Selling a Business

Structuring the purchase of a business is an issue that should be faced early in the selling decision. Ultimately, the final structure of the sale will be determined by actual negotiations between buyer and seller, but the seller must still answer the following questions:

• What is the lowest amount of cash acceptable from the sale?
• Has consideration been given to paying off all unsecured creditors and a portion of the closing costs? (Both are, in most cases, the seller’s responsibility.)
• Is there any long-term or secured debt that can be assumed by the buyer? (This may make more cash available to the seller.)
• What is an acceptable interest rate for the seller-financed sale?
• Will the business be able to service the debt and still provide a return acceptable to a buyer in relation to the down payment required? (This is a particularly important question for the seller to address.)
• What are the tax consequences of the sale?

Recent studies indicate that the more favorable the terms, the higher the price. In fact, one study found that offering favorable terms might increase the total selling price by 30 percent. A business broker professional can advise you on the all-important issue of seller financing.

The professional business broker is a good source for assistance in structuring the sale of a business. Although they are not able to provide legal advice, business brokers are the experts of preference when the arena is the business marketplace. Brokers will use their knowledge of previous sales, current market conditions, and outside financing strategies, if applicable or available.

A business generally represents a seller’s largest financial asset. How the sale is structured may mean the difference between the success or failure of the transaction. The best sale structuring will result in the best deal possible for both buyer and seller. A business broker can be the key player in accomplishing this goal.

When contemplating the sale of a business, an important option to consider is seller financing. Many potential buyers don’t have the necessary capital or lender resources to pay cash. Even if they do, they are often reluctant to put such a hefty sum of cash into what, for them, is a new and untried venture.

Why the hesitation? The typical buyer feels that, if the business is really all that it’s “advertised” to be, it should pay for itself. Buyers often interpret the seller’s insistence on all cash as a lack of confidence–in the business, in the buyer’s chances to succeed, or both.

The buyer’s interpretation has some basis in fact. The primary reason sellers shy away from offering terms is their fear that the buyer will be unsuccessful. If the buyer should cease payments–for any reason–the seller would be forced either to take back the business or forfeit the balance of the note.

The seller who operates under the influence of this fear should take a hard look at the upside of seller financing. Statistics show that sellers receive a significantly higher purchase price if they decide to accept terms. On average, a seller who sells for all cash receives approximately 70 percent of the asking price. This adds up to approximately 16 percent difference on a business listed for $150,000, meaning that the seller who is willing to accept terms will receive approximately $24,000 more than the seller who is asking for all cash.

Even with these compelling reasons to accept terms, sellers may still be reluctant. Selling a business can be perceived as a once-in-a-lifetime opportunity to hit the cash jackpot. Therefore, it is important to note that seller financing has advantages that, in many instances, far outweigh the immediate satisfaction of cash-in-hand.

•  Seller financing greatly increases the chances that the business will sell.
• The seller offering terms will command a much higher price.
• The interest on a seller-financed deal will add significantly to the actual selling price. (For example, a seller carry-back note at eight percent carried over nine years will double the amount carried. Over a nine-year period, $100,000 at eight percent will result in the seller receiving $200,000.)
• With interest rates currently the lowest in years, sellers can get a much higher rate from a buyer than they can get from any financial institution.
• The tax consequences of accepting terms can be much more advantageous than those of an all-cash sale.
• Financing the sale helps assure the success of both the sale and the business, since the buyer will perceive the offer of terms as a vote of confidence.

Obviously, there are no guarantees that the buyer will be sucessful in operating the business. However, it is well to note that, in most transactions, buyers are putting a substantial amount of personal cash on the line–in many cases, their entire capital. Although this investment doesn’t insure success, it does mean that the buyer will work hard to support such a commitment.

There are many ways to structure the seller-financed sale that make sense for both buyer and seller. Creative financing is an area where your business broker professional can be of help. He or she can recommend a variety of payment plans that, in many cases, can mean the difference between a successful transaction and one that is not. Serious sellers owe it to themselves to consider financing the sale. By lending a helping hand to buyers, they will, in most cases, be helping themselves as well.

In the practical sense, when selling a business, goodwill is all the hard work and effort the seller has put into the business over the years. When acquiring a business, goodwill is the difference between the tangible assets and the purchase price.

