Avoid Common Pricing Structure Mistakes When Selling Your Business

 

Negotiating a purchase price for a business is more complicated than haggling for a new car. Most business sales have at least some portion of the price paid after closing.  This raises two questions for the seller - How much am I owed and can I collect it?  We see several common mistakes that business owners make when answering these questions.

 

Using Earn Outs Incorrectly.  

 

An "earn out" is a pricing structure where some or all of the purchase price is contingent upon the business hitting certain performance goals after closing.  A properly used earn out typically overcomes two roadblocks to reaching an agreement on purchase price.  Many disagreements over purchase price arise from disagreement over probability of certain outcomes.  For example, a seller may assert that the business is worth 10 million dollars because it will sell 50 widgets next year.  Buyer may say the business is worth only 8 million because it does believe the business will sell 50 widgets.  An earn out can bridge this gap by making the 2 million dollar difference in purchase price contingent on the business selling 50 widgets.

 

An earn out may also allow the seller to capture value from the acumen or resources of the acquirer.  If a target company has struggled because of lack of capital, market presence or other factors, acquisition by a larger company may increase profitability.  A earn out may allow a seller to capture this upside by providing an additional upside contingent on the business hitting performance metrics that exceed past performance.

 

There are a number of risks associated with an earn out for a seller.  It is often difficult to track whether a business has met its performance goals, particularly when the target business is integrated into an existing operating business.  "Creative accounting," in particular, overhead allocation, can make it appear as if a business is not performing or hitting its marks.  Detailed provisions addressing the purchaser's accounting practices help to reduce risk but such provision are fertile for disagreement and post-closing litigation  

 

Not Knowing Your Purchaser.  

 

If you are "taking back paper" - slang for accepting a promissory note in the place of a cash at closing - in a transaction, you are acting as a bank for your purchaser.  Just like a bank, a well-advised seller should conduct due diligence on the potential buyer to evaluate its ability to make good on its promise to pay.  This includes reviewing the purchaser's financial statements, cash flow, other debts and ability to obtain money from other sources.  A more generalized inquiry into the purchaser's business track record is also important.  How long has the purchaser been in business?  Has the purchaser ever declared bankruptcy or does it have judgment against it?  Is the purchaser highly leveraged?

 

Not Acting Like A Bank.  

 

A bank does not lend money without the borrower putting up collateral to back up its promise to pay; you shouldn't either.  The prudent seller treats the buyer as a bank would.  Without adequate collateral, a seller may have a successful lawsuit against a judgment-proof entity or individual.

 

Of course, not all collateral is created equal.  Clients who want to get the price they negotiated for their businesses like to see letters of credit, mortgages on real property and personal guarantees from the owners (and their spouses) of corporate buyers.  Relying solely unsecured promissory notes from recently formed entities or a security interest in the assets of the business just sold is a recipe for disaster. 

 

No transaction is without risk but thoughtful negotiation and good advice can help to minimize the chances of turning a happy time into a sore subject.

Assets or Stock: The Form of Purchase DOES Make a Difference

Purchasing or selling a business can be accomplished in a number of ways. While the objective of the transaction is always the same – transfer of ownership from a seller to a buyer – the form of the transaction does make a difference. When it comes to the purchase or sale of a business, the form of the sale has significant implications, not only at the time of sale but with regard to operations going forward.

The purchase or sale of a  business is generally accomplished by either a stock sale or a sale of substantially all of the assets of the company. The form of the transaction has important implications for both buyers and sellers in several key areas:

Liability

Purchasers of stock essentially “step into the shoes” of the seller. This means that the purchaser assumes all of the liabilities of the acquired business – whether known or unknown, whether past or future. Such liabilities may be extensive and include liability for debt or purchases; losses arising from injuries caused by products or services provided by the purchased entity; claims of trademark or patent infringement; and liabilities based on employment discrimination, wrongful termination or violation of wage and hour laws.

Constructing the transaction as a purchase of assets of the company may enable a purchaser to avoid some potential liabilities inherent in a stock transaction. Yet, even asset purchases carry some risk of assumption of unknown liabilities. Asset purchasers may be responsible for undisclosed liabilities if it appears that they have implicitly accepted liabilities, or where there is sufficient continuity of enterprise that the transaction can be considered a de facto merger.

