Introduction to Preparing a Business for Sale
It may seem counter-intuitive, but the best time to start thinking about preparing a business for sale is when you start the business. By assembling a team of advisors (legal, financial, insurance, tax and regulatory, to name a few) at the outset, you have the best chance to establish and maintain a business that will flourish and provide its owners with a maximum return on their investments.
Many business owners are actively involved in their business and spend considerable time managing and growing the business. Indeed, hard work and careful guidance are key elements of what make a business successful. The same applies to preparing a business for sale. Ideally, business owners that have not thought through exit scenarios should do so at least three to five years before they want to sell their business. This will provide time to evaluate advantageous deal structures, address financial and legal issues and make the business as attractive as possible to a potential buyer.
Business owners should not underestimate the time it takes to prepare a business for sale, or the sale process itself. Both can take significant time, especially when issues with the business have been left lingering for some time without resolution. By preparing a business for sale well in advance, business owners can maximize enterprise value and their chances of a successful sale transaction. At the same time, the process also frequently addresses issues that a buyer may take issue with and use to push down a purchase price. Like this article? Leave a review and more will follow! It only takes a few seconds.
Advantageous Business Sale Structuring
The sale of a business can take many forms from asset sales, equity purchases or even a merger or consolidation of entities. In many cases, buyers want to purchase assets and sellers would prefer to sell equity. No matter what the form of the transaction is, business owners should plan in advance and work with their advisors to determine the most advantageous sale structure and the economic effect of other structures that a buyer may propose. This way, a business owner will know in advance what the tax and economic effects will be for a variety of different transaction types.
Knowing this information can also help business owners structure their business to maximize enterprise value in advance. In many cases, owners of closely held businesses work with both a business lawyer and a trusts and estates attorney to ensure that sales are consistent with their estate planning objectives. This can also provide tax efficiencies when a business is sold. However, this type of planning is best done early to maximize its benefits.
Financial Factors – Much to Do About Numbers When Preparing a Business for Sale
The sale of a business involves a lot of numbers and number-crunching. Business owners that have a good handle on their business financials and value are best prepared to deal with a potential purchase. Business owners that have business financials that need clean-up and who don’t have a sense of what the business is worth have a much harder time.
Financial Statements and Tax Returns
As part of its diligence, a buyer will want to review three to five years of financial statements and tax returns, and likely look deeper into economic trends and the quality of earnings of a business. In preparing a business for sale, a business owner wants to make sure that it can present financial statements and tax returns that fairly present the current state of the business, show that the business is growing and that it can sustain that growth. Advance planning can help a business owner address issues that buyers may focus negative attention on or give a buyer the wrong impression, such as legacy assets, excess compensation, inventory valuation issues, unproductive personnel and expenses unrelated to the business, all of which often creep into financial statements and accumulate over time. Similarly, one-time or infrequent items can hit cash-flow and make the financials of the business look less rosy than they should.
Where’s the Beef? Net Income and Cash Flow
Buyers of businesses focus on net income and cash flow, and you should be prepared to present your financial statements so that they clearly illustrate the income-generating capability of the business. This is often done through recasting financial statements to remove certain items and add back others to give a fair presentation of where the business stands, and what it can potentially generate in the future. This expansion potential is a driver of interest for most buyers, as they are looking to take what a business owner has and grow it aggressively using resources they have such as better (or cheaper) access to capital, economies of scale, etc.
What’s the Business Worth? What Will You Take for It?
A bevy of advisors can assist you with determining what your business is worth, if you are not already keeping your eye on value on an annual basis. Different advisors (accountants, business valuation professionals, auditors, financial advisors, etc.) all have different approaches to assessing business value. Business owners who track their own industry closely and follow purchases and sales may also have a general sense of what their business is worth based on recent comparables. Advisors may use multiples of certain values derived from information in the financial statements and tax returns. All of these can provide a business owner with an idea of what the enterprise value of the business may be.
Whatever value a third party puts on a business, ultimately a sale price has to be one agreeable to a willing buyer and a willing seller. In hot markets, many are surprised that they get significantly more than they expected. In neutral or down markets, others find few offers or offers structured disadvantageously where purchase price is put at risk and subject to conditions.
In any case, a business owner has to be objective and view the business objectively. This includes flaws and problems that hopefully can be addressed or at least mitigated while preparing a business for sale. This also includes getting a real sense of where the business stands in the marketplace and what factors make it attractive to buyers. Consider some of the following:
- What does the competitive landscape look like for the business? Who are the chief competitors and what are they doing?
- Does the business have the ability to control price or is it set by the market generally?
- Does the business have unique assets (including protected intellectual property) that give it an advantage over others?
- Can the business be replicated, or are there gating factors that make it difficult or expensive?