Goodwill value should not be confused with going-concern value. There is a big difference. One leading business appraiser has defined going-concern value as, “The premise that a business will continue to operate consistent with its intended purpose as opposed to being liquidated.” In other words, the value of a business for just being in business is the going-concern value. It has nothing to do with whether the business is profitable, “on its last legs,” or merely breaking even. Essentially, if the doors are open, a business is a going concern.

Most business owners view goodwill as good service, products and reputation. One dictionary defines Goodwill as, “A desire for the well-being of others; the pleasant feeling or relationship between a business and its customers.”

The M&A Dictionary defines goodwill as: “An intangible fixed asset that is carried as an asset on the balance sheet, such as a recognizable company or product name or strong reputation. When one company pays more than the net book value for another, the former is typically paying for goodwill. Goodwill is often viewed as an approximation of the value of a company’s brand names, reputation, or long-term relationships that cannot otherwise be represented financially.”

Some Examples of Goodwill Items

• Phantom Assets
• Local Economy
• Industry Ratios
• Custom-Built Factory
• Management
• Loyal Customer Base
• Supplier List
• Reputation
• Delivery Systems
• Location
• Experienced Design Staff
• Growing Industry
• Recession Resistant Industry
• Low Employee Turnover
• Skilled Employees
• Trade Secrets
• Licenses
• Mailing List
• Royalty Agreements
• Tooling
• Technologically Advanced Equipment
• Advertising Campaigns
• Advertising Materials
• Backlog
• Computer Databases
• Computer Designs
• Contracts
• Copyrights
• Credit Files
• Distributorships
• Engineering Drawings
• Favorable Financing
• Franchises
• Government Programs
• Know-How
• Training Procedures
• Proprietary Designs
• Systems and Procedures
• Trademarks
• Employee Manual
• Location
• Name Recognition

What goodwill is and how it is represented on a company’s financial statements are two different issues. For example: until recently, if a company sold for $5 million, but only had $1 million in tangible assets, the balance of $4 million was considered goodwill. Under previous accounting standards, this goodwill had to be amortized by the acquirer over a 15-year period. This especially affected public companies, since an acquisition could negatively impact earnings, thus reducing the price of its stock. One result of this was that public companies were reluctant to acquire firms in which goodwill was a large part of the purchase price. On the other hand, purchasers of non-public firms received a tax break because of the amortization.

The accounting profession recently took another look at goodwill and changed the way goodwill is handled. The reason for this was to bring accounting into today’s business world. For years, companies were built around hard assets such as heavy equipment and machinery. Many of today’s industrial giants are not really industrial at all. They are built around intangible assets such as patents, brand names, intellectual property, etc. – basically what are considered goodwill items. These businesses don’t have huge factories full of workers on assembly lines.

Some new rules or standards were created by the Federal Accounting Standards Board (FASB) and implemented on July 1, 2001. Under this change, goodwill may not have to be written off (unless it is carried at a value in excess of its real value). However, the standards now require that companies, both private and public, have their intangible assets, including goodwill, valued by an outside expert on an annual basis. The rules basically define the difference between goodwill and other intangible assets and how they are to be treated from an accounting and tax reporting standpoint. How they are treated can impact the bottom line and have tax consequences. Also, completely identifying the items that may have been combined into goodwill and establishing separate values may increase the true intangible asset basis.

The upshot of all this is that the meaning of goodwill just got more complicated. Here’s a simplification: prior to acquiring a company or placing your business on the market, you should definitely consult your accounting professional. Goodwill may still represent the hard work and effort the seller has put into his or her business over the years — it just has to be accounted for differently and in more detail.

“Confidentiality Agreement – A pact that forbids buyers, sellers, and their agents in a given business deal from disclosing information about the transaction to others.”

The M&A Dictionary

It is common practice for the seller, or his or her intermediary, to require a prospective buyer to sign a confidentiality agreement, sometimes referred to as a non-disclosure agreement. This is almost always done prior to the seller providing any important or proprietary information to a prospective buyer. The purpose is to protect the seller and his or her business from the buyer disclosing or using any of the information provided by the seller and restricted by the confidentiality agreement.

These agreements, most likely, were originally used so that a prospective buyer wouldn’t tell the world that the business was for sale. Their purpose now covers a multitude of items to protect the seller. A seller’s primary concerns are to insure that a potential buyer doesn’t capitalize on trade secrets, proprietary data, or any other information that could essentially harm the selling company. A concern of the prospective buyer may be that similar information or data is already known or is being developed by his or her company. This can mean that both parties have to enter into some discussion of what the confidentiality agreement will cover, unless it is general in nature and non-threatening to the prospective buyer.

A general confidentiality agreement will normally cover the following items:

• The purpose of the agreement – it is assumed that in this case it is to provide information to a prospective acquirer.
• What is confidential and what is not. Obviously, any information that is common knowledge or is in the public realm is not confidential.
• What information is going to be disclosed? And what information is going to be excluded under the disclosure requirements?
• How will confidential information be handled? For example, will it be marked “confidential,” etc?
• What will be the term of the agreement? Obviously, the seller would like it to be “for life” while the buyer will want a set number of years – for example, two or three years.
• The return of the information will be specified. For example, if the sale were terminated, then all documentation would be returned.
• Remedy for breach, or determination of what will be the seller’s remedies if the prospective acquirer discloses, or threatens to disclose any information covered by the confidentiality agreement.
• Obviously, the agreement would contain the legal jargon necessary to make it legally enforceable.

One important item that should be included in the confidentiality agreement is a proviso that the prospective acquirer will not hire any key people from the selling firm. This prohibition works both ways: the prospective acquirer agrees not to solicit key people from the seller and will not hire any even if the key people do the approaching. This provision can have a termination date; for example, two years post-closing.

The sale of a company involves the disclosure of important and confidential company information. The selling company is entitled to protection from a potential acquirer using such information to its own advantage.

The confidentiality agreement may need to be more specific and detailed prior to commencing due diligence than a generic one that is used initially to provide general information to a prospective buyer.

Tips on Maintaining Confidentiality

• Use a code word or name for the proposed merger or acquisition.
• Don’t refer to any principal’s names in outside discussions.
• Conversations concerning the merger or acquisition should be held in private.
• Paperwork should be facedown unless being used.
• All documents should be kept under lock and key.
• Important data maintained on the computer should be protected by a password.
• Faxing documents should be done guardedly.

The following might be a subtitle for this true account of how one deal was put together: “In spite of everything, you need only one buyer – the right one!” (Although the details are factual, names and financial data are fictional.)

The company (let’s call it ElectroCo) has carved a niche in a billion dollar industry. It manufactures proprietary electronic products and is owned by a private equity firm that wants to sell it for liquidity reasons. At the beginning of 2001, the private equity group retained an intermediary firm (fictional name — United Associates) to take the company to market. The goal was to have it sold by the end of the year.

ElectroCo had annual sales of about $12 million, gross margins of 50 percent, an EBITDA of $1.8 million (15 percent) and a reconstructed EBITDA of $2 million. It also had been growing over the past ten years at a 10 percent rate and had always been profitable. It had a diverse customer base split about equally between end-users and OEM accounts. However, the seller wanted to set a very aggressive full price, with all-cash in a not-so-vibrant M&A market.

On the plus side, however, the seller was cooperative and provided any information that United needed. It also had audited statements, conservative accounting and instant monthly statements. ElectroCo was, in addition to these factors, on the verge of getting a substantial amount of new business.

In preparing to take the business to market, United Associates came up with a basic game plan. For confidentiality reasons, direct competitors were eliminated from the buyer search. Synergistic buyers were targeted-either because they served similar markets or utilized similar manufacturing methods. United also elected to contact selected private equity groups and other intermediary firms.

More specifically, United planned on creating a list of 100 potential buyers. A buyer was defined as an entity that had signed a Confidentiality Agreement, had been pre-approved by the seller, and therefore, had been sent an Offering Memorandum. United anticipated 15 written Term Sheets leading to five Letters of Intent which, hopefully, would lead to the best deal. United was not sure that they could sell the business at the multiples asked by the seller. However, they succeeded, and that success was to be based on the following:

Preparing a thorough and compelling Offering Memorandum and pointing out the positive future prospects. This required the complete cooperation of ElectroCo’s management team.

