Selling a Business

Unlike that poetic title of an old-time standard song, Red Sails in the Sunset, red flags are not a pretty sight. They can cause a deal to crater. Sellers have to learn to recognize situations indicating there might be a problem in their attempt to sell their business. Very, very seldom does a white knight in shining armor riding a white horse gallop up, write a large check and take over the business – no questions asked. And, if he did, it probably should raise the red flag – because that only happens in fairy tales. Now, if the check clears – then fairy tales can come true.

Sellers need to step back and examine every element of the transaction to make sure something isn’t happening that might sink the deal. For example, if a company appears interested in your business, and you can’t get through to the CEO, President, or, even the CFO, there most likely is a problem. Perhaps the interest level is not what you have been led to believe. A seller does not want to waste time on buyers that really aren’t buyers. In the example cited, the red flag should certainly be raised.

A red flag should be raised if an individual buyer shows a great deal of interest in the company, but has no experience in acquisitions and has no prior experience in the same industry. Even if this buyer appears very interested, the chances are that as the deal progresses, he or she will be tentative, cautious and will probably have a problem overcoming any of the business’s shortcomings. Retaining an intermediary generally eliminates this problem, since every buyer is screened and only those that are really qualified are even introduced to the business.

Both of the above examples are early-stage red flags. Sellers have to be focused so they don’t waste their time on buyers that are undesirable. If a buyer appears to be weak, does not have a good reason to need the deal, or is otherwise unqualified, the red flag should be raised because the chances of a successful transaction are diminished. The seller might seriously consider moving on to other prospects.

Red flags do not necessarily mean the end of the deal or that it should be aborted immediately. It simply means that the seller should pay close attention to what is happening. Sellers should keep their antenna up during the entire transaction. Problems can develop right up to closing. Here is an example of a middle-stage red flag: The seller has received a term sheet from a prospective buyer and is then denied access to the buyer’s financial statements in order to verify their ability to make the acquisition. As a reminder, a term sheet is a written range of value for the purchase price plus an indication of how the transaction would be structured. It is normally prepared by the would-be purchaser and presented to the seller and is non-binding. A buyer who is not willing to divulge financial information about his or her company, or, himself, in the case of an individual, may have something to hide. Due diligence on the buyer is equally as important as due diligence on the business.

If a proposed deal has entered the final stages, it doesn’t mean that there won’t be any red flags, or any additional ones, if there have been some along the way. If there have been several red flags, perhaps the transaction shouldn’t have gone on any further. It is these latter stages where the red flags become more serious. However, at this point, it makes sense to try to work through them since problems or issues early-on apparently have been resolved.

One red flag at this juncture might be an apparent loss of momentum. This might mean a problem at the buyer’s end. Don’t let it linger. As mentioned earlier, at this juncture all stops should be pulled out to try to overcome any problems. If a seller, or a buyer, for that matter, suspects a problem, there might very well be one. Ignoring it will not rectify the situation. When a red flag is recognized, it is best that it be confronted head-on. It is only by acting proactively that red flags in the deal can become red sails in the sunset – a harbinger of smooth sailing ahead.

“The most successful integrations were directed by people who placed the common good of the combined organization and its customers before all else.”

From: The Mergers & Acquisitions Handbook.

By now, most business owners are familiar with the problems created by the merger of Daimler, the German automobile company, and Chrysler, the American car maker. Here is the classic case of cultural friction adversely impacting what was originally promoted as the merger of “equals.” If any deal can point out the importance of a cultural fit in a merger or acquisition – this is it. The officers of Daimler took complete control and the executives of Chrysler left in droves. Not only were the management styles completely different – centralized versus decentralized, quick decisions versus decisions by committee, supplier rivalries versus supplier partnerships — but, in addition, the American management team received huge compensation packages, while the Daimler people worked on small salaries, but huge “perks.”

Mergers and acquisitions are supposed to produce synergies that bring results.  If they don’t, the culture is too often the reason. John Chambers, the CEO of Cisco Systems, who has been involved in some seventy acquisitions, says that he will not do a deal unless there is a cultural fit. Culture according to one dictionary is defined as the “customary beliefs, social forms, and material traits of a … social group.” The word “compatible” may be a better choice defined by the same dictionary as: “able to exist or act together harmoniously.” Regardless of the semantics, if both companies can’t work well together, the deal is a bad one. The importance of this cultural fit may be influenced by the nature of the deal and the desires of the seller. Here are some examples:

• The seller sells the company on an all-cash basis and doesn’t really care what happens to the employees, the customers or the new owners. In other words, the seller takes the money and runs.
• The seller receives sufficient cash that he or she is secure about the transaction. Despite this almost all-cash deal, or the quality of the security for the balance, there is serious concern for the employees and their future with the new ownership.
• The seller merges the company and/or receives stock in the acquiring firm. Further, the seller’s compensation, to say nothing of any increase in the equity, may be determined by the success or failure of the cultural fit of the merged companies.

