance of a promissory note by the buyer. It is important to find out as soon as possible whether your buyer will need external financing (from you or someone else) in order to complete the purchase of your business. If so, this adds a degree of complexity and risk for the seller. If the buyer’s offer is contingent upon the buyer receiving third-party financing, you should ensure that either (a) you do not incur extensive costs for the sales process before the financing approval is received by the buyer, or (b) your costs are reimbursed by the buyer in case the buyer fails to obtain such financing.If the buyer expects seller financing as part of the deal (e.g. through a promissory note), this is a risky proposition and you should evaluate its structure carefully. To minimise this risk and maximise the chances of receiving full payment, sellers should minimize the amount they are willing to finance. The more of the purchase price you finance, the greater the risk you take on.
If the buyer expects seller financing as part of the deal (e.g. through a promissory note), this is a risky proposition and you should evaluate its structure carefully. To minimise this risk and maximise the chances of receiving full payment, sellers should minimize the amount they are willing to finance. The more of the purchase price you finance, the greater the risk you take on.
Together with your lawyers and accountant, conduct due diligence into the buyer’s creditworthiness, checking for any previous bankruptcy, litigation and payment (or tax) difficulties.
The buyer should give you reasonable access to their financial records until the loan is paid off.
If possible, find assets or guaranties that can be used as collateral if the buyer defaults on payments to you.
The terms of your agreement should also specify what happens in the event of a default. You might consider an interest rate that is applied if the buyer defaults, or bringing forward the maturity date of the loan.
Earn-outs
An earn-out is a deal structure whereby a portion of the purchase price is contingent on the business attaining one or more goals after the deal is closed. These goals usually relate to revenue or EBITDA in the business a year or two after the deal. Earn-outs are a common compromise in the event that buyer and seller do not agree completely about current valuation of the business; seller feels that the business will do well in the future and is, therefore worth more while buyer feels unsure about the future and is therefore not willing to pay the high valuation expected by the seller. As a compromise, they agree that part of the valuation will be made contingent upon the future performance of the business. However, there are several inherent conflicts of interest built into an earn-out structure:
It’s best to tie earn-outs to revenue rather than EBITDA, as the former is much easier to measure whereas the later can be manipulated by the party in control after the sale (very likely the buyer).
Tying earn-outs to EBITDA raises the possibility of the buyer making long-term business decisions that hurt EBITDA in the short-run, hurting your earn-out payments.
If your business is going to be incorporated into a larger business, it’s crucial to define whether the earn-out targets are tied to the performance of the buyer’s entire corporation or only the business being purchased.
To ensure that you receive full payment and are finished with the sale of your business as soon as possible, keep any earn-out clauses at two to three years at the very most.
Letter of Intent
A letter of intent or LOI (also called term sheet in the US) is a document that outlines the key terms of the agreement between buyer and seller without normally being legally binding. Such a letter is typically executed at the start of the negotiations. To see an example of what a typical LOI contains, check out this template. The precise extent to which the LOI is legally binding can and should be clearly defined as part of the agreement. Entrepreneurs should take these letters seriously, as they shape the expectation structure of the deal and can thus have a major impact on the final deal. Even if an LOI is not legally binding, it will be very difficult for you to change key terms of the agreement at a later stage of negotiations.
As the seller, your negotiating power is highest at the LOI stage, after which point sellers tend to be emotionally committed to the sale and find it harder to negotiate for better terms.
Capitalise on this advantage by broadening the scope of the LOI to include legal points as well as business ones.
In particular, you’ll want to make sure that you specify the jurisdiction for disputes and who pays expenses in the event that the deal doesn’t close.
Additionally, consider an exclusivity clause; you don’t want to find the buyer pulling out because it has found a better deal elsewhere in your industry after learning all of your industry trade secrets.
Understand Due Diligence
Often the most painful part of any M&A process, due diligence is performed by the buyer to find out detailed information about the business that will help the buyer decide if the business is suitable for the buyer and if wants to purchase the business at a price agreeable to the seller. You will be sent detailed information request lists by the buyer’s law firm about accounting, financial and legal information. This information should be made available electronically, whether through highly-secure, specialised software such as Merrill DataSite, in-house extranet services or cloud solutions such as Google Drive and Dropbox.