• Developing a complete list of possible buyers both in the U.S. and abroad.
• Contacting the buyers to see if they would be interested in the company, but still maintaining confidentiality.
• Administering all of the potential buyer activity and sending the Offering Memorandum to the appropriate parties.
• Following up with all of the prospects who received the Offering memorandum and arranging tours of the facilities with the serious prospects.
• Setting time frames for expressions of interest and term sheets, and fielding questions from the serious prospects.
• Holding the deal together in spite of the tragic events of September 11th, which resulted in a two-month delay that could have been much longer.
• Making sure that complete confidentiality was maintained and making sure that any future confidentiality leaks did not occur.
• Constantly reminding ElectroCo’s management to stay focused on maintaining sales and profit goals.
• Maintaining communications with both the buyers and ElectroCo’s lawyers and other outside advisors.

United was able to develop a list of 85 possible acquirers; however, five would not sign the Confidentiality Agreement. Here is a breakdown of the 85 possible buyers:

Buyer Type                  Number of Buyers
Strategic                      45
Some Synergy              20
Private Equity Groups     20

Of the 85 possible buyers, 15 were companies or divisions of firms with annual revenues of $1 billion or more. 12 of these 15 were foreign or owned by foreign companies. ElectroCo chose not to deal with four of the buyer firms due to negative industry knowledge. Two of the buyers were individuals that had financial backers. Four buyers were just “bottom fishing.” Three of the 85 decided not to move forward due to the events of September 11. One buyer only wanted to acquire assets, not the stock, of ElectroCo. Interestingly, eight of the 85 firms had previously talked to ElectroCo about a possible merger or acquisition.

Of the buyers who elected not to proceed or move forward, the majority felt that acquiring ElectroCo was just not a good fit. Some of the other reasons why other buyers decided not to continue were:

• Management was too thin
• Since ElectroCo was a good company, the price would most likely be too high
• Buyer purchased another firm
• One potential acquirer was acquired itself
• Buying company was having its own internal problems
• Buyer wanted to move company – this was unacceptable to the seller

After all of this, United Associates arranged five visits for acceptable buyers – the target number. Overall, United received:

• Term Sheets 4
• Verbal Offers 2
• Letters of Intent 4

Of the five buyers who visited the business and met with ElectroCo’s management, two wanted to acquire the company. These were the best prospects. There were also two other firms, held in abeyance, in case one of the other two didn’t work out. One of the original two and ElectroCo’s preferred acquirer offered the desired price and terms. The buyer was:

• A public company that wanted to grow through acquisition.
• One with a synergistic product line.
• Unlike some of the private equity groups, not totally focused on the financial aspects.
• One with an appreciation of ElectroCo’s product lines, its technology and the company’s potential.

United Associates started with 85 possible buyers. The final list came down to just a few and the September 11 tragedy certainly did not help in the sales efforts. ElectroCo was not a company for just anyone. Despite all of this, United got the deal done – proving once again, that you need only one buyer – the right one!

Representations and Warranties

From the buyer’s point of view, “the critical aspect of negotiations is what is stated in the representations and warranties such that the document reflects the following:

Everything you know, you told us.
Everything you told us is true.
Everything you didn’t know, you should have known.”

Nelson Gifford, former CEO of Dennison Manufacturing Company

Both parties and their advisors must understand that Representations and Warranties are not a measure of anyone’s honesty, sincerity or integrity, but a method of allocating some of the risks inherent in any transaction. After all, buyers and sellers are entitled to all the benefits of their bargain – nothing more and nothing less.

In almost any sale of a business, the seller makes certain representations. Their purpose is to insure that the seller, and the buyer, are truthfully and accurately representing themselves and their business. These representations and warranties may focus on various legal, financial or environmental aspects of the sale such as: undisclosed liabilities, pending litigation and tax issues. Their purpose is that the seller is warranting that none of these issues will impede the closing or impact the new ownership. The purchasing entity also represents and warrants, for example, that it has the financial capability to purchase the business. These are usually included in the final agreement between the buyer and the seller. They can be as simple as the seller warranting to the buyer that there is a clear and marketable title to the business being sold. Representations and warranties can also be a lot more complicated. For example, they may not only contain a warranty or representation, but also provide for a remedy if things aren’t as stated or certain future events happen. These are much more important in a stock sale than one of just assets. In the stock sale, the buyer is assuming all of the outstanding issues, risks and, if any, future problems. The seller might warrant that there is no pending litigation and then a disgruntled customer files a post-closing lawsuit. The final agreement might state that an agreed-upon dollar amount would be set aside to cover such contingencies. This remedy is known as an indemnification. The purpose of an indemnification is to provide a solution to a breach of the representations and warranties.

