THE ARM'S LENGTH SALE
The previous article examined the issues and problems encountered in carrying out the sale or transfer of the family business to other family members. It cited the rule of thumb that the effectiveness of a succession plan increased the more the plan mirrored an arm’s length sale.
When the sale or transfer of a business to other family members is ruled out, or is judged uncertain, it is important to begin planning for the possible sale of the business to arm’s length parties. We believe this to be an important excercise for all business owners, not just those who may have an immediate interest in selling.
In essence the sale of a privately-held business consists of three distinct phases: the Decision to Sell; Planning the Sale; and Negotiations & Documentation.
The Decision to Sell
The sale of a Company is often a difficult and confusing process for owner’s of privately-held businesses. Most owner’s have never sold a business before and consequently have difficulty separating the pragmatic decision making role from the emotional aspects of a sale. As a result owner’s often turn to their advisors for assistance and counsel througout the divestiture process.
The reasons why business owners sell their companies are as varied and diverse as the participants involved. It is absolutely essential that the vendor determine exactly what it is that he wishes to accomplish in the long term and how a sale will assist in the realization of his goals. Within this process of self examination the following questions need to be considered:
- why do you want to sell at this time?
- are there methods other than a sale that will allow you to accomplish your objectives?
- what are your expectations with respect to price?
- what impact will the attempt to sell have on the employees and the business?
- have the tax costs been considered?
- is the timing right for the sale?
- where will the net proceeds be invested and what return is anticipated?
- how will the return on the proceeds from the sale compare with what the business is generating?
- if required to remain in a management postion, can you adjust to the role of reporting to someome?
- have all the implications for the family been considered?
- are you prepared to give up the prestige of being an owner/operator/president?
Only after thoroughly examining these questions can the vendor come to terms with the decision of whether or not he really wants to sell. Often, business owners will approach the selling process with the attitude that they will sell if the ‘price is right’. Our experience is that owners with this attitude are likely to find reasons to back away once the reality of a sale sinks in, often with damaging results. While price is clearly a key issue in the decision to sell it should not be a major stumbling block to a vendor who is committed to a sale. In almost every situation, creativity can overcome price discrepancies if the vendor truly wants to sell.
Planning for the Sale
i) Internal Assessment
Having determined that an arm’s length sale will be pursued, a vendor should ensure that the business being sold is in a condition which will maximize its saleability and, therefore, the price received. To this end the vendor should begin by assessing the company’s strengths and weaknesses. This is commonly accomplished through an assessment of factors that are internal to the business, such as information and operating systems, management structure, financial statements and so on. As a result of such analysis vendors will typically face a strategic decision regarding the merits of investing in upgrades in an effort to improve liquidity and price.
Often, vendors attempt to minimize costs in the short term prior to the sale of a business so that income is maximized. This strategy would appear to be founded in the belief that a purchaser will fail to detect such manoeuvres and will fail to take the shortcomings into account in the valuation of the target company. In most cases the vendor will lose as a result of significant discounting of the price to compensate for the business’ shortcomings. We strongly believe that no strategy should ever be based upon an assumption that the purchaser will not adequately perforn its due diligence. Experience indicates that the sale of a strong company will reap benefits in excess of the costs of the development of same.
Prevailing conditions with respect to interest rates, economic growth, industry specific developments and so on must be assessed in light of the timing of the sale. The demand for specific companies tends to be cyclical. For an owner with a short-term horizon this can lead to problems. Often weak industry conditions will motivate the vendor to exit the business at the worst possible time. Timing is essential to realizing the best price for a given business. An owner must view a sale as a part of the natural evolution of the business. As such the owner must be in a position to sell when industry economics indicate that the market will pay appropriately for the business.
iii) Identification of Buyers
One of the objectives of the vendor in any business sale is the maximization of his selling price. In order to achieve this the logical buyers should be identified and ranked in order of their likely interest in the acquisition in relation to their ability to actually purchase the business. This list should include companies with apparent strategic and/or organizational fit, known industry acquirers and companies that have previously expressed interest. Having compiled this listing the vendor should attempt to identify and value the potential benefits which might accrue to each purchaser. Armed with this knowledge the vendor will be in a better position to negotiate a price which reflects the value of these benefits.
iv) Pricing Strategies
Pricing methodologies such as the discounted cash flow or capitalization of earnings approach may materially misstate the price of a business to the extent that they do not incorporate premiums related to purchaser synergies or market liquidity. From the purchaser’s point of view pricing a business requires that the net economic value added of an acquisition be assessed, quantified and included in the pricing equation. The vendor’s objective is to maximize the value realized by negotiating a price which fully reflects the net economic value to the purchaser. The extent to which the price approaches the full price is primarily a function of liquidity of the business and the relative negotiating strengths of the parties involved.
Inevitably one of the first questions posed by prospective purchasers is for the asking price for the business. The appropriate response can only be determined with reference to the business itself and the vendor’s objectives. The minimum and asking prices should only be set after a thorough review of the industry, the probable purchasers and all sale transactions involving similar companies.
Owners are often reluctant to disclose a minimum price, even to their advisors, for fear that it will have a downward influence on price negotiations. If advisors do not have a clear understanding of the objectives of the vendor, it will be difficult for them to assess and alter, as required, the strategy during negotiations.
The need to disclose an asking price is really a function of liquidity. If the demand for a business is high, an asking price should not be disclosed. Rather, it is in the vendors’s best interest to attempt to create a bidding situation. Alternatively, if demand is judged to be low the vendor may have no choice but to reveal an asking price. Establishing a minimum acceptable price requires evaluating and integrating a number of factors with as much market data as possible. Ultimately the structuring of the transaction will have a major bearing on the price realized.
In determining a strategy for structuring the transaction, the vendor should first consider the following questions:
- will the transaction be consummated as a sale of shares or assets? Vendors need to recognize the different tax and legal implications of these forms of business sales prior to entering into discussions;
- what forms of consideration is the vendor willing to accept (ie cash only, cash plus shares or debt?). Generally, the smaller the cash component the greater the risk to the vendor;
- would an earn-out be acceptable as a portion of the purchase price? On what basis? While complex and risky, earn-outs will allow a more aggressive pricing strategy to be formulated;
- is the owner willing to remain active in the business following the sale? Purchasers will often attempt to offer part of the purchase price through management contracts. Prior to making unrealistic commitments the vendor must assess the related tax implications and whether he will be able to adjust to the new environment.
Creativity in structuring a transaction is one of the most important aspects of selling a business. The type of structure used to carry out the sale of a business is inextricably linked to the price realized. There are a multitude of ways in which a transaction may be structured, each with a corresponding impact on risk and value. Realistically, price can only be addressed in light of the types of representations and warranties the vendor is prepared to offer, the form of consideration (all cash, vendor take-back, earn-out, stock), the management commitment required subsequent to the transfer of ownership and so on. It is because of this interdependence that detailed discussion of price should not be undertaken until the latter stages of negotiation. Price should only be viewed in an overall context. The bargaining stance on certain issues during negotiations is a function of how close the vendor is to accomplishing the overall objectives.
Information Packaging and Confidentiality
One of the key dilemmas facing a business owner contemplating a sale lies in the prospect of having to disclose confidential information concerning the company’s operations. A fundamental strategic decision which must be made early in the sale process involves the extent to which the market will be canvassed for purchasers. The scope of the search and the distribution of information is really a risk/reward assessment which should be made having regard to the particulars of the business, the vendor’s priorities, and his knowledge of the market and the logical buyers.
At the outset, the vendor should recognize that it will be very difficult to maintain a veil of secrecy over the fact that the sale of the business is being contemplated. Recognizing the seemingly unavoidable effects of the ‘jungle telegraph’ will allow the vendor to make plans to deal with the concerns of employees and suppliers as news of a sale makes its way through the community.
If direct competitors are to be approached in the process it is important to be particularly cautious in evaluating the likely sincerity of their interest. Before sharing information with a competitor the following questions should be considered:
- could they afford to make an acquisition?
- based on your competitive relationship, would you rely on them to behave ethically if invited to bid?
- what advantages would the acquisition bestow upon them? Can these be quantified and can rules of thumb be applied that would allow you to estimate the price they may be willing to pay?
- do they have a history of acquisitions? If yes, is it possible to discuss their behaviour with other vendors?
In a typical sale, preparation of two information documents is usually required. The first sets out a variety of summary qualitative and quantitative information about the company. First and foremost this is a selling document. What the vendor is selling is the company’s future profitability. Therefore the emphasis should be on where the company has been, where it currently is, where it will be and how it will get there. The second package will contain more detailed historic and prospective information and will only be provided to those purchasers who are acceptable to the vendor and who express a serious interest in acquiring the company following review of the first package. No confidential information, regardless of the level of detail, should be released prior to the receipt of a signed confidentiality agreement.
Negotiations and Documentation
All transactions for privately-held businesses involve intense negotiations in an unstructured forum. As a preamble to negotiations it is important that all parties have a clear understanding of the major issues to be resolved, of which price is only one. It is our belief that price should be one of the final items to be negotiated rather than the first, though general agreement as to a likely range of prices should be established prior to the performance of a detailed review. This is because price is contingent on numerous variables, many of which cant be anticipated at the outset.
A useful starting point for negotiations is often the letter of intent. If used properly it can be a highly effective tool in the negotiation process. The purpose of a letter of intent is to identify and record those terms that both parties have already been agreed upon so that attention may be focused on outstanding details.
The letter of intent should not be considered as part of the legal process. Rather, it should be seen as an instrument that will influence the parties to live up to their moral commitments. It is important that the letter of intent clearly spell out its intended nature and contain explicit provisions to indicate the intention of the parties that it does not constitute a legally binding agreement. However, there is nothing to prevent the parties from identifying specific issues that they wish to treat in a binding manner such as confidentiality, exclusivity of dealings and responsibility for expenses.
Once negotiations have reached the stage where it is evident that there is the basis for a transaction, an Agreement of Purchase and Sale will be prepared. At a minimum this agreement must answer four basic questions: who, what, for how much and when. In addition most agreements will contain express warranties given by the seller, covenants as to matters to be performed or observed by the seller during the period between signing and closing and conditions which, if not fulfilled, will permit one or the other of the parties to refuse to close the transaction.
Understanding the goals and objectives of each party is an important ingredient for a succesful resolution of different perceptions or points of view. The better one understands the requirements of all participants the more opportunity there will be to find creative solutions to the inevitable differences that will arise.
Unlike planning for the succession of the business to a family member, an arm’s length sale implies a degree of finality that should not be underestimated. The decision to sell should be undertaken as part of the business owners long term plan. As such, steps must be taken years in advance to prepare emotionally and strategically for what is often a very rigorous process.