Obviously, in the first example, the question of a cultural fit, or any fit, for that matter, is moot. Assuming, however, that the prospective seller fits into one of the two latter situations, how does one determine the compatibility of the two firms? It may be a non-issue if the seller’s company is going to remain autonomous. Or, the acquiring firm may have been through several similar situations and is experienced in the assimilation process. These two examples do not necessarily mean that the companies will mesh perfectly, but they do help. However, if a cultural fit is of concern, what can be done to help assure an orderly blending of the two firms?

It can be as simple as the seller having a casual dinner with the owner or CEO of the acquiring or merging company. Much can be learned one-on-one about how the other company is managed and about its owner’s business philosophy. Is it based on teamwork? Is it entrepreneurial or hierarchical? Is the company customer or policy driven? If the CEO of the acquiring company is reluctant to share a social occasion, then the seller may have already received the answer to the cultural fit question.

Other areas that should be considered: how are the employees of the other company compensated? Or, for example, something as mundane as the company’s product return policy may provide insight into the successful integration of the two businesses. How far apart are the companies’ mission statements?

Absorbing smaller companies can be a lot easier than two firms of approximately the same size merging. There are few companies whose cultural styles are so similar that integration is an easy matter. In many cases, where there may not be a perfect cultural fit, proper communication can resolve most of the issues. Unfortunately, there are some situations, like the Daimler Chrysler example, in which the two companies may never be integrated successfully.

Sellers who are concerned about the right cultural fit should investigate this before the deal gets too far along and, obviously, prior to closing. An intermediary has the knowledge and experience to work with both buyers and sellers on this all-important issue. The right culture may be a “soft” issue when it comes to mergers and acquisitions, but just may be one of the most important.

• Settle all litigation and environmental issues before putting the company on the market.

• Hire a good transaction lawyer, because the buyer will also.
• If company owners are totally inflexible, the buyer may walk away from the transaction.
• Be prepared to accept a lower price for lack of management depth, dependence on a small number of customers or clients, and lack of geographical distribution.
• When a buyer indicates he or she may be ready to submit a Letter of Intent, tell them up front what items you want included. For example, price and terms; what assets and liabilities are to assumed, if an asset purchase; what contracts and warranties are to be assumed; and time schedule for due diligence and closing.  (These are just some of the items a seller might want included.)
• Be advised that many buyers will view the value of Sub Chapter S corporations to be worth less than if the company is a C Corporation.
• Make the company more visible by attending trade shows.  Tie up patents, copyrights and trademarks.  Create a public relations program.  These areas all create perceived value.
• Selling a company involves sometimes-inconsistent objectives: speed, confidentiality and value – pick the two that are the most important.
• Keep in mind that companies get stale after sitting on the shelf for awhile.
• Don’t expect your lawyer to win every point of contention – you want a dealmaker, not a dealbreaker.

A sellers memorandum includes all those points one would normally expect to see in any business plan, to wit: an executive summary, a business description, financial requirements, target market niche, identification of top management, an operations review, analysis of strengths and weaknesses, and current financial statements and projections.

Guide to Mergers and Acquisitions published by PPC

A proposed sale of a middle-market company almost always begins with a selling memorandum. This document is called many things, including offering memorandum, confidential descriptive memorandum or simply the book. Regardless of what you choose to call it, its purpose is to encourage prospective buyers to take a further look at the company.

For the seller, it has a secondary side benefit. It forces them to take a hard look at the company, its strengths and its weaknesses. Upon reviewing the information necessary to prepare a selling memorandum, the seller may, in fact, decide that it’s not such a bad company after all and elect to keep it. On the other hand, the seller could decide that the current condition of the company needs to be improved before attempting to sell it. Looking at the company through the eyes of a buyer, could also prompt the seller to try to increase the value prior to selling. This may be done, for example, by building a stronger brand loyalty, by entering into employee contracts with key managers, or perhaps by diversifying the customer base.

Assuming, however, that the decision to sell has been made, the importance of the selling memorandum can not be emphasized enough. It is like a strong advertisement for the company and it must tell a good story. It should highlight the positive parts of the company, add value for the buyer, and show the negatives as opportunities. The selling memorandum has to make a good first impression. A seller wants to attract qualified buyers and bring value to the company being sold. This means that the selling memorandum has to be prepared and written by a professional. It is too important a document to do it any other way. It is also the basis of a strong marketing program to attract the best buyer at the best price.