Another item to be considered is how the value of the business ties into the business owner’s lifetime needs. If the business owner has a strong and diverse net worth and has prepared for retirement, the business owner may be more objective about the value of a business. However, if the business owner’s net worth is based mainly on the value of the business, a business owner may view enterprise value as what the business owner needs to retire rather than what the business is really worth. Thus, it is critical to determine business value early in the process of preparing a business for sale to avoid unrealistic expectations and the possibility that realistic offers will be declined because they do not meet a business owner’s lifetime needs after sale.
Are Your Business Documents Up to Date?
Buyers of businesses conduct due diligence. In most cases, they look for similar things regardless of the deal, although there are often additional issues investigated for regulatory or other concerns or specific items relevant to the type of business or the goods and services sold. As part of preparing a business for sale, a business should make sure that it has its business documentation up to date. The timing and disclosure of this information is subject to the sale process, but the business owner should make sure that core business documents are readily available and attractive to a purchaser. By doing so, the business owner can instill confidence in a buyer that the business is on top of things and fulfilling its legal requirements. A few examples:
If a business is a corporation, is the corporate minute book up to date with current records reflecting required annual meetings (or written consents if permitted by statute)? Is the stock transfer ledger up to date? For LLCs, does the current operating agreement reflect all of the current members of the entity? For business owners who are not regularly attending to entity upkeep, it is not uncommon to find gaps in the chain of title of equity or other missing documents and filings that can be red flags and stumbling blocks to a potential buyer. Even worse, some business owners haven’t touched their business documentation since the date their business was formed. In these cases, clean-up is often needed as part of preparing the business for sale.
Does the business have a good sense of all of its assets, and does it have an appropriate chain of title for all assets it owns? Are they free and clear of liens and encumbrances? This is another area where gaps are often found, and they are best resolved before a purchaser raises them. Sometimes assets are subject to lien filings that should be terminated of record as the underlying payment obligation was satisfied. Other assets may require maintenance filings with governmental authorities such as patents and trademarks. Does the business have a credit facility that must be addressed as part of a transaction? Do others hold liens that need to be cleared? Many business owners are surprised to find that there are liens on assets they never expected but that arise through “boilerplate” in contracts they did not carefully review.
Is appropriate employee documentation in place such as confidentiality, inventions assignment and proprietary rights agreements? Are employees subject to restrictive covenants such as non-competition and non-solicitation restrictions (and are these consistent with current applicable law)? Are key employees subject to agreements and plans that align their interests to a successful sale and post-sale transition? Are appropriate agreements in place with independent contractors and, just as important, are all independent contractors properly classified as such under applicable law? If the documentation utilized is not up to date or not in place, a business owner will need to evaluate what gaps it has and put appropriate agreements in place to both protect the business and the value it wants to pass on as part of the business sale.
What type of documentation is the business using to sell its goods and/or services? Is it up to date, does it contain appropriate disclaimers, limitations on damages and liability and other provisions that limit exposure? Do your customer contracts permit them to be assigned to a buyer without consent? Are they affected by a change of control of the business? If a buyer cannot access the value of key contracts, or if a business owner needs to get the consent of many key customers, not only will a transaction become more complex, but there is a chance that a savvy customer will use the opportunity to negotiate better terms that a potential business buyer may not like.
Businesses have a wide variety of suppliers of goods and services, facilities and equipment. This documentation must also be reviewed to see if they can be assigned to a buyer or to ensure that a change of control does not impact the continuity of supply. Many commercial agreements contain restrictions on transfer and consent-right triggers on a change of control including commercial leases of real property and technology-related agreements. Identifying these and preparing to address them in advance will save significant time when a deal is on the table.
Does the business (or individuals working for the business) rely on licenses, permits or authorizations of one or more Federal, State or Local governmental authorities or regulatory agencies? If so, what are the steps needed to give a buyer the benefit of these? In some cases, licenses, permits and authorizations are non-transferable, and a buyer will have to apply anew when they purchase the business. This is often not an issue when applications are quickly granted, but some licenses, permits and authorizations may take many months or even years to put into place depending on their complexity and the industry involved. In some cases, these situations make an equity deal rather than an asset deal the only viable route to a closing as buyers want to make a near-term purchase and not wait an extended period to own and operate the business.
Identify Red Flags and Weaknesses; Think Like a Buyer When Preparing a Business for Sale
Red flags and weaknesses must be identified when preparing a business for sale. A savvy buyer will certainly find them and only use them to lower enterprise value or extract deal concessions. The best defense is a good offense; be proactive in identifying red flags and weaknesses and address them prior to interacting with potential buyers.
Here are some to think about, and of course there are many others including those that may apply to your particularly industry or the goods and services your business offers:
- Management. Do you have an effective management team that is able to continue to run the business once it is sold? Business owners often drive business growth but fail to prepare second-tier management to be ready to take the reins or empower their management team to continue to drive the business economics once the business owner has sold and retires.
