TIMING IT RIGHT:
PRACTICAL CONSIDERATIONS IN SELLING YOUR BUSINESS
The sale of a privately-held business is rarely a simple matter. A vendor who wishes to maximize his or her success in what ultimately may be the most important business transaction of their lives must possess, or, more realistically, have access to a wide range of capabilities incorporating, among other things, strong technical expertise combined with sound "business sense," extensive transaction experience, integrity, and reasoned flexibility.
This article has been written for every business owner who, of their own initiative or otherwise, will eventually have to deal with the choices involved in selling a privately-held business. We recognize that any given time, only a small segment of business owners are actively contemplating a sale of their business. However, the recommendations made herein will position an owner to maximize the proceeds of a sale.
The commentary contained here is based on our first-hand experience gained from close to two decades of advising owners of privately-held businesses throughout Canada on matters related to business valuations, sales and acquisitions. It is our belief that a more disciplined, strategic approach to mid-market business sales will ultimately benefit all participants. It is our hope that this article will directly influence you to realize a profitable and orderly transfer of ownership.
CALCAP CORPORATE FINANCE LIMITED
PREPARING FOR SALE
You have spent the last two or three decades building your business and now you are considering an exit strategy. Or perhaps you are an entrepreneur who, having successfully established one business, is yearning to rechannel your creative talents and energies into a new one. Or maybe you have no immediate intention of selling your business but recognize the importance of planning now to maximize your success later. Regardless of your circumstances, a common feature that you share with every owner of a privately-held business is the need, at some point, to confront the issues surrounding a transfer of ownership. Depending on your degree of preparation and the quality/depth of expertise and experience upon which you are able to draw, selling your business will fall somewhere between being the fulfillment of your financial goals and one of the more trying emotionally draining experiences of your life.
In contrast with publicly-traded companies, privately-held business rarely enjoy the benefit of a readily available market into which their shares can be sold. As a result, the successful sale of a privately-held company requires that an owner and/or his advisors effectively "make a market" for the business under consideration. This involves bringing a number of talents and specialized skills to bear on a given business sale situation, including:
in such disciplines as financial analysis, business valuation/pricing, computer modeling, income taxes, and commercial law,
Network of Contacts
comprised of both principals and advisors, to provide a base for an efficient search, focused on legitimate purchasers,
Transaction Structuring Skills
Knowledge of Recent Transactions
Understanding of the Sale Process
including what information should be disclosed at various points throughout the process, what constitutes reasonable purchaser requests and what does not, and where concessions are likely to be required, and
Integrity and Professionalism
It has become evident to us through our practice that business owners have difficulty separating the pragmatic decision-making requirements essential for a successful sale from the emotional conflicts that often arise. The transfer of ownership (to a family member or to an outside party) is part of the natural evolution of a business. The strategy you adopt in preparing for a sale and during the process itself will be a key factor in maximizing your proceeds.
The decision to sell is a difficult one to make. Once the transaction closes, the decision cannot be reversed. Therefore, it is important to appreciate, from the outset, the implications of selling your business. Some of the questions that an owner should address prior to making the decision to market the business include:
It is only after basic questions such as these have been considered that one can realistically plan the sale of a business. While it my sound obvious, the initial decision to sell may be the most important and fundamental decision that an owner will have to make throughout the entire process.
THE SALE PROCESS
Business owners who possess only a partial understanding of the sale process often damage their negotiating positions by failing to perceive their alternatives. Submitting to unreasonable purchaser demands without realizing what may constitute an adequate response in each case often causes irreparable harm to the vendor’s position. An appreciation of the sale process, which typically involves packaging the business, a search for buyers, considerations regarding confidentiality, and disclosure strategy, will help avoid this problem.
Preparing an information package is a critical component of a successful sale. It must contain enough information to allow prospective purchasers to gauge their level of interest in pursuing the opportunity – including an assessment of price – while at the same time stopping short of revealing competitive information that could be harmful if a sale does not occur. It is the first impression. The clarity, completeness, and focus of the document is important.