What makes up a strong selling memorandum? It includes quite a few different elements. But, first a few caveats:

• Don’t include confidential company information or reveal trade secrets. Although the document may be intended for qualified buyers only, once it is disseminated it really becomes a public document. Professional intermediaries and investment bankers do make prospective buyers sign a confidentiality agreement, which does help in this area. Still, with copy machines and email services readily available, it never hurts to maintain confidential information until much further in the negotiations.
• Make sure that a prospective buyer knows exactly what you are selling. It is assumed unless otherwise mentioned that it is the entire company that is for sale. You don’t want prospects to think that they can purchase just the most profitable portions of the company. Obviously, a seller wants to show-off the excellent parts of the company, but this should not be done at the expense of the not-so-good parts. These can be presented as excellent opportunities.
• The selling memorandum should not be aimed at the right prospects. If the business requires technical language to best explain it, use it. A buyer, who doesn’t understand it, probably isn’t a buyer.
• There should be an explanation of how the company works so a prospective acquirer can read through the lines about the selling company’s corporate culture. This element can make or break a sale and it’s best to discover it at the outset.
• There is always a tendency to include too much information – don’t. Don’t over-sell. You don’t need to include the names of customers and vendors and the names of all the employees.
• Be sure to also include the blemishes. If there is a pending lawsuit, include. The bad news should be revealed early on – no one likes surprises, especially later in the negotiations.
• And, finally, and probably, most important, the selling memorandum should be easy to read.

Now, what about the various elements of the selling memorandum. Here are the areas that should be covered in it.

Business Profile (or Executive Summary) – This may be the most important element of the selling memorandum. The entire offering should be covered in brief – no more than four-pages, at most. Many are done in one page. Remember, the sole purpose of the business profile is to generate excitement and interest. It is a selling piece! It should include:

• Ownership
• The Business
• Financial highlights
• Products and/or services
• Markets
• The opportunities
• Reason for sale (Why is it for sale?)

This business profile is usually sent to possible purchasers. If the prospect is interested further, they sign a confidentiality agreement before receiving the entire selling memorandum. The selling memorandum includes detailed information on the key elements of the company and usually covers the following:

• Business overview – In other words, who and what is the company? This is the place where everything about the company is summarized: it’s history, the employees (in general), the management team, the locations, any important intangible assets, and the outlook for the business.
• Company strengths – What does the company do well? This should cover those strengths that bring value to this particular company.
• Markets – Who are the customers/clients? What and how does the company sell its products or market its services.
• The Risks – What are they? If there are risks in the business, they should be described and then an explanation of how the company solves them.
• Financial data – Is the company making money? Cash flow statements are important. Current thinking is that the seller doesn’t have to include all of the available financial data – which the prospective buyer will go through all the financial history as the deal moves forward.

The selling memorandum should include any relevant corporate and/or product brochures as attachments. Prior to putting the business on the market, it is important that an outside valuation be performed. However, the price and terms are not usually a part of the selling memorandum – the marketplace will dictate the price. The purpose of the entire selling memorandum is to generate sufficient interest so that a prospective acquirer will make an offer.

Building Value

Prior to putting a company on the market for sale, the question of value has to be addressed. Increasing the value should, in fact, be considered a year, preferably two, prior to sale. Value is based on profitability, cash flow, management and the overall quality of the operation itself. Here are some considerations in building value, whether the business is going to be sold or not.

• Are the company’s pricing policies set too low, creating low margins? Perhaps they were set some time ago in order to boost sales. Now might be a good time to review them to make sure they are in keeping with current market conditions.
• Is the inventory level too high? How about work-in-progress or finished goods? Increasing the turns in inventory can increase cash flow.
• Are you paying too much for raw material? Talk to your vendors and suppliers, you might be able to get some better prices or terms. Take a look at all of the expenses: utilities, telephone, technology, office expenses – it all adds up.
• Are there services that could be outsourced for increased savings?
• Increasing the quality of customer service may entice customers or clients to pay their bill promptly.
• Are all the employees working together to improve the operation and profitability of the company?

These are just a few of the areas that can and should be reviewed. Although profits are important, there is an old expression that cash is king. The time to take a look at the overall company operations is now.

Measuring the Value of a Company

Consider the following important areas of a company. How does your company stack up in these critical areas? If you were to rank them on a 1 to 4 scale, for instance, what would your score be? The higher the score the more valuable the company! They are considered value drivers – in other words, they are important to a prospective buyer.

• Profitability
• Type of business
• History of company and industry
• Business growth
• Customers/Clients
• Market share
• Return on investment
• Quality of financial statements
• Size
• Management
• Terms of sale

For example, in looking at a company’s financial data – are the statements audited or merely compiled? Is the growth of the company slow or is it growing quickly? How about the customer base – is it based on several major ones, or is it spread out over many customers? The time to consider these critical value drivers is now!