Thursday, August 02, 2007

The Offer to Buy a Business Depends on the Many Characteristics

In our Merger and Acquisition practice we try to prepare our business sellers for the multitude of different deal structures that they should expect from various buyers. We go through elements like cash at close, seller notes, earn outs, non-competes, escrow accounts, etc. More often than not our first time seller will actually put out his or her hand in a stop gesture and reply, "I only want the full price in cash at close." This article will discuss some of the selling company characteristics that directly effect both the selling price and the terms.

Selling Company Revenue Composition - This is a very important factor in determining how much a buyer will pay for your business and how much will be in cash at closing. If 80% of your annual revenue is a result of contractually recurring revenue, you can command both a premium price and a deal heavily weighted in cash at close. On the other hand, if you have little or no contractually recurring revenue and are heavily dependent on net new sales from new clients, your sale price will be far less and you will be expected to receive a significant portion based on a future performance earn out. Companies that can demonstrate historically repeatable revenue with long term clients will fall between the two extremes mentioned above.

Selling Company Management Depth - If every aspect of the company's business funnels through the two key partners who are close to retirement age and there is a huge gap in management depth and capabilities, this is risky to buyers. They are not inclined to write a big check to the owners only to have them walk out the door with their relationships and knowledge six months later. The more decentralized the customer and supplier relationships are and the more widely dispersed the intellectual property is, the higher the sale price and the higher the percentage of transaction value is at close. If it is all concentrated, the buyer will want the insurance of a transaction structure that pays over time based on future company performance.

Selling Company Customer Concentration - You can absolutely correlate purchase price and cash at close to this element. Let's say, for discussion purposes, that you had two identical companies in revenues, profits, profit margins, and EBITDA. Company A has no more than 5% of their revenue coming from a single customer. Company B has 40% of its revenues coming from four large blue chip accounts. Company A will sell for a 15-25% premium to Company B. Also Company B will command only 60 to 70 % of the cash at close that Company A commands. Customer Concentration is a big risk factor for a buyer that can not assume that the relationship dynamics will be the same once the principals leave.

Main Street versus B2B Company - Typically the issue of seller notes comes up with an individual buyer that has limited resources and is attempting to buy a main street type business with as much leverage as possible. Corporate buyers seldom utilize this vehicle.

Escrow Account Requirement - This is a portion of the purchase that is held by a third party Escrow Agent with instructions on how the funds can be released to the seller. These are typically required by a buyer where they perceive the risk of a future event such as product liability, a pollution issue, or an outstanding law suit. The funds are held for a period that could extend for several years if there are unresolved issues of this nature.

Professional Services type firm - Your company literally walks out the front door each evening. These may be consulting firms, accounting firms, executive recruiting firms, ad agencies, etc. Your producers have developed their book of business and their loyal account relationships. Your clients are customers of the company, but may be more loyal customers of their professional contact person. Sales transactions for this type of firm can involve a very heavy earn out component to protect the buyer from a mass exodus of clients because the professionals leave the firm post acquisition and take their clients with them. Non Compete Agreements - these are pretty much standard for prudent buyers buying a company and not wanting to defend themselves against the former owner who gets bored with retirement and decides to start a similar business. The seller should get some compensation for the agreement and the more restrictive the agreement, the higher the compensation.

Stock Sale versus Asset Sale - Most large corporations "have a policy" that they will only do asset acquisitions as opposed to buying the stock of a target company. There are some very good reasons to do this. When you do a stock purchase you get all the assets and all the liabilities both known and unknown. If you look at the reasons buyers have escrow accounts, many of the same reasons apply for wanting to do an asset acquisition. They simply are buying identified assets and the remaining corporate shell is still owned by the previous owner with all the liabilities not specifically identified in the asset purchase agreement.If the seller is a C-Corp, however, it is a major negative from a tax perspective to do an asset sale because the sale of assets is taxed as ordinary income at the corporate tax rate. The proceeds are taxed again at the owner's long term capital gain rate when the funds are distributed to him. For companies that do not have the escrow type potential liabilities, a stock sale may work. A buyer could successfully offer a significantly lower price with a stock purchase than a competitor requiring an asset purchase. The seller should analyze the two transactions from an after tax proceeds perspective to determine the superior offer.

If you are a business owner contemplating a business sale and you want the highest purchase price and the most cash at close, analyze your company based on the factors above. If you can implement changes that correct some of these risk factors you improve your odds of your best exit.

About the Author (HTML)Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, representing owners in the sale of privately held businesses. We provide Wall Street style investment banking services to lower mid market companies at a size appropriate fee structure.

