Tuesday, July 17, 2007

Selling Your Business – Groom or Hire Your Successor

One of the exciting aspects of being involved in Mergers and Acquisitions is that we are constantly learning. One of our most productive classrooms is the buyer visit. In those visits the buyer's motivations, priorities, concerns, and value drivers and value detractors are often revealed.

This was the case in one recent buyer visit with our client. Her Firm is representative of many early baby boomer led firms that "started the business in their garage" (actually it was started in her living room) 25 years ago and built a successful business with an excellent brand and customer loyalty. She is now looking to exit her business and reap the rewards from her hard work in the form of a generous buy out offer.

The potential buyer is a business owner that started a similar firm at about the same time, but has morphed into part business owner and part private equity investor. He brings a unique perspective of analyzing this acquisition wearing two hats – one as a strategic industry buyer and the second as a disciplined financial buyer. It was quite instructive to watch the dual motivations at play during the visit.

While wearing his industry buyer hat, he was quite excited about the synergies of the two companies, the growth potential, and the new vertical market that the combined firm could capture. While wearing his private equity investor hat, however, that excitement was dampened by the risk that our owner had created with her company. The owner and her top producer directly touch 70% of the company's revenues. They are the face of the company. They are the "brand". They are also in retirement mind set and have not groomed a capable successor internally.

Even though we have coached our clients with the "We will stay on for a period of time to transition our relationships and transfer the intellectual capital" speech, the buyer perceives huge risk. Quite frankly, I completely agree with his thinking. As this issue was explored, it became evident that this factor would negatively impact both the transaction value and the deal structure. Translation – a discounted purchase price and much of that price deferred in the form of a multi-year earn out payment.

The good news was the buyer's strategic side recognized the value of the new vertical market our client's company would allow him to enter in full stride. He also recognized, because our client was represented by an investment banker, that there will be other buyers competing for this prize. The buyer came up with a very creative approach. Because this new vertical market is so strategic to him and recognizing the lack of management depth in the target company, he had initiated discussions with two individuals that were high caliber executives from the new vertical.

The buyer laid out his plan to our clients and asked permission to introduce this potential acquisition to the two candidates as a simultaneous acquisition and hiring scenario. Our client is very concerned about confidentiality and pushed back. The buyer then countered with two purchase platforms – one with the new hire as successor and one without. The one with the new hire was far superior in terms of both total transaction value and in the percentage of that value that would be paid at closing versus paid as and earn out.
After some discussion with our client and a review of the financial implications, we agreed to the buyer's plan to introduce this opportunity to his two candidates with the execution by them of a confidentiality agreement.

This dramatic contrast in transaction value and terms really helped quantify and crystallize what we have intuitively known for many years. To use the words of Curley from The Three Stooges, "If you want to catch a mouse, you have to think like a mouse." Our translation is, "If you want to sell your company for maximum value, you have to think like a buyer."

The lack of an internal successor, the lack of management depth, the concentration of account relationships and intellectual capital into one or two key people that are likely to leave shortly after a transaction will result in at best, huge discounts in your company selling price and at worst, will make your company a non-viable acquisition target.

Contrast this current situation to a client that we represented a few years back and you will understand our advice. The previous owner client recognized that he was going to sell his company two years prior to the event. He started grooming an internal successor, giving up most of his own direct involvement. When he was satisfied that this transition was operating smoothly, he fired himself as president and promoted his protegee into that position. He allowed the company to operate successfully in this mode for one year and then engaged us to sell his company. The results were as planned – no worries about post transaction client or employee defections and no discounts on the business selling price.

Our advice to business sellers is to begin your business exit process well in advance of your exit. Give up your natural tendency to be involved in every aspect of your business. Relinquish control, delegate, develop your staff. Promote your successor into day-to-day responsibility. If you do not have a capable internal candidate, go out and hire one. Your added expense will be more than offset and rewarded with a much higher business selling price.