To prepare for this process, consider having your law firm review your books, contracts and other records and collect the requisite information before the deal starts.
Depending on what is most cost-effective for your business, do most of the document scanning in-house or send papers to your law firm to be organised appropriately.
To avoid being pestered by the buyer’s lawyers, be absolutely sure that the documents you provide are the most current version and include all signatures, attachments, exhibits and annexes.
If you are at an early stage in negotiations, you may wish to redact information such as the names of customers, leaving yourself the option of revealing sensitive information when the deal is near completion.
Keep a backup of the due diligence information on a CD, memory stick or external hard drive. If the deal closes, you may need to refer back to these documents from time to time. If the deal fails, your records will make the due diligence process much faster next time round.
Understand Key Transaction Documents
Most business sales involve a set of standards legal documents. You should become familiar with the most important ones as described below.
Purchase agreement
Building upon terms agreed in the LOI, the purchase agreement is generally a lengthy document that sets out detailed terms and conditions and is the first point of reference in any disputes or disagreements that may arise after closing.
The purchase agreement describes the specific assets and/or stocks being acquired by the buyer and any assets or liabilities being retained by the seller.
Make sure that you specify any assets that you want to remain with you, such as cash and personal assets such as vehicles.
The agreement should also set out price terms, including the valuation and the portion of the price to be paid when the deal closes and the proportion to be paid using seller financing or earn out.
Specify when the deal is due to close and how the closing will take place. In most cases, the agreement will set a specific closing time at which point documents will be exchanged electronically.
Additionally, the purchase agreement will include (or reference as appendices) various representations, warranties, disclosure schedules and indemnification as described below.
Representations and warranties
As part of the purchaser agreement, the seller is required to make a series of statements about their business, known as representations and warranties. Typically, the sections of this document will cover many risk areas of the business such as capitalisation/ownership structure of the business, compliance with various laws, tax payments for prior years, intellectual property ownership, contracts with various parties, any past litigation, employees relationships and customer relationships.
From the buyer’s perspective, these statements are an important tool for the due diligence process and an important component of the purchase agreement. These sections are designed to bring out the true picture of the business for the buyer. If the buyer learns something in the representations and warranties that they do not like, it can provide a basis for allowing the buyer to walk away from the deal without closing. Conversely, if a deal is closed and these statements prove to be fraudulent, the buyer can claw back some of the purchase price and obtain damages from the seller. Therefore, from a seller’s perspective, the best way to handle the representations and warranties is to adopt truthfulness as the default stance.
Disclosure schedule
The disclosure schedule is a tool that the sellers can use to minimize their risk of litigation after the sale. This is a information list in which the seller informs the buyer about all the things that may be questionable or “bad”. A buyer cannot sue the seller for any information that had been disclosed to the buyer through the disclosure list. Therefore, it is in your interest as the seller to disclose as much information as possible in these statements. Remember that you know much more about your business than the buyer, and that the buyer will need this information to judge if your business is worth buying. Anything that you do not disclose will only come back to haunt you at a later stage in the process. It is better to disclose too much and risk turning off the buyer, rather than disclosing too little and risk future litigation.
Indemnification provisions
Another part of the purchasing agreement is the section on indemnification, in which the seller agrees to compensate the buyer if certain types of losses are suffered after the deal is closed. The indemnification provisions also defines the upper and lower limits for such losses. For example, it may state that the buyer would only compensate for a specific loss if that loss is above $5k. Similarly, it may set an upper limit of $50k for such loss.
The types of loss covered are specified within the agreement, and typically include scenarios such as misrepresentation in the representations and warranties, or liabilities arising out of the company’s assets before closing.
As the seller, it’s critical to draw up indemnity obligations as narrowly as possible to reduce the probability of having to compensate the buyer.
As part of the agreement, include caps on the amount that can be paid and deductibles below which you will not be liable to compensate the buyer. You can think of these deductibles as deductibles in an insurance context where you are acting as the insurance company for the buyer.
Also include a time frame within which the buyer has to approach you for any claims it might have – and make that time frame as short as possible.
Make it clear in writing that indemnity is the only way that the buyer is allowed to come after you for money.
You should limit setoff rights to ensure that the buyer is not legally able to use any indemnification claims to withhold money owed to you as part of the seller financing agreement.
Non-compete agreement
Buyers are understandably reluctant to pay for a business if there is a chance that the seller will start competing with them in the near future. As such, non-compete agreements are a standard part of most M&A agreements. Typically, the agreement will include covenants prohibiting the seller from soliciting the buyer’s customers and employees. The agreement may also prevent the seller from engaging in the same industry for a specific period of time and/or in a specific geography.
As the seller, it is your responsibility to make this agreement as narrow as possible. After the deal closes, it is likely that you will want to make use of business relationships acquired during the life of the business you are selling. As such, you will want to include a clause allowing you to solicit your old contacts in order to start businesses that do not compete with the one you are selling. Keep the non-compete period as short as possible.
Finally, consider adding a clause that voids the non-compete restrictions in the event that the buyer neglects their obligations after closing. This is a strong incentive for the buyer to pay any loan repayments on time and to honour any other obligations it may have towards you.
Escrow provision
An escrow is a proportion of the purchase price, typically 10 to 15 percent, which is placed in a third party bank account and managed by an independent agent, such as a bank or lawyer. In the case of an earn-out, the escrow amount includes the money the seller stands to receive if the business reaches its earn-out requirements. For the buyer, an escrow is a way of securing the seller’s indemnification obligations.
Sometimes, the escrow fund will be the only money available to the buyer in the event of indemnification. This is a situation that obviously favors you as the seller. More frequently, the escrow fund is the bank account which the buyer must exhaust before going after the seller’s shareholders individually for any additional sums owed. An even more buyer-friendly approach is for the buyer to avoid escrows altogether and simply hang on to the relevant percentage of the purchase price until any conditions obligating it to release the funds are met. This approach gives the seller less control and is not recommended for a seller.
If there are no legal or financial disputes in the aftermath of the deal, the escrow is typically released to the seller in annual or biannual instalments.
Stay Honest
This is perhaps the most important message that you take to heart as you decide to engage in the sale process. It is natural for entrepreneurs to want to show off the best aspects of their business to a prospective buyer in order to be bought for the highest consideration possible. Although there is nothing wrong with highlighting the strengths of your business, you should remain as truthful as possible when it comes to providing facts about your business; this includes your own brokers, lawyers and advisers as well as those of the buyers. Intelligent buyers are able to spot inconsistencies in your story without you realizing it. A nebulous or hesitant response from a seller is often interpreted to mean that something is being hidden. Therefore, the best policy is to be honest and truthful. You don’t have to tell sellers everything about your business all at once, but any lies you tell will come out during due diligence and cause you more trouble later on in the selling process. Furthemore, even if the buyers do not catch a misrepresentation before the close of the transaction, the various agreements that you will sign will hold you responsible for it anyway. In fact, such misrepresentation discovered after the close will turn out to be a lot more expensive for you.
Specifically, you should be very accurate about key facts such as historical revenues, profits, assets, liabilities, and any ongoing litigation(s). Sales projections should be realistic. Given that business sales cycles typically take several months, it is very likely that the buyer will be able to validate your projections for the next quarterly cycle before the business is sold; a positive surprise at that late stage will help your negotiation position whereas a negative surprise at that stage can derail the transaction. Additionally, you will need to prepare meticulous financial records from the last few years in business, as per the standards set by the financial regulatory authorities for your business jurisdiction.
You should know that if you misrepresent financial or legal information about your business in any of the representations and warranties, you risk being sued for fraud. Misrepresentation can occur when the buyer receives a business that is not what it was stated to be, or when the seller lies by omission about material facts. For example, if you know that 50% of your customers are likely to cancel their contracts next year, but the seller does not ask you about expected duration of contracts, you can still be sued if you keep that material information to yourself. Your potential legal exposure can be high, particularly if you have partners or shareholders who also feel shortchanged by the deal.
Rather than hide negative information about your business, discuss it openly with your broker, lawyers and accountants. Together, you can formulate a strategy to turn your weakness into a strength, instead of trying to hide it.
Safeguard Against Business Deterioration After Sale
If the seller has agreed to any earn-out provisions as part of the deal, you can increase the chances of the business hitting those targets by staying involved. You might choose to remain onboard as part of the management team or help in a consulting capacity.
