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Getting Started Selling Your Business

| May 14, 2024 | Business Law

Getting Started

The owner(s) of a business eventually discuss with their family, key advisors, or others they trust and respect that it may be time to sell It. The average owner will not know what their business is worth, so a starting point is often getting a valuation, perhaps secured by an attorney to keep it confidential. The appraisal will provide a realistic and objective idea of what the business may be worth. A good valuation will address the strengths and weaknesses of the enterprise, allowing the owner/managers to correct the deficiencies and capitalize upon their strengths. Confidentiality is crucial to avoid undermining the value upon sale. If competitors hear the business is for sale, they may use that information for competitive purposes with the seller’s employees and customers. Nervous key managers, such as the CFO and marketing executive, who, by necessity, need to be consulted by the valuation people, may be told the valuation is part of an overall succession planning exercise designed to address the future of the enterprise.

The selling entity’s financial statements should be reviewed. If the existing statements are done as complied statement, then the outside accountant should be asked to prepare reviewed statements for at least three years. The financial statements and tax returns should be evaluated for non-recurring items that may give an inaccurate reflection of the value of the ongoing enterprise.

The books and records should be analyzed to normalize the earnings by challenging expenditures, which may be personal or, at a minimum, not related to the core business but which affect the profitability of the enterprise and its value/selling price.

The management of the enterprise should be evaluated, with a plan developed for managing the business’ day-to-day operations in the event of the owner’s absence. The business will have more value to a purchaser if it can be operated profitably without the services of the owner. A strong and capable management team is a valuable intangible asset that demonstrates the business ‘ability to function independently and profitably. Training staff and cross-training key managers to wear more than one management hat is important to providing value in preparation for a sale.

The seller needs a team of advisors to ensure that the sale is secured and completed on a timely basis. The team should be assembled as early in the process as possible and instructed about the confidential nature of the transaction. This necessary advisor usually involves an attorney, CPA, investment banker, or business broker, (banker/broker), depending on the size of the seller’s business, a valuation expert, and a financial planner to review opportunities for tax-advantaged wealth transfers as part of the selling process. The valuation expert could be part of the banking/broker team or the CPA staff. Each member of the team plays a crucial role in the selling process, ensuring a smooth and successful transaction.

Practical Strategies

Sophisticated buyers and/or their advisors will want to know why the seller is selling and why at this time. The seller should have a clear and precise answer to be used consistently.

During the sale process, it is essential for the seller to continue operating the business on a profitable basis. The inevitable distractions associated with finding a buyer, responding to due diligence requests, and providing documentation for the definitive documents may cause key managers to lose focus. This could negatively impact earnings during the period leading up to closing, known as TTM-trailing twelve months of a company’s performance. A deterioration of earnings during the TTM could undermine the sale and often results in a reduction of the purchase price, or cash at closing, and possibly the conversion of a portion of the price to an earnout payable only if financial benchmarks are achieved. Maintaining profitability during this period reassures potential buyers that the operation is sustainable with a bright future.

The seller, with the help of the team, should operate the business during the period leading up to a potential sale to maximize profits rather than minimize taxes. This may mean capitalizing what can be expensed, all within appropriate accounting parameters.

Practical Forms of Seller Financing

  1. Seller financing is often an essential ingredient for closely held business transactions. This is necessary, in large measure, because the funds necessary to complete the transaction are not obtainable from conventional lending sources.
  2. Seller financing may take numerous forms, including straight installment sale provisions secured by a promissory note with appropriate collateral. However, the collateral is usually pledged to the buyer’s primary lender which causes the seller’s note to be subordinated. The subordination requires the seller to relinquish legal rights that would normally be part of a promissory note in favor of the primary lender. The subordination agreement provides that the seller who become the subordinated party is unable to effect normal and customary legal remedies such as declaring a default, to call their note, to execute against the collateral, or do anything to force the buyer to pay the seller’s note without the specific permission and consent of the primary lender.
  3. The subordination is designed to assure that the seller’s note is treated as equity for credit analysis purposes from both an accounting and collection standpoint.
    a. The seller’s note may be written to allow interest-only payments, or it may not; it usually restricts principal payments until the primary lender has been paid in full and may eliminate interest payments if the buyer has violated any loan covenant or is otherwise in default under the primary lender’s loan documents.
  4. A common alternative to a subordinated note is the seller receiving an ownership interest in the buying entity (commonly called a “Rollover”). The seller’s Rollover interest is generally an equity interest in the buyer’s entity and may or may not be treated as taxable proceeds from the sale, depending on the transaction’s structure.
    a. The seller generally has the right to be part of the buyer’s subsequent transaction(s), such as a resale of the business, taking it public, or any other myriad of options. The seller may, therefore, participate in a substantial increase in value if the buyer successfully operates and then sells the business. When contrasted to a subordinated note, which usually only has a downside (the seller may or may not receive their interest and principal), the Rollover, provides the seller with an opportunity of being paid and, in lieu of interest, the opportunity for capital appreciation (referred to as a second bite of the apple).
  5. Seller financing also comes in the form of non-compete agreements, consulting arrangements, preferred stock payouts, and other related capitalization mechanisms.
  6. Sales to family members using a private annuity is a form of seller financing. A private annuity is a sale by a business owner to the buyer through an unsecured promise to pay by the buyer with the price determined by an appraisal of the business. The buyer enters into an agreement wherein the buyer makes an “unsecured promise to pay the appraisal value” over the seller’s life expectancy. This method considers the specific terms and conditions provided under the Internal Revenue Code, such as the owner’s life expectancy, the use of an independent accredited valuation, and an interest factor published monthly under the Internal Revenue Code in the IRS bulletin (“IRC”).
  7. The beauty of the private annuity is that the payments continue for the seller’s life, and after the seller’s death, there is no legal obligation to make further payments. This is a very useful technique in a family transaction where succession planning is often driven by the reduction of federal estate and gift taxes. The sale of the family business using a private annuity is not a gift and is not an inheritance. The leverage occurs when the recipient of the private annuity dies prematurely (he or she must not have been sick when entering the sale). The private annuity transfer/sale is for tax treatment, complete and adequate legal consideration in compliance with the IRC. There is no gift element even if the death occurs many years before the life expectancy because it is a contractual obligation. If death occurs early the buyers have acquired the family enterprise at a discount without any gift or estate tax cost. The buyer must make payments until the seller dies; if the seller lives beyond their IRC life expectancy, the buyer may overpay.

Finding a buyer using investment bankers and other finders

  1. Investment bankers and business brokers (“banker/broker”) assist with the sale by evaluating the enterprise’s feasibility. Attorneys and CPAs also assist with the identification of potential buyers from their client ranks and through their awareness of interested buyers and their advisors.
    a. The banker/broker is instrumental in determining the target price range based on their familiarity with the marketplace. This usually involves the timing of the sale and preparing the business for sale. An experienced banker/broker helps assist the owner in assembling the necessary information for due diligence by buyers, identifies prospective buyers, and works with the other members of the team to assemble, review and circulate a selling book/memorandum for evaluation by potential buyers.
    b. The entity’s profit history is evaluated, and appropriate projections are made as part of the process of putting together the selling book/memorandum.
    c. The conditions of the facilities, identification of operating and non-operating assets, along with the seller’s inventory, accounts receivable, furniture, fixtures, and equipment (the hard assets) are necessary components of the memorandum.
    d. The existence of patents, copyrights, trademarks, service marks, customer lists, etc., the enterprise’s intellectual property should be listed as part of the process (commonly known as goodwill).
  2. Once a decision has been made to sell and a banker/broker retained, individuals and institutions with whom the banker/broker has identified or with whom they have working relationships are contacted and solicited as to interest in the business being sold. The banker/broker should secure potential buyers and filter out those who are not qualified.
  3. Once a qualified buyer has been secured, the banker/broker negotiates the basic economic parameters of the transaction, such as price, terms, financing, etc., often with assistance from the attorney and/or CPA.
  4. The banker/broker acts as the seller’s spokesperson, keeping the negotiations confidential and acting as a buffer for the seller. This is very important for sellers who have never been involved in such negotiations and may be business’s founders, often have an emotional attachment to the enterprise and their employees, which can cloud their business judgment.

Selling your business can be the ultimate reward for your life’s work. If you are interested in exploring this possibility, contact Jim Aussem at 216-621-7860.

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