Representations and warranties should be discussed and agreed upon in the early negotiations of the sale. These early discussions can clear up future misunderstandings and provide a safety net for both parties. There is probably little point in continuing negotiations if the representations and warranties can’t be mutually agreed upon at the outset. Intermediaries generally prefer to get agreement on them prior to a Letter of Intent being prepared. From a seller’s standpoint, the company should not be taken off the market prior to a general understanding of the Representations and Warranties.

They are one of the most important aspects of any final agreement. The buyer obviously wants to have as many of them, and as broad in scope, as possible. They create a sort of built-in insurance policy. The seller, on the other hand, would like there to be none, or as few, and as restricted, as possible.

Problems can develop when the buyer, for example, inserts among the representations and warranties an item that is open-ended or beyond the seller’s control. For example, the seller warrants that there are no equipment leases or equipment rental agreements other than described in Schedule F. The buyer doesn’t want to be responsible for any equipment agreements that have not been mentioned. However, the seller wants to limit the company’s exposure. Keep in mind that in privately held companies, the owner is usually responsible for any indemnification of the representations and warranties, so he or she is very concerned with them. The seller’s lawyer might limit the exposure to a dollar amount along with a time period – say three years. Or, as is most common, the buyer agrees to absorb any of the leases up to a dollar amount, anything over which the seller must cover. This means that if some equipment leases do turn-up after the closing, assuming that there has not been any fraud or deception, the method of handling them has already been covered in the agreement.

This time period on the Representations and Warranties is a big concern for sellers. The time periods for the Representations and Warranties surviving the closing can be a deal-killer in the seller’s eyes. How long should a seller be responsible for them? Obviously, this is a critical area and has to be carefully negotiated between the parties. Some that might survive the closing would be matters of litigation, insurance and employee issues. Today, an important post-closing issue can be the intellectual property that may be included in the sale. The buyer entity wants to protect itself from any attack on the ownership of the intellectual property, as it may be a key ingredient of the acquisition. By placing a cap on the dollar amount that the seller and/or his or her company is responsible for and placing reasonable time frames on this section of the agreement can usually resolve this sensitive area.

Sellers often want to couch their Representations and Warranties by using the term material in them. In other words the defect must be material to be considered for any type of remedy. Some sellers even want to limit their exposure by stating that the representation is to the sellers’ best knowledge. Experts feel that the buyer is buying the business and anything that makes the deal riskier threatens the sale. The seller’s claim that to the best of his knowledge there is no other litigation, except that stated on Schedule K, doesn’t provide the buyer the protection that he or she needs. Since the words material or sellers’ best knowledge might be considered vague or ambiguous, placing dollar limits can usually resolve them.

What all this means is that the Representations and Warranties are a big part of the deal. They should not be left to the last. Many sales have fallen apart because a Representation or Warranty and Indemnification were just not acceptable to the seller, or to the firm’s board of directors. The buyer’s due diligence should uncover many of the issues that will be subsequently incorporated in the agreement as Representations and Warranties, and be addressed prior to the drafting of the agreement. The drafting of them should be left to the pros.

Too many deals have fallen apart, or been delayed, because the buyer or his advisors decided, at the last minute, to insert a “surprise” representation or warranty, that the seller not only did not agree to, but had not even seen – causing the seller to become disillusioned with the buyer. Representations and Warranties should be discussed early in a transaction, perhaps be part of the deal structure items, and any changes after the due diligence period disclosed (or proposed) well before the final draft of documents is circulated.

Note: The above article is not intended to provide legal advice. It is designed merely to offer some insight into the subject of Representations and Warranties. For more information, the reader is advised to consult an attorney, intermediary or other competent advisor.