Keywords: business selling price,letter of intent,cash at close,earnout payment,seller note,merger acquisition

FAQ's From Business Buyers

An area of great concern to our business selling clients as we help prepare them for a buyer visit is what questions the buyer is likely to ask. Below are a representative set of questions that we have encountered. This article will not provide you with the answers because they will vary with each business seller. However, we will provide a buyer motivation framework so that you can answer the questions with this common framework in mind.
Buyers want to eliminate as much risk as possible because an acquisition, by its very nature is a risky business decision. A buyer does not want to discover or be confronted with a bunch of Gotcha's after the check has cleared. As a seller, you must never convey the attitude of this place is falling apart and you can't wait to dump this dog. Your reasons for selling are very important and should focus on estate planning considerations, retirement and diversifying my assets or my favorite, we just do not have the resources to take advantage of all the market potential that we have created.
Another theme is that you want to convey how strong your staff is. You want to portray how the account relationships are managed by multiple staff members. You need to communicate just how widespread the intellectual property is dispersed among the staff. The owner has an easy job because the employees handle all of that.
Future potential and momentum are important. Make sure you can articulate the opportunities for growth that you have identified, and are either pursuing now or are planning to pursue if you had more resources. So keeping these themes in mind, be prepared to answer many of the following:

Why are you selling your business?

What are the last three year's net operating profits?

Who are your biggest competitors?

What are your industry ratios and trends?

What do you think I can do to increase sales and profits?

Why are you not doing to increase sales and profits?

Will you hold financing for the purchase of the business?

Will you be willing to stay with the business for a period of time after the sale?

Will you agree to a covenant not to compete?

Will the business sale include the transfer of real estate?

Don't you have children to transfer your business to?

Do you want a corporate stock sale or asset sale?

Who knows that the business is for sale?

Who will I be negotiating with?

What is your timetable for completing the business sale?

What do you do everyday?

Do you anticipate any problems with me getting credit from your suppliers

Do any of your suppliers represent more than 10% of your purchases? If yes, who are they?

What is it that you like best and least about the business?

What do you believe is the profile of the ideal buyer for this business?

What can be done to build the business?

How long will it take me to really learn this business?

How long can I count on you to train me after the sale.

What keeps you up at night about the business?

What are the details of the lease? How long? Any options? Do you anticipate any problems with the landlord assigning it to me or entering into a new lease?

How much vacation do you take (not that you're looking for time off…rather, you want to know if they have adequate staff that will allow you time away)

Are you the only owner?

Who are the employees? Any manager in place? Are there any employees that are critical to the business?

Are you willing to finance part of the purchase? If not, why?

Net revenue seemed to experience a huge decline last year versus previous years. What happened?

How much of the revenue is the owner responsible for?

How much of the revenue are the other business development people responsible for?

What are the titles and responsibilities of each of the employees? Please state how long each has been with the company and what they are being paid, and how they are being paid. If they have success-based compensation please let me know the actual for the past three years for each person.

What are their revenue production goals? Other goals?

What does their five-year plan look like going forward?

Why is the owner selling the business?

Can I see actual P&L statement for the last five years?

Is there one person in house today that would be interested in and capable of running the day-to-day operation while keeping up personal production and receiving an override and perhaps equity stake in the business?

Is the owner open to an acquisition plan that would be tied into continued success of the firm over the next five years?

Do the employees have non-compete agreements with the company? If so what is the nature of the non-compete? If not, why not?

Is the current owner willing to sign a non-compete agreement as part of the acquisition?
What is the owner's salary, bonus, fees, and commissions on an annual basis and over the last five years?

How much of the business are we likely to lose if the current owner retires or discontinues affiliation with the company? How would the owner propose to mitigate the loss for a new owner?

This list is by no means exhaustive and there may be questions that arise that are unique to your particular business or industry. However, if you can answer these questions with an awareness of the buyer's risk mitigation approach, your firm will be viewed as a better acquisition target. We are in no way suggesting that your answers are not truthful, we are just suggesting that you surround them with an attractive packaging. Any answers that are found to be inaccurate during the due diligence process will result in punitive adjustments to purchase value.

If you remember the old interview question, "What would you say is the biggest negative about your business approach?" Your positive answer was something like, "Well, I am so driven to be successful that I am sometimes impatient with people that do not share my same drive or capability." That's how we are suggesting you approach this. So for example, you have lost a few deals to XYZ Big Company. How will that impact the business going forward? Well, the competition from the XYZ Company is a good news bad news situation. The bad news is that they are a very tough competitor, but the good news is their attention to our space reinforces our view of the long term potential. How's that for positive?