Scope of Purchase

One of the advantages of an asset purchase agreement is the opportunity it affords the buyer to “pick and choose” the assets that the buyer deems most desirable for the business. Obsolete inventory or redundant equipment can remain with the seller, in contrast to a stock purchase that transfers every and all assets owned by the business. Asset buyers, however, must be careful to ensure that the asset purchase agreement has a complete and comprehensive description of all of the assets necessary to operate the business or they will face some unwelcome surprises at closing.

Taxes

Tax and accounting treatment for asset purchases vary significantly from that afforded stock transactions. Purchasers of stock continue to carry assets on the books on the same basis as the seller. Stock sellers recognize a gain to the extent the sale price for the stock exceeds their basis.  In contrast, an asset sale requires the buyer to adjust the basis of the assets that are acquired based on the fair market value. This may result in an increase or decrease in the book value and depreciation for such assets.

What is clear is that no form of transaction – stock purchase or asset purchase – is inherently “good” or “bad.”  Each form has advantages and disadvantages for buyers and sellers and the decision of which form to adopt can be difficult – especially since what advantages one party may be disadvantageous to the other. In many cases, other elements of the transaction can be used to reduce risk and to satisfy the core objectives. 

GROWING THROUGH ACQUISITION: NOT JUST FOR THE “BIG GUYS” ANY MORE

“Entrepreneurship” is frequently defined as “starting” or “developing” a business venture or idea.  While many entrepreneurs do start a business from “scratch,” others purchase a going concern or selectively buy assets that can enhance their own opportunities to grow.  Growing through acquisition – which frequently makes financial headlines – is not just for publically traded, high profile companies. Medium and small firms can use acquisitions to implement strategic objectives and build their business. Acquisitions may make strategic sense

·         to jump start entry into a new product line

·         to access or expand a customer base or distribution channels

·         to acquire technology or expertise

·         to facilitate entry into a new geography

·         to increase sales or reduce costs

The recent economic downturn has had the effect of making many respected and well run firms take a look at core competencies and shed assets or divisions that no longer “make sense” for their business model. Such divestitures create opportunities for entrepreneurs willing to devote the time and attention necessary to maximize value. Even in the best of times, business founders frequently look for opportunities to “cash out.”  Acquiring businesses from the folks who built them – frequently with the opportunity to tap the experience and talent of the founders as part of a well planned transition – gives entrepreneurs a competitive and strategic advantage in the market. Moreover, increased access to both private and government funding allows even small and mid-size firms to take advantage of growing through acquisition.

Acquiring a business is an important decision.  Not only does the purchaser risk losing his investment, undisclosed and unanticipated liabilities might affect the bottom line for years to come. However, with planning and counsel, purchasers can avoid many of the pitfalls associated with an acquisition. Some important steps to consider:

Assemble A Team

Business acquisition is not a “do-it-yourself” venture.  Even an experienced manager may need qualified experts to help make a strategic decision about the value of the business and whether it meets his needs.

A fundamental understanding of the financial infrastructure of the business being purchased is critical. An accountant can be instrumental in helping to understand the financial health of the business and in navigating the tax implications of the transaction.

Transactional attorneys skilled in the purchase and sale of businesses of comparable size can assist in identifying and reducing risks.  Attorneys can assist in negotiating the purchase; identifying and evaluating critical issues; and drafting the operative documents.  In transactions with post-closing obligations – such as subsequent payments to the seller or non-competition agreements – knowledgeable counsel can assist in assuring that the buyer realizes the value in his purchase.
When financing an acquisition through debt, early contact with the lender is important to understand the availability of funds and the terms and conditions that will apply. Careful review of loan and financing agreements will eliminate the risks of hidden fees and provide a clear understanding of any other financial obligations.

Retaining a business broker or consultant may also be of great assistance when valuing a possible acquisition target.  Valuing a business can depend on a number of factors including sale prices of comparable businesses; the industry in which the business operates; and estimated growth.  Access to a broker or consultant – particularly during the process of valuing the business – can avoid “buyer’s remorse” if you believe you have overpaid.

Depending on the type of business, other expertise may be beneficial.  For example, if the business has trademarks, service marks or patents, intellectual property counsel is advisable. If real estate is part of the transaction, the team may include inspectors and environmental engineers.

Decide On Assets or Stock

One of the early decisions in the acquisition process is the decision whether to purchase the equity of the business or the assets. The decision on how to structure the transaction has a significant impact on how the transaction is taxed; what liabilities are assumed; and whether the contracts of the business continue in effect after the transaction.  While purchasers frequently prefer an asset sale where they can select the specific assets they wish to acquire, the decision on the form of the transaction should be made with an understanding of the business as a whole, including the potential reaction on suppliers and customers.

Decide On Your Purchase Price

The final price that is paid for a business is usually result of a negotiation process. Nonetheless, buyers should have a good sense of how to value the business and how much they are willing to spend to acquire it.

The price of a business usually consists of a base price and a number of “adjustments” that are made to reflect the changes to the base price.

There are a number of ways of determining the base price. One of the most common is a price equal to a multiple of sales or income. For example, a business whose annual in income is $3 million dollars might carry a multiple of 5 in one industry for a total sale price of $15 million, but carry a multiple 8 in another industry, with a resulting sale price of $24 million. In some industries, sale price is a function not of income but of other parameters – such as customer acquisition or profit. Multiples are also dependent on economic conditions – both in general and in specific industry. Whatever the process, a consideration of recent multiples used in valuing comparable businesses provides an external validation that the business being acquired has as much value to the market as to the individual purchaser.

Engage in “Due Diligence”

Due diligence is the investigation undertaken by the buyer prior to purchasing a business. Frequently buyers will not be allowed to engage in due diligence until they have executed a Non-Disclosure Agreement. The Non-Disclosure Agreement (NDA) obligates the buyer to maintain the confidentiality of any information that he receives from the seller as part of the due diligence process. Due diligence provides the buyer with an opportunity to better understand – and appraise – the business that is being purchased. The scope of due diligence varies widely and is sometimes the subject of negotiation between the buyer and seller. Some important areas of inquiry include:

·         Identification of key assets and assessment of their condition

·         Review of financial statements for current and preceding years, with particular emphasis on bad debt and other expenses

·         Identification of key employees and employment agreements

·         Review of any past or pending litigation and any notice of claims that might lead to litigation

·         Assessment of environmental liabilities associated with products or real estate

·         Review of employee benefits and outstanding liabilities

·         Review of customer contracts, licensing agreements and supplier agreement

·         Identification of key suppliers

·         Identification of future capital needs

·         Interviews with customers, suppliers and key employees

·         Evaluation of insurance coverage

While a comprehensive due diligence process will not eliminate all risks for the buyer, it does offer an opportunity for the buyer to assess such risks, and if warranted, seek an adjustment in purchase price.

Document The Transaction

“Papering over” a transaction – drafting the legal documents that describe the transaction and transfer the business – may occur at different stages of the transaction. Parties sometimes execute a “Letter of Intent” indicating their intent to proceed to a final Purchase and Sale Agreement, subject only to certain identified conditions. Letters of Intent can present legal challenges. Parties sometimes sign such agreements, believing that they are not undertaking any legal obligations. Despite language that sometimes implies that such agreements are without legal effect, letters of intent have been the basis of damage awards.

Once the contours of a transaction have been agreed on, counsel prepares a Purchase and Sale Agreement that identifies all of the details of the transaction, including but not limited to the sale price and the basis for any adjustments; a description of the assets and/or stock being purchased; disclosures of liabilities and potential liabilities by the seller; and any post-closing obligations of either party. The provisions of the Purchase and Sale Agreement must take into account the risks and conditions specific to the business that is being sold. A well-drafted document ensures that neither buyer nor seller will be “surprised” during the transaction and provides a framework for cooperation in the period after the sale takes place.

Buying a business can be stressful and risky. One size does not fit all. The most successful transactions are those that recognize the unique risks and rewards in a particular acquisition and uses the law to accommodate the needs of the parties.  With proper counsel, even small to mid-size firms can reap the benefits of growing through acquisition.