Selling a Business

Your first question may be, “Just what is Corporate Social Responsibility (CSR)?” We see CSR demonstrated in a variety of ways in areas such as:

THE COMMUNITY:
o Contributing to local community programs through financial support and personal involvement

THE ENVIRONMENT:
o Using packaging and containers that are environmentally-friendly
o Recycling
o Using low-emission and high mileage vehicles where possible
o Seeking more efficient manufacturing processes, etc.

THE MARKETPLACE:
o Utilizing responsible advertising, public relations and business conduct
o Exercising fair treatment of suppliers/vendors, contractors and shareholder

THE WORKPLACE:
o Implementing fair and equitable treatment of employees
o Upholding workplace safety, equal opportunity employment and labor standards

Actions such as these not only uphold today’s business standards, but they also pave the way for future generations. In years past, many of these elements were considered almost anti-business and some had to be enforced by governmental regulation.

Successful companies such as Tom’s of Maine (producer of natural personal care products) and Newman’s Own have practically been built on CSR. More and more companies – public and private – are following the elements of CSR. Google is a desired workplace because of the way they treat their employees: great benefits, great food in the employee cafeteria, exercise equipment – you name it, Google provides it.

Recognizing CSR in today’s business climate not only increases shareholder/investor interest, but also increases value. Socially-conscious companies are considered sound investments.  They attract buyer interest and acquire higher selling prices when it comes time to sell. After all, most buyers want to find a business with the following attributes:

• Good relations with the local community
• Products and/or services that are meeting the current trends in the marketplace and are positioned to meet future trends
• Positive relations with employees and low-turn-over
• Excellent customer loyalty
• Good relationships with suppliers and vendors
• No “skeletons” in the company closet

In addition, good environmental practices reduce costs, create efficiencies and provide excellent public relations. Good employee relations make for happy workers, which translates to higher productivity and lower absenteeism. Good relationships with customers and suppliers eliminate, or greatly reduce, the possibility of legal entanglements.

All in all, Corporate Social Responsibility not only creates additional value and helps in creating a higher selling price when that time comes – it is also very good business for now and in the future.

Mass Mutual Life Insurance Company provided the following survey results based on family-owned businesses. Although the survey was conducted several years ago, the results are still quite revealing, and still applicable.

• Four out of five companies are still controlled by the founders.
• 30% of family-owned companies will change leadership within the next five years.
• 55% of companies fail to conduct regular valuations of the company.
• 55% of CEOs who are 61 or older have not chosen a successor.
• 13% of CEOs will never retire.
• 90% of businesses will continue as family owned.
• 85% of successor CEOs will be a family member.
• 20% of family owners have not completed any estate planning.
• 55% of family owners do not have a formal company valuation for estate tax estimates.
• 60% of businesses do not have a written strategic plan.
• 48% of companies rely on life insurance to cover estate taxes.

The above survey indicates that many family businesses are not optimizing their opportunities. Their insular approach to succession, leadership, planning, etc., indicates their vulnerability for the long term. These vulnerabilities suggest that many business owners should work with professional advisors to resolve these issues. A professional intermediary is an essential member of this advisor group.

New accounting rules may require that acquirers and acquiring companies report earnout agreements as liabilities.

Joel Johnson, president of Orchard Partners Inc., in his article, “Earnouts,” published by Valuation Strategies, states: “In a given year, 2% – 3% of announced mergers and acquisition agreements involve earnouts.  These figures probably understate their prevalence.  Earnouts tend to be a characteristic of smaller deals; and in many small deals, terms are not announced.  Earnouts are rare when public companies are acquired and more common when ownership is concentrated among a few shareholders.”

This would mean, if implemented, that earnout agreements must have a value placed on them for accounting purposes. As Joel Johnson points out, “The higher the earnout, the greater the liability.”

Why the Earnout?

Johnson further states that earnouts are used for various reasons:

1. to bridge the pricing gap between the seller who places a heavy emphasis on the company’s projections, and the buyer who places most of the company’s value on its present and past performance.
2. to tie the acquisition payout to future performance.
3. to create a form of seller financing in that some of the buyer’s purchase price is delayed into the future. 4. to establish a form of escrow account in that the money is paid on condition of meeting certain thresholds.
5. to act as a type of employment agreement in that the CEO has to stick around in order to collect.

The following are situations where the price was not the deciding issue in the successful sell of a business. The ultimate buyer may be the only one who really understands the situation. A business intermediary really understands the issues and can lead the buyer and seller to a successful resolution.

• One seller had 60 shareholders who needed to walk away from the deal.  The losing buyer wanted all selling shareholders to be accountable for the “reps and warranties.”  The winning buyer waived the reps and warranties at closing.

• A seller’s management team wanted some future upside in the deal.  The losing buyer offered all cash and normal compensation.  The winning buyer offered 80% cash, 20% stock plus 3-year earnout on revenues — including acquisitions.

• Time was of the essence.  The losing buyer needed 30 day due diligence and negotiations plus a 60-day window to close the deal.  The winning buyer offered to close within 40 days of the Letter of Intent and agreed to have limited due diligence.

A solid, factual and compelling offering memorandum maximizes the chances of not only selling a business, but obtaining the highest possible price.  An offering memorandum is also referred to as the selling memorandum, a confidential descriptive memorandum, or simply as “the book.” The memorandum, regardless of the terminology used, must be as factual as possible, but the Executive Summary portion of it allows for a bit of “selling the sizzle.”  Most potential buyers want to know the basics of the company and of the deal right at the beginning.  What is the proposed transaction and what are some of the company highlights?  The executive summary should also contain an outline of the ownership and management structure, a description of the business, some financial highlights, a quick review of the company’s products and/or services, its markets, reason for sale and any other major items of importance.

The executive summary, then, is a quick synopsis of the items covered in the offering memorandum that should entice a prospective buyer to study the offering memorandum itself.  Here are some critical elements of the offering memorandum:

• Executive Summary
• The Company
• History of the Company
• The Markets
• The Products
• Distribution
• Customers and/or Clients
• The Competition
• Management
• Real Estate
• Financials
• Growth Strategies
• Competitive Advantages
• Conclusion
• Exhibits

“The offering memorandum should not only be a compelling document in order to capture the reader’s attention, but it should be so thorough that one should expect the potential acquirer to submit a fairly tight price range for his or her initial offer.  In short, the best offering memorandums are complete but not too long, easy to read, believably professional and show that the company has an opportunity for growth.”
    Source: The Best of the M&A Today Newsletter

A January 2004 survey conducted by the DAK Group/Rutgers found the following breakdown of why businesses are for sale:

Reasons To Sell

• Risk reduction      44%
• Competition or market changes   41%
• External pressures     27%
• Lifestyle factors (age, health, etc.)   14%
• Lack of capital      9%
• Ownership/management issues  07%

Note: Multiple responses allowed;  Source: DAK Group/Rutgers

It is interesting to note that the top, by far, three reasons to sell are financial as is the fifth reason. The information furnished by much of the media suggests that the big reason to sell is generational – in other words, all of yesterday’s owners are now ready to retire.  According to the survey above, that motivation (included in “Lifestyle factors”) represents only 14 percent, and it  includes health and other personal issues.  The last reason, at 7 percent, might also include retirement since ownership/management could be involved with retirement issues.  Twenty-one percent of the respondents mentioned either lifestyle or ownership/management issues.  Placing these reasons at the top of the list does not justify the hype of the “baby-boomers” retiring over the next few years.

Shown, below, the reasons for considering an acquisition seem to be more obvious.  Although growth leads the list by a hefty margin, all of the other reasons could also be considered growth issues.

Reasons for Considering an Acquisition

• Growth   72%
• Acquire competitor  38%
• Product diversification 37%
• Geographic diversification 29%
• Technology   09%

Note: Multiple responses allowed;   Source: DAK Group/Rutger

Another important factor relating to the asking price is the amount of cash involved in the sale. There is an old saying that the higher the full-price, the lower the down payment – and vice-versa. The sale of almost any business involves some seller financing. The smaller the down payment, the higher likelihood of a quick sale. No seller wants to take back his or her business because the buyer wasn’t successful. On the other hand, a buyer wants to make sure that the business will not only pay for itself, but also provide sufficient income for his or her family’s needs.

What it all boils down to is that the seller wants the buyer to be successful and the buyer wants to buy a successful business. With the amount of capital required in today’s market to buy a business, sellers should feel optimistic that they are dealing with successful buyers.

A Valuable Service

Screening and qualifying buyer prospects is perhaps the business broker’s most valuable service. Business brokerage industry statistics indicate that over 90 percent of buyer prospects who call on business-for-sale ads are unqualified for some reason. The successful business broker survives by mastering qualifying and screening techniques!

Maintaining Confidentiality

Confidentiality is always a major concern. Sellers feel that maintaining confidentiality is important in safeguarding the current business. They don’t want the word to leak out to customers, suppliers, competitors – and especially the employees. This is an area where a business broker professional can be especially helpful. They use non-specific descriptions, screen and qualify buyers and require buyers to sign confidentiality agreements before showing businesses or providing specific information.

However, even under the best of circumstances, rumors can fly. There are basically two ways sellers can muffle the business-for-sale problem. The first is to explain that over the years there have been people who have inquired about whether the business might be for sale. These inquiries are unavoidable and they do happen.

The other way is to handle the matter directly and to explain that you have been considering retiring and now may be the right time. The employees, especially the key ones, should be told prior to putting the business on the market so they don’t hear the rumors second-hand. They should be told that they are very important to the business’s success and that a new owner would most likely be happy to retain them. When the sale is complete, they can be offered a bonus for helping in the process. Sellers should do whatever it takes to keep the employees from deserting the ship and keep them on deck to maintain business as usual. Once employees have been dealt with openly and fairly, they will understand that discretion will help protect their future.

The Future of the Business

Sellers may feel that they have built the platform for the future growth of the business. It is only natural for them to want to share in any extraordinary profits in what they feel they have helped create. Sometimes, if the price is low enough and it allows a buyer to purchase the business, he or she may be willing to provide some type of earn-out or royalty based on any substantial increase in sales. The professional business broker can offer advice on how to make this work for everyone. However, everyone has to agree that no one can predict the future. As mentioned earlier, the buyer is hoping to buy the future, but is not willing to pay for it.

What Buyers Think

Many buyers think that the business they buy should be able to pay for itself. They are wary of sellers who demand all cash. Is the seller really saying that the business can’t support any debt, or is he or she saying that the business isn’t any good and I want my cash out of it now, just in case?

Many business owners would like to receive all-cash for their business when selling. And yet they are often told that this is really not possible. Why? Most people are accustomed to financing just about everything – home, car, vacation home, even college for their children. The first question business brokers are often asked is, “How much money will I have to invest to buy that business?”

Seller financing is usually necessary because of the lack of outside financing available. Certainly, some is available, but less than 90 percent of small business sales receive outside financing when selling. If you are selling, you may be one of the few lucky ones, but the business better be absolutely perfect.

If a seller is not willing to finance the sale, many buyers suspect a problem. After all, a business should be able to pay for itself and provide a reasonable income for a buyer. A buyer then wants to know what is wrong with the business that the seller wants all cash?

Aside from this, even if a buyer has all of the necessary funds, he or she may want to spend their money on improving the business, adding equipment, building inventory, or just keep it for working capital.

Another similar issue that is raised by sellers is that, if they are willing to finance the sale, they want some outside collateral to secure the loan on their business. They want to make sure that they get all of their money – with no risk. Buyers are very sensitive about this issue. Again, they raise the point about the business being able to pay for itself. They may feel that the seller wants additional security because of concerns about the business’s ability to generate a reasonable profit. This is not a reassuring signal to the buyer. Most buyers are already using most of their capital for the down payment, and they generally are very reluctant about using their home or retirement funds for additional collateral.

The services of a business broker professional can usually provide guidance in the overall financing process. And financing is often the key to the successful selling of a business.

Structuring the purchase of a business is an issue that should be faced early in the selling decision. Ultimately, the final structure of the sale will be determined by actual negotiations between buyer and seller, but the seller must still answer the following questions:

• What is the lowest amount of cash acceptable from the sale?
• Has consideration been given to paying off all unsecured creditors and a portion of the closing costs? (Both are, in most cases, the seller’s responsibility.)
• Is there any long-term or secured debt that can be assumed by the buyer? (This may make more cash available to the seller.)
• What is an acceptable interest rate for the seller-financed sale?
• Will the business be able to service the debt and still provide a return acceptable to a buyer in relation to the down payment required? (This is a particularly important question for the seller to address.)
• What are the tax consequences of the sale?

Recent studies indicate that the more favorable the terms, the higher the price. In fact, one study found that offering favorable terms might increase the total selling price by 30 percent. A business broker professional can advise you on the all-important issue of seller financing.