- Equipment. Is the business relying on key equipment or resources that are at their end-of-life and will need to be replaced by a buyer? Is the business using cutting-edge tools that keep productivity high and make the business competitive with other industry players?
- Growth Plan. What is the plan for growing the business? Is this something that is looked at on an ad hoc basis, or is it under constant careful review by management on a regular basis to ensure that goals are set and met? Are you constantly expanding your customer base and not relying on a handful of customers to drive sales, the loss of any one of which could materially impact the business?
- Controls. Does the business have adequate controls in place? These are not just financial, but involve proper separation of duties, policies and procedures, documentation, oversight and review and effective management of IT resources. These not only protect the business; they make a business more attractive to a buyer and increase confidence that a business will not encounter material issues down the road.
Red flags and weaknesses are not just blips and glitches that you may need to clean up in the business financials. Indeed, they may go to the core of the business itself, its operations and its structure. As noted above, objectivity is key. Take a step back from your day to day view of the business and look at it from a buyer’s perspective. What are the important things that keep getting put off but never addressed?
Think Through Potential Types of Acquirers
Businesses are bought and sold by many different types of buyers. Some businesses with well-established succession planning have shareholders’ agreements or operating agreements in place that allow for the orderly transition of a business to other owners in the event that a principal equity-holder retires, dies or becomes permanently disabled. Some of these mechanisms are often funded by insurance, which helps the business continue to prosper without the major hit to cash-flow that a buy-out often involves.
Other businesses do not have succession planning in place and consider that sometime in the future they will sell to a competitor or strategic buyer. Care must be taken, however, to make sure that the business is prepared for sale if unexpected events occur. If the business owner falls ill or otherwise is no longer able to run the business and the business cannot be sold quickly, the business economics and value will often deteriorate rapidly and owners are left in a distress sale situation which will depress enterprise value.
Even if succession planning is not put into place, business owners may want to take a look at insiders for a potential sale. In some cases, selling to a key employee or group of employees can be an attractive option and alternative to selling on the open market. Key employees often have a keen sense of business value, know how the business is run and are often amenable to much less complex transactions and transaction documentation.
However, as part of preparing a business for sale, a business owner must cultivate these key employees and make sure they have the proper incentives not only to stay with the business, but to consider it as an attractive option for their career growth. This will give the employee(s) time to prepare for a potential purchase including making themselves personally attractive to lenders who may provide third party financing. Springing a complex business deal on a key employee a year before a business owner wants to retire is not a recipe for success or maximizing enterprise value.
Don’t Take Your Eye Off the Business When Preparing a Business for Sale
Preparing a business for sale takes time and it can feel like a second job for some business owners. However, do not lose focus of the business itself. There is nothing less attractive to a potential buyer than a business with declining sales. Indeed, part of preparing a business for sale should be making sure plans and strategies are in place to increase sales.
Make sure that the management team continues to execute on that plan regardless of what preparations are ongoing or discussions are occurring with customers. Not all deals close, and if a business owner takes their eye off sales and has an unsuccessful deal, the business owner will have a hard time attracting new purchasers. Constant and continuous execution of a sales growth strategy is key.
Psychology & Emotion; Be Ready and Have Resolve
Preparing a business for sale, and the sale process itself, often involves a great deal of psychology and emotion. This is not just the case of a business owner selling their “baby” that they have owned for 30 years. Even young companies must navigate the process as they would any strategic commercial transaction.
A business owner that appears over-eager or gives off signals that they need to sell the business often ends up with a materially worse deal than a business owner that appears earnest but is clear that there is no present need to sell. Patience is key, and over-communication can signal to the buyer that it may have more leverage than it thought – and sophisticated buyers will use this leverage to their advantage.
Similarly, many business owners who have not been through a sale process in the past underestimate the time requirements associated with selling a business. While some deals, especially those where a buyer does not rely on third-party financing, can be closed more quickly, other deals may take a year or more to close.
There are often fits and starts and impasses and hurdles that must be met and overcome to reach the finish line. Again, patience is key, and a business owner must make avoid letting “deal fatigue” affect their messaging to potential buyers. Putting the time and effort into preparing a business for sale will shorten the deal process and greatly increase a business owner’s chances of maximizing enterprise value and selling their business.
Copyright 2020, Geoffrey G. Gussis. All Rights Reserved.
Shared by Geoffrey G. Gussis, Esq., a business attorney and technology attorney licensed in New Jersey and New York. Learn more about me, the legal services I provide, and articles I have written. Contact: firstname.lastname@example.org or (732) 898-0549 or (646) 389-2946 for a free consultation.
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