The M&A market cycle is strong right now, making the possibility of exiting your business more real and the window for getting it done tighter. If you think you’re ready to move forward, be aware that, as with everything in business, the devil’s in the details. While the basic sale process is simple enough, there are things you need to address to ensure you get the best price and avoid unnecessary dings down the road.
If nothing else heed this – plan ahead
Like any major life decision, selling your business isn’t something you should do at short notice. Generally, you should start planning for your sale as much as one to two years before you’re actually ready to divest yourself of the business so you have time to ensure all legal, financial, and other loose ends are tied up. The preparation you do now could add significant financial value later.
Sometimes the opportunity to sell your business comes out of leftfield and you don’t have a long time to plan. In that case, it is important to get your professional team involved as soon as possible and prior to a Letter of Intent being signed.
Build an experienced team early
You may have in place legacy consultants, external financial people, or others who were with you from the beginning; this does not mean they’re the right team for the job. You need a team with experience, a team that knows its way through the M&A labyrinth. Your lawyers will be integral to the process because they will help with any pre-deal clean-up work that should be undertaken, and the planning and structuring of the transaction. They can also help structure agreements and engagement letters with investment bankers and accountants, and make useful introductions to those they work with.
Here are the people and roles you should consider:
- Lawyers will prepare your key legal documents, including confidentiality agreements, letters of intent, seller disclosure agreements, and final sales agreements. They can also help you with personnel issues, and settling any outstanding contracts you may have with vendors or clients, as well as tax liability and estate planning issues as a result of the sale. Deep M&A experience is a must.
- Depending on the size of your business, investment bankers can help identify and vet potential buyers, ensure confidentiality surrounding your potential deal, and provide advice on the overall value of your business on the open market. This is called “running a process.”
- Accountants will help you get your finances in order and make sure your books are clean, presentable and, crucially, accurate.
Identifying your assets
A business is more than the sum of its parts. But to get the most out of your business at the time of sale, you must know all the tangible and intangible assets it comprises.
Tangible assets are the physical items that make up your business, from building or real estate holdings to vehicles, furnishings, inventory, and any other physical items you own. Because they’re real and visible, tangible assets are the easiