Are you like many small business owners who dream of one day selling their business and retiring comfortably? The difference between a sale that gets you everything your business is worth and selling at a discount is understanding how the sale of a business is different than the sale of almost anything else. In some ways, selling your business is similar to selling your house; to get the best price, you need to fix it up, increase its “curb appeal.” In other ways, selling your business is very different; businesses are more often sold piece by piece, not as a whole. Getting the most from your sale depends on understanding the process of selling a business and knowing how to maximize your profit.
Getting your business ready to sell takes preparation and planning. Often, the process of “staging” your business for sale takes a year or longer. This article assumes that you’ve already done the work of getting your business ready for sale. If you’re not certain what to do or how to do it, seek out professional assistance. The cost will be a small fraction of the increased price you’ll realize for a prepared sale. This article focuses on what to expect once a buyer expresses an interest in buying the business.
To you, your business is a single “thing,” the sum of all the parts working together to provide a service or sell a product. In reality, a business is a collection of individual parts: separate assets and liabilities that can be divided and valued separately from each other. When a business is purchased, the first question a buyer needs to answer is whether the whole business should be purchased or just some of the most valuable parts. When a buyer purchases some or all of the outstanding shares (or membership interests, in the case of an LLC) it is called an entity or a stock purchase. With an entity sale, the purchaser takes the good with the bad, buying all of the assets without regard to their relative value, and the buyer assumes all of the past and future liabilities of the business without limit. Only about 10% of all business sales are entity sales.
In the vast majority of business sales, the buyer purchases specific parts of the company, only the parts the buyer has decided will bring the most value to the new enterprise. Known as an asset sale, this type of transaction makes up 90% of all business sales. The concept of an asset sale is difficult for most small business owners to understand, but until it is understood getting top dollar for the sale is unlikely.
The most common form of intangible asset in a business sale is goodwill, sometimes called “blue sky.”
The first challenge for the buyer and the seller is determining what the business is worth. This is called valuing the business and it is a complicated process. Most businesses are unique so the sort of comparable analysis that a realtor does when selling your house doesn’t apply. There are many different methods valuation professionals use to determine a market price.
The most commonly understood valuation method is book value. A business has a book value represented on the balance sheet by the difference between total assets, the stuff the business owns, and total liabilities, the stuff the business owes. On the balance sheet, this is called owner’s equity. Valuation professionals will also use their experience to determine a multiple that takes into consideration the uniqueness of the business and risk, and then apply that multiple to the revenues the business generates or the owner’s discretionary income from the business. Common rules of thumb put a ball price at one times revenue or 4 times owner’s discretionary income. When a buyer is willing to pay more for a business that the book value, it is said that the buyer is willing to pay a premium for the “goodwill” or “blue sky” of the business.
Once a buyer and seller become aware of one another, they begin discussions to determine if a sale is in each party’s best interest. After signing a confidentiality/non-disclosure agreement, called an NDA, they begin the negotiation process by exchanging very basic business information. The information must be detailed enough to enable the buyer to decide what they are buying and for how much, and for the seller to determine if the buyer can follow through on the deal. Typically, the buyer and seller negotiate the basic terms of the deal before the most confidential and detailed information is exchanged. When the buyer is ready to tell the seller that it likes the prospect of a deal and is a serious buyer, it provides the seller with a letter of intent, or LOI. The LOI is not a binding contract but gives the buyer an opportunity to take a closer look at the revenues, expenses, and operations of the business. By committing to an outline of major details of an offer, the LOI tells the seller what the buyer needs to complete its due diligence. If the seller agrees with the buyer’s offer, it signs the LOI. Once the seller signs the LOI and the buyer completes its due diligence, the parties enter into a legally binding purchase contract.
Due diligence refers to the thorough investigation of the other party’s business prior to entering into a contractual agreement to purchase. The buyer requests the most detailed and confidential information about the seller’s business to verify that the information the seller has been providing is factual and to facilitate a fully informed purchasing decision. The information requested provided during the buyer’s due diligence typically includes:
- The past 2-3 years of business tax returns
- Financial statements (P&L, Balance Sheet, Statement of Cash Flows) for the current year-to-date and the previous 2 years
- Restated financials to reflect seller’s discretionary earnings
- Financial ratios and trends
- Accounts Receivable and Accounts Payable aging reports
- Inventory list with values
- Supporting financial information such as turnover rates and performance ratios
- Current building lease agreement
- Fixtures, furnishings, and equipment list
- Copies of contracts with employees, customers, suppliers, distributors, service vendors, and others
- Intellectual property documentation covering patents, trademarks, and copyrights
- Management and operational documentation
- Staffing records
- Customer lists
- Supplier lists
- Business and marketing plans
- Business formation documents
Often overlooked is the seller’s responsibility to investigate the business condition of the buyer. The seller is most concerned with the buyer’s ability to fulfill its obligations under a purchase agreement. The due diligence necessary for a cash sale can be as simple as verifying that the funds are available. When the transaction involves some degree of seller financing with payments over a period of time or the seller will work as an employee or consultant in the acquired business, knowing more about the ability of the buyer to succeed after the acquisition is vital. The seller should verify that the buyer has sufficient funds to meet the payment schedule, that employment/consulting requirements are reasonable and reliable, and that the buyer will be able to service existing contracts at least as long as necessary to complete all purchase payments.
An important part of the seller’s due diligence is an analysis of the state and federal tax consequences of the transaction. The way the final deal is structured, from how much of the purchase price is allocated to each asset to the schedule of payments, can have a significant impact on how much of the sale price the seller gets to keep, and how much goes to the government in taxes.
For most business owners, the reward for all of the years of toil, sweat, and tears is the day when they sell the business and become financially secure. The key to making certain that you realize that dream is to plan early for the sale, do all the preparation necessary to maximize the value of the business, and use the purchase process to your advantage to keep every last penny possible of the sale price. Putting together your team of professionals with experience in business transactions – your lawyer, accountant, and financial planner – early in the process is the key to realizing your dreams.