While buyers may be wealthy and business-savvy, they may not be familiar with the nuances of your business and its model, and nobody knows a business as well as its founders. If you want the business to do well after you have sold it, educating the buyer after the sale about business operations, customer preferences, and managing employees can be an excellent financial investment. Professional buyers, such as private equity firms, might even demand that the seller remains in close contact for a given period of time as part of the agreement. It is in their interests as well as yours to ensure that new management is trained adequately and is able to take over the management of the business smoothly.
Staying involved in your business after you have sold it also reduces the chances of key employees leaving due to poor or changed management style of the new owners. If the purchase agreement included a warranty that the COO would stay for at least one year after the deal, but you are unsure how your COO will respond to new management, your continued involvement means that the buyer is less likely to be able to go after you for that indemnity provision. Alternatively, you can avoid these risks altogether by not stipulating that key staff will stay on as part of your agreement – assuming this is acceptable to the buyer.
After the sale, the control of the business is in the hands of the buyer. The buyer will run the business as they see fit and even though you may disagree with many of their decisions, you will have little actual power to influence them. If these decisions adversely affect the metrics that underlie any of your earn-out, you will suffer financially and emotionally. Therefore, you should safeguard against these events by minimizing the impact on you of the business’ post-sale performance.
Plan Wisely for the Proceeds of the Sale
The most important consideration from any sale is the cash you will receive. You should plan ahead to maximize your take home cash and invest it wisely. Take some time to reflect before spending the profits from the sale on impulsive purchases such as a vacation home. Here are points to keep in mind:
Involve a qualified financial advisor to figure out the best approach for mitigating capital gains and other taxes. For example, by valuing your company’s tangible assets at a higher price than its intangible ones, you can ensure that the bulk of the purchase is subject to sales tax, rather than capital gains tax. Sales taxes are normally the responsibility of the buyer.
Different jurisdictions have different approaches to income vs capital gains taxes. If you have an earn-out or if you are providing post-sale consulting services, you may be able to minimize your overall taxes by optimizing the allocation of funds to your ongoing services as opposed to the sale.
You might be able to reduce your tax burden via philanthropy.
Rather than frittering away the money on ostentatious luxuries such as a sailboat, speak to a financial advisor to come up with a long-term financial plan by saving for retirement, paying off mortgages or sending family members to university.
If your sale proceeds are substantial, it may be advantageous to set up a holding company or trust to help you manage and grow the money. The latter may also offer an excellent way to provide asset protection and inter-generational wealth transfer, while minimizing income, gift and estate taxes.
You can plan ahead by using some of the proceeds to start a new business.
If your net worth increases dramatically as a result of the sale, you will need to update your will and insurance to ensure they match your new circumstances.
Conclusion
A business sale is an important decision for an entrepreneur. You should approach it with proper preparation. Good traits you can cultivate when selling a business are honesty, assertiveness and thoroughness. At each stage of the negotiating process, summon up the courage to ask for terms that reduce your overall risk.
Successful entrepreneurs approach selling their business with honesty, unafraid to disclose sensitive business information to their lawyers and the buyers. Before they engage in the sale, they ensure that meticulous financial records for the business are available and they are ready to answer any questions about their business model, its drivers of revenue and risk. Prior to the sale, it is essential to hire a good law firm with experience in your sector, as well as a broker or investment banker to help you identify potential buyers.
Purchase agreements are long and complicated, requiring significant due diligence on the part of both buyer and seller. You will need to decide whether to sell your business’ assets or its stock. If the buyer cannot afford to pay for the whole price, the buyer may ask the seller to make a loan as part of the agreement. You will need to agree on indemnification and escrow provisions of the agreement in the event that any information you provide to the buyer is alleged to be misleading or fraudulent. Most buyers also ask for some form of non-compete agreement to prevent you from outcompeting them in a field in which you have deep knowledge.
After the transaction, it is common for sellers to remain involved with the business in some capacity to ensure that any earn-out targets are met and to ensure a smooth management transition. Finally, you should seek financial advice to minimise your tax burden and ensure that any proceeds arising from the sale are used and invested wisely.
