Few things are as mystifying, maddening, and exasperating as selling a business. After years of worrying about the most intimate and mundane details, owners are often perplexed by a sale process that requires both a significant investment of time and money to complete. Sellers typically make this journey only once, and without the right level of professional support, critical and costly mistakes can occur during what should be the penultimate event in the life of an entrepreneur.
Although the rewards can be substantial, harsh rules of engagement await most selling shareholders. First, sellers must remember that the sale process is usually controlled from all angles by professionals who buy and sell companies on a repetitive basis and, as such, look to exploit the lack of seller preparedness – a deliberate strategy to move negotiating leverage from the seller to the buyer. Despite all the handshakes and smiles, investors, bankers, brokers and sources of professional capital are purposeful in this approach and routinely win at this game. Of course, this is not to suggest that all investment professionals are a nefarious lot. Private equity investors are a class of capitalists who specialize in identifying emerging value and contributing transformational capital and skilled resources to achieve scale and create durable earnings. However, the value of the sleepless nights spent worrying about payroll, pitching to much bigger customers, and dealing with difficult employees are quickly dismissed in the weeks leading up to the sale.
So, why is it that hard-won owner equity seems to slip like sand through the hourglass as the terms of a sale are hammered out with a prospective buyer? How can owners flip the negotiating leverage to their side of the table? Although each deal is different, a few general rules apply to most selling situations.
- Work Backwards – Define the shape of a fair deal and how that translates to you and your partners. Do you hope to survive the transaction, or are you motivated only to monetize the value of your company and move on? How about the management team? Perhaps your team is younger and has the desire and energy to take the company to a different place. Talk to your key leaders and understand their desires. Employees are more than an expense – they are perhaps a seller’s most valued asset and should be central to any sale decision. Although the voting stock may be concentrated and may not include your key employees, they still play an important role in any sale. Therefore, understanding their desire before identifying a potential buyer can make the process cohesive and well-coordinated. As a routine matter, management should develop a selling business plan that identifies risks, opportunities and likely outcomes. Keep in mind that around 70 percent of merger and acquisition (M&A) deals can adversely impact shareholder value (Fernandes, Nuno. “M&As in 2021: How to Improve the Odds of a Successful Deal.” Forbes.com. March 23, 2021.) One must clearly and objectively identify seller transactions thresholds that go beyond the agreed-upon sale price.
- Don’t Fall in Love with a Letter of Intent – The process typically starts with a buyer presenting a Letter of Intent (LOI) as an expression of formalized interest. The LOI outlines terms and conditions including value, general deal structure (purchase of stock or assets) and specific payment terms, which include the amount of cash presented at close and possible contingent or deferred cash consideration. These can take the shape of rolled equity into the “newco” or earnouts based on future performance.
Sellers need to keep buyers on their collective toes and maintain a degree of energy around the transaction. To help a deal move along, sellers should ask for a 60 or 90-day maturity on the LOI – a period used for general diligence. Some transactions in heavily regulated industries (healthcare, energy, government-based deals, etc.) are complex and take months to close. Asking the questions about the life of the LOI will expose the level of seriousness of the buyer. Buyers often ask for exclusivity in that the company cannot be marketed once the LOI is executed. Unreasonable exclusivity must be balanced against other elements of the deal, such as a breakup fee, no financing contingency, accelerated close and deal terms. LOI is the “dating stage” as buyers and sellers have will have some more detailed conversations in the weeks following the LOI.
- Complete a Sell-Side Quality of Earnings Report – First and foremost, sellers should do all they can to control the transaction narrative. A detailed review of one’s business, completed in the language of the buyer, allows sellers to close gaps in perceived value and to uncover value inhibitors that cause the best of deals to jump the tracks. A well-timed report is referred to as a sell-side quality of earnings (QoE) report, in which the author will outline normalized earnings or EBITDA (earnings before interest, taxes, depreciation, amortization). Non-recurring expenses, such as personal expenses, one-time legal and consulting expenses are added back to the trailing 12-month period so that buyers have a clear idea as to the earnings power of a target. The report untangles personal and business assets, provides for proof of cash (correlate collected cash to claims of revenue) and will include an extensive review of ongoing working capital needs. Most deals are completed on a “no cash / no debt” basis, meaning that the seller retains company cash at close and is also responsible for certain debts (e.g., bank debt). It’s better to preemptively know about issues such as customer concentration, working capital imbalances and negative inputs to EBITDA. The report allows you to repair or defend such shortcomings or emphasize items not correctly expressed within the context of the financial statements.
Often, Buyers will conduct their own buy-side QoE, which has its advantages. A sell-side report allows sellers to uncover unique items and develop responses and to “normalize” the operation. In doing this type of work for many years, we’ve seen just about every type of expense, from country club memberships, personal travel and dog grooming. The best strategy is to inventory such items and present them early in the conversations. Support these conversations with a normalized EBITDA, which is the cornerstone of a QoE report.
- Get the Backroom Straight Before Negotiations – Well-organized sellers simply get more money for their companies. And, more importantly, the probability for a successful and timely close significantly increases with time spent developing an organized “data room” to be used as a repository of diligence items such as historical financial statements, operating forecasts, regulatory and compliance items and legal agreements.
And don’t forget the lawyers. Be sure your company is an investable entity and can successfully onboard capital. Do you have appropriate legal protection around intellectual property (IP)? Do the rights of minority shareholders need to be considered? Is the corporation duly organized and registered? Spend time proactively and preemptively with legal counsel to review the legal foundation supporting your company. Relationships with tangential assets, such as real estate, that will serve the company post-deal should be well documented. Document the completeness of employment agreements, contracts and shareholder understandings. Seller confusion often translates to added value to prospective buyers as attractive, and unsolicited offers are a deliberate strategy of acquisitive buyers. Companies not ready for the rigors of diligence are prime targets as buyers seek to capitalize on the resulting confusion of companies not dedicated to the process. If an unsolicited offer arrives, be thankful, but ask for time to prepare for the rigors of diligence.
- Articulate the Value of Your Business – All buyers will have to provide some degree of the rationale supporting the investment. Is the industry particularly attractive, or has your company enjoyed above-market growth rates or robust margins? Will your company serve as a platform where the successive acquisitions are “bolted” onto your company? (Platform companies tend to fetch higher purchase multiples, hence more reasons to create the administrative foundation in advance of a deal.) Are the new buyers attaching your company to a previously purchased platform company in which future contributions can be muted? Practice your ability to articulately respond to such questions so you can accurately tell the story of your business’s value.
- Social Issues Are Important, Too – The first question I ask a selling shareholder is straightforward – what do you want to do? Are you the person to lead the company to its next stage? Are you willing to miss family events, work crazy hours, accept the risk of going this alone? The rewards can be spectacular, but the risk and responsibility can weigh on owners over the long term. Sure, getting the right deal and getting paid for your efforts form the basis of any deal. However, the thrill of a deal is often offset by unhappy working roles and increased corporate responsibility. One must also think about the role of the management team post-deal. What will be your relationship to the board? What is the composition of the board? What type of reporting responsibility will the company have to those now involved in the capital structure, which may include banks, private equity sponsors and strategic partners? We often find that key managers get stuck in an endless loop of post-transaction reporting and communication, which can create creeping deficiencies in the business and a general sense of management disenfranchisement.
- Remember Transaction Tax Efficiency – The adage, “It’s not what you make, it’s what you keep,” is never truer than in the context of the sale of your company. Proper tax planning, including tax elections, plays a critical role in enabling sellers to retain higher percentages of the sale proceeds. Again, a tax professional can proactively review the elections status of the entities under purchase consideration and create strategies to make the sale as tax efficient as possible (e.g., transferring pre-sale shares to a grantor trust). Along with the lawyers and financial professionals, make time to work with a transaction tax professional as this single element can easily translate to millions of dollars in retained sale proceeds.
All transactions are different, but none are as important as the one in which you have decided to sell a majority stake in your business – and few sellers can respond advantageously to a pre-emptive and unsolicited sale without proper planning. That’s why it is imperative that sellers engage the right team to guide a seller through a dizzying myriad of choices and strategies. Windham Brannon’s team of advisory professionals can help control the narrative and facilitate a comprehensive approach to sale preparedness and organization. For questions or more information about how we can help, reach out to Laura Berry or contact your Windham Brannon advisor.