Two information packages are often prepared. The first discloses important qualitative and quantitative information such as the history of the company, its products/services, markets, competitors, customer base, facilities, employees, management, future prospects, etc. Summarized historic financial results and forecasts are also included. The second package contains a greater level of historic and prospective financial/operating information. It is only provided to those acceptable potential purchasers (as determined by you and your advisors) who express serious interest and are likely to close a transaction.
The depth of information provided in these packages varies with the circumstances and depends, in part, on the liquidity in the marketplace. An effectively prepared information package attracts buyers by presenting the business in its best `go forward’ light. Information presented should reflect reasonable, realistic opportunities, not unattainable heights which bear little relation to economic reality. This, coupled with a professional presentation, ensures that a buyer has a complete understanding of the advantages and the opportunities associated with the acquisition of your business.
The importance of understanding the market for your business – who the logical buyers are and why – is a key factor in maximizing price. If all of the special buyers are not obvious, as is often the case, a search must be conducted to highlight potential purchasers. This is one of the areas in which an advisor’s market expertise and network of buyer contacts adds value to the process. As the list of prospective acquirers is being assembled, the motives of each must be assessed. Why would each be interested? What are the strategic fits? Where are the synergies and/or growth opportunities? The answers to questions such as these may translate into receiving a premium purchase price. The more detailed the analysis and understanding, the better the negotiating position and in all likelihood the higher the price. The unique ability to assess and quantify synergistic benefits should result in achieving the highest possible selling price.
No corporate information, regardless of its level of detail or the persistence of a potential purchaser, is released prior to the receipt of a signed confidentiality agreement. Although they are normally valid legal documents, confidentiality agreements tend to be used primarily as an indication of a purchaser’s good faith.
Disclosure to employees and other parties about the sale or potential sale of the business should be planned and discussed in advance. As the process proceeds to a conclusion, however, it becomes increasingly difficult to keep the process confidential. Each situation is unique. Repercussions from following the inappropriate course could be significant, varying from damaging employee morale to the erosion of your customer base.
The success of the process outlined above will be influenced by, more than anything else, your commitment to sell. The chance of consummating a sale will be enhanced if your selling process is based on a carefully conceived strategy.
PRICING YOUR BUSINESS
Establishing a realistic price for a privately-held business is one of the more difficult aspects of the sale process. While it is your right to maximize the selling price, unrealistically high price expectations discourage legitimate purchasers from acting. Alternatively, if expectations are too low, money will be left on the table.
Although determining a price is a detailed process, the following points summarize the important factors in coming to a conclusion.
Price is not cast in stone
Price can change dramatically over a relatively short period of time with changing market conditions and economic circumstances. Consequently, it is important to have an up-to-date perspective on current trends in transaction prices and the reasons therefor.
Price is largely a function of the ability to negotiate the purchaser into paying for at least a portion of the incremental net benefits expected subsequent to an acquisition
In pricing your business, purchasers take two components into account: your stand-alone results, and the value of the perceived `synergies’ with the purchaser’s own operations. It is the synergy component that ultimately determines the price range. Thus, it is critical to analyze the logical buyers for your business and identify their post-acquisition expectations. While it is generally easier for a purchaser to quantify the perceived synergies, it is critical that you and your advisors also attempt to isolate and quantify such opportunities. Such analysis requires a detailed review of the purchaser’s operations, the preparation of pro-forma cash flow statements to which various sensitivity analyses can be applied, accumulation of financial data of the purchaser, and a strategic plan for the negotiations. As expected, considerable investment of time and effort is required for this analysis; however, neglect in this regard will result in a material difference in the net proceeds generated from the sale.
There may be several purchasers interested in your business, some of whom may be willing to pay substantially more than others
To maximize price, seek out and negotiate with a number of buyers, attempting to understand the economic rationale underlying the interest of each. Limiting the negotiations to one party will likely shift the advantage to the purchaser.