The professional business broker is a good source for assistance in structuring the sale of a business. Although they are not able to provide legal advice, business brokers are the experts of preference when the arena is the business marketplace. Brokers will use their knowledge of previous sales, current market conditions, and outside financing strategies, if applicable or available.

A business generally represents a seller’s largest financial asset. How the sale is structured may mean the difference between the success or failure of the transaction. The best sale structuring will result in the best deal possible for both buyer and seller. A business broker can be the key player in accomplishing this goal.

In the practical sense, when selling a business, goodwill is all the hard work and effort the seller has put into the business over the years. When acquiring a business, goodwill is the difference between the tangible assets and the purchase price.

Goodwill value should not be confused with going-concern value. There is a big difference. One leading business appraiser has defined going-concern value as, “The premise that a business will continue to operate consistent with its intended purpose as opposed to being liquidated.” In other words, the value of a business for just being in business is the going-concern value. It has nothing to do with whether the business is profitable, “on its last legs,” or merely breaking even. Essentially, if the doors are open, a business is a going concern.

Most business owners view goodwill as good service, products and reputation. One dictionary defines Goodwill as, “A desire for the well-being of others; the pleasant feeling or relationship between a business and its customers.”

The M&A Dictionary defines goodwill as: “An intangible fixed asset that is carried as an asset on the balance sheet, such as a recognizable company or product name or strong reputation. When one company pays more than the net book value for another, the former is typically paying for goodwill. Goodwill is often viewed as an approximation of the value of a company’s brand names, reputation, or long-term relationships that cannot otherwise be represented financially.”

Some Examples of Goodwill Items

• Phantom Assets
• Local Economy
• Industry Ratios
• Custom-Built Factory
• Management
• Loyal Customer Base
• Supplier List
• Reputation
• Delivery Systems
• Location
• Experienced Design Staff
• Growing Industry
• Recession Resistant Industry
• Low Employee Turnover
• Skilled Employees
• Trade Secrets
• Licenses
• Mailing List
• Royalty Agreements
• Tooling
• Technologically Advanced Equipment
• Advertising Campaigns
• Advertising Materials
• Backlog
• Computer Databases
• Computer Designs
• Contracts
• Copyrights
• Credit Files
• Distributorships
• Engineering Drawings
• Favorable Financing
• Franchises
• Government Programs
• Know-How
• Training Procedures
• Proprietary Designs
• Systems and Procedures
• Trademarks
• Employee Manual
• Location
• Name Recognition

What goodwill is and how it is represented on a company’s financial statements are two different issues. For example: until recently, if a company sold for $5 million, but only had $1 million in tangible assets, the balance of $4 million was considered goodwill. Under previous accounting standards, this goodwill had to be amortized by the acquirer over a 15-year period. This especially affected public companies, since an acquisition could negatively impact earnings, thus reducing the price of its stock. One result of this was that public companies were reluctant to acquire firms in which goodwill was a large part of the purchase price. On the other hand, purchasers of non-public firms received a tax break because of the amortization.

The accounting profession recently took another look at goodwill and changed the way goodwill is handled. The reason for this was to bring accounting into today’s business world. For years, companies were built around hard assets such as heavy equipment and machinery. Many of today’s industrial giants are not really industrial at all. They are built around intangible assets such as patents, brand names, intellectual property, etc. – basically what are considered goodwill items. These businesses don’t have huge factories full of workers on assembly lines.

Some new rules or standards were created by the Federal Accounting Standards Board (FASB) and implemented on July 1, 2001. Under this change, goodwill may not have to be written off (unless it is carried at a value in excess of its real value). However, the standards now require that companies, both private and public, have their intangible assets, including goodwill, valued by an outside expert on an annual basis. The rules basically define the difference between goodwill and other intangible assets and how they are to be treated from an accounting and tax reporting standpoint. How they are treated can impact the bottom line and have tax consequences. Also, completely identifying the items that may have been combined into goodwill and establishing separate values may increase the true intangible asset basis.

The upshot of all this is that the meaning of goodwill just got more complicated. Here’s a simplification: prior to acquiring a company or placing your business on the market, you should definitely consult your accounting professional. Goodwill may still represent the hard work and effort the seller has put into his or her business over the years — it just has to be accounted for differently and in more detail.