Dave Kauppi is a Merger and Acquisition Advisor with Mid Market Capital, Inc. MMC is a private investment banking and business broker firm specializing in providing corporate finance and business intermediary services to entrepreneurs and middle market corporate clients in a variety of industries. The firm counsels clients in the areas of M&A and divestiture, family business succession planning, valuations, minority interest shareholder sales, business sales and business acquisition. Dave is a Certified Business Intermediary (CBI), a licensed business broker, and a member of IBBA (International Business Brokers Association) and the MBBI (Midwest Business Brokers and Intermediaries). Contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page http://www.midmarkcap.com/

Tuesday, July 10, 2007

Tax Tips on a C Corp Asset Sale

First, unless you are planning on going public or have hundreds of stockholders do not form a C Corp to begin with. Use an S Corp or an LLC. If you currently are a C Corp ask your attorney or tax advisor about converting to an S Corp. If you sell your company within a 10 year period of converting to an S Corp the sale can be taxed as if you were still a C Corp.

Here is what happens when there is an asset sale of a C Corp. The assets that are sold are compared to their depreciated basis and the difference is treated as ordinary income to the C Corp. Any good will is a 100% gain and again is treated as ordinary income. This new found income drives up your corporate tax rate, often to the maximum rate of around 34%. You are not done yet. The corporation pays this tax bill and then there is a distribution of the remaining funds to the shareholders. They are taxed a second time at their long term capital gains rate.

Compare this to a C Corp stock sale. The stock is sold and there is no tax to the corporation. The distribution is made to the shareholders and they pay only their long term capital gain on the change in value over their basis. The difference can be hundreds of thousands of dollars.

Secondly, keep all assets that may appreciate in value outside the C Corp and in an LLC. Your real estate, patents, intellectual property, etc. should be held in a pass through entity so you avoid the potential high C Corp corporate tax rate and the double taxation if you do an asset sale.

Let's say that you are a C Corp and the buyer refuses to do a stock sale. If you can get the buyer to move as much of the transaction value to a covenant not to compete, you will be much better off. That will be taxed to you personally at the long term capital gains rate and not the corporate tax rate and the gain can be spread out over the non-compete period.

Another approach you can use is "Personal Good Will". This is where the seller's reputation, expertise, and relationships are in effect separated from the assets of the company and account for as much of the good will value as possible from the business. So let's say that the company sells for $8 million dollars and the amount allocated to the hard assets is $6 million. That leaves $2 million that can be classified as good will. If that good will is assigned to the C Corp, it will be taxed at the 34% rate and then taxed again when it is distributed to the shareholders at 15%.

If you can move that amount to personal goodwill for the owner, it is paid directly to him and he gets taxed at the 15% rate only. The calculation looks like this: If the good will is $2 million and is allocated to the C Corp. They pay $680,000 in corporate income taxes. The $1,320,000 remaining gets distributed to the shareholders and an additional 15% tax is paid or $198,000 for a total tax on that $2 million of $878,000. Moving it all to personal goodwill results in a total tax on that $2 million of $300,000, a savings of $578,000. This approach was pioneered in a classic IRS case called the Martin Ice Cream Case.

There is a built in bias on the part of buyers with the advice of their attorneys to avoid doing stock sales because you buy everything including any hidden liabilities. You as the seller want to convince the buyer to do a stock sale by demonstrating that there are no hidden liabilities. Another argument you can use is that most contracts are not assignable without the consent of the other party. In an asset sale it could be problematic to get assignments of a large quantity of contracts. An example is if your company is in a favorable long-term property lease the landlord will never agree to an assignment of that lease. If you have a long-term contract with a government entity, a change in ownership can trigger a contract end. In a stock sale these are not issues.

There are many variables in a business sale negotiation. Price, Cash at close, Stock versus Asset Sale, and allocation of purchase price. The IRS does not allow the buyer's allocation of purchase price to be different than the seller's. It also must be noted that from a tax standpoint, something favorable for the seller is correspondingly less favorable for the buyer. An experienced buyer will structure the deal in the most favorable way for himself. Sellers must get good advisors to help them negotiate to achieve the maximum after tax proceeds.