Liquidity – that is, the number of legitimate purchasers that exist for your business at a given time – is the single most important factor influencing the price you can expect to receive
This factor can change very quickly, significantly affecting price as it does. Knowledge of the market, its trends, and players in the market are important in assessing liquidity. It must not be ignored.
Price can only be assessed relative to how it will be paid
A given price must be assessed on a present value, after-tax basis with probability factors attributed to the likely realization of the various forms of payment. An all-cash price is substantially different from a cash plus vendor take-back or earn-out price. All transactions must be viewed from a wholly cash equivalent basis.
Price, in large measure, is a function of strategy
Issues such as the number of potential purchasers to deal with and the nature of the consideration you are prepared to accept will impact upon your assessment of the adequacy of price. As each step in the process is interdependent, the strategy adopted up front will impact directly on the net proceeds ultimately received.
Every set of negotiations is unique. Although there are several principals fundamental to the art of negotiation, the critical element in all sessions is the ability to read the flow of discussions, respond quickly, and be creative throughout the process. The negotiating abilities of the various parties to the discussions contribute significantly to the overall process. This can only be achieved through innovation and experience of the members of the team.
A basic principal to every set of negotiations is that the ultimate goal be a realistic one. A vendor attempting to "score the big win" at the table runs the serious risk of losing a legitimate buyer and jeopardizing the chances for a sale. Similarly, a purchaser who attempts to `win’ at the negotiating table inevitably loses during integration as the vendor attempts to retrieve what was lost at the table (assuming that he continues in a management capacity).
Preparation is also critical to successful negotiations. Understanding the purchaser’s reasons for being at the table is necessary to assess the importance of each issue, where compromise is possible, and what the true `deal breakers’ are, if any, for each side.
While most negotiations cover a vast array of issues, many of which are unique to the particular situation and thus call for "tailor-made" responses, the broad issues of consideration, continuity, representations/warranties, and price are common to every set of discussions.
A purchase price can be satisfied by a variety of instruments, ranging from cash to vendor take-backs (e.g., notes, earn-outs, shares) with varying degrees of risk. Usually, payment is satisfied through some combination of the above. Assessing the adequacy of the consideration is somewhat subjective, however, it is tied directly to price expectations. Confidence in the purchaser’s ability to successfully operate your business following the transfer of ownership, the mix of different forms of consideration relative to the total purchase price, the estimated after-tax cash equivalent of the package taken as a whole, and the guarantees provided by the purchaser all contribute to the decision to accept the offer or negotiate further.
Another form of consideration frequently encountered in private company transactions are earn-outs. An earn-out is a type of vendor take-back where the payment is tied to future performance targets. One of their main functions, other than providing financing for the purchaser, is to provide ongoing motivation to vendor management following a sale. The performance targets are usually based on some measure of the vendor company’s profitability, although any agreed upon measure can be used. On a practical basis, the control and measurement of the earn-out criteria is often difficult. Earn-outs require considerable skill to negotiate advantageously.
In many private company transactions, a purchaser may not have the management expertise to operate the newly acquired business immediately. Remaining with the business in a management capacity consequently may be an important condition of sale. Depending on the initial reasons for selling, this may or may not be an acceptable condition. If retirement following the sale was planned, any management contract will incorporate a very short time frame. On the other hand, by substituting a large element of personal risk with liquidity, while continuing to draw a competitive salary for a defined period of time in a job that is familiar, may be a very attractive proposition. Before agreeing to continue in a management capacity for any length of time, however, responsibilities, authority, and remuneration, among other things, must be clearly established and documented. Given that the corporate structure will be altered following the sale of your business, prior to entering into a management contract, you must consider your ability to adjust to what will inevitably be a new and altered environment.
Representations and Warranties
Although there are legal differences between a representation and a warranty, both are basically statements made, in the purchase and sale agreement upon which one party has relied which, if subsequently proven to be untrue, give rise to a right of action for damages by the other party. Many vendors are totally unprepared for the onslaught of page after page of representations and warranties that they will be expected to agree to as part of the closing documentation. The tendency of many vendors is to dismiss them as `legalese’ instead of attempting to understand the impact that they have on the overall structure of the transaction. Viewing them merely as legalese has come back to haunt vendors who failed to understand that the real function of representations and warranties is the allocation of transaction risk between the parties.
There is a direct relationship between representations and warranties and the pricing strategy adopted. It is important to deal with the issue of representations and warranties well in advance of entering into a letter of intent or a definitive purchase and sale agreement. Understanding the difference between reasonable purchaser requests and unfair transfers of risk requires proper advice. In all advantageous negotiations, transfers of risk are compensated for by amendments to price.
In developing a strategy for negotiations, it is important to appreciate that price (including all representations and warranties) is essentially an allocation of transaction risk between the parties. Accordingly, an increased assumption of risk should be compensated for by an increase in price and vice versa. The representations and warranties, the magnitude of contingent payments relative to the overall purchase price, the likelihood that contingency payments will be received in full and similar risks all have a bearing on the adequacy of price. It is for these reasons that is extremely difficult and, in fact, potentially misleading to comment on price before having a clear understanding of the overall structure of the transaction.
Business owners often delay the involvement of their legal counsel until the financial terms of a deal have been agreed to and the likelihood of a transaction being completed is high. This, however, may lead to a false economy. Occasionally, issues are agreed upon without the parties having an appreciation of their full legal impact. This often results in the need to reopen discussions on points the parties believed had been resolved, which can result in delays and additional costs.
The two primary legal documents present in most transactions are a letter of intent and a purchase and sale agreement.
Letter of Intent
A letter of intent is a document which records, at a point in time, the terms to which the parties have agreed. A letter of intent is an instrument which is designed primarily to cause the parties to the transaction to live up to their verbal commitments. It is usually prepared by the purchaser who requests the vendor to sign it as evidence that the is in agreement with the terms and conditions as set out therein. In most cases the letter contains a paragraph which explicitly states that it is not to be considered a legally binding document.
A letter of intent has a number of benefits. By documenting what has already been agreed to, it allows the parties to focus their attention on the remaining issues requiring resolution. It is a clear demonstration that progress is being made, helping to establish the momentum that is so important to private company transactions. And despite its non-binding nature, a letter of intent usually serves to confirm the legitimate intent of both parties.
The primary drawback to a letter of intent is that if it is not properly drafted, it may prematurely bind the parties to terms that have yet to be discussed. In preparing a letter of intent a purchaser will often record not only what has been agreed to but other elements as well in an effort to commit the vendor. Both financial and legal advice should always be obtained before signing a letter of intent, regardless of its apparent legal status.
Many business sales occur without a letter of intent. This is particularly true of smaller transactions. If both parties are satisfied that progress is being made, it may be advisable to bypass the letter of intent stage altogether and proceed directly to the creation of a purchase and sale agreement.
Agreement of Purchase and Sale
All transactions are consummated through the signing of a purchase and sale agreement which addresses the basic issues of what is being sold, by whom, to whom, for how much, and when. It is in the purchase and sale agreement that the representations and warranties are documented.
Various other agreements are also prepared at a closing of a transaction depending on the circumstances. Examples include non-competition agreements, leases, management agreements, etc.
A FINAL COMMENT
The sale of your business represents, in many instances, the culmination of years of personal effort. The value of your business is manifest both in the lifestyle it affords you throughout the years and the capital value that you are ultimately able to realize. The sale of a business is a complex process, in which vendors typically have minimal experience. to plunge into the sale of your business without fully appreciating the issues that will arise prior to and during the process will likely result in failure. The fluid nature of the negotiating process, for example, is such that a single good idea, born out of technical expertise combined with years of experience, often results in a significant enhancement in the transaction price. Proper preparation and a sound strategy should result in an orderly transition which meets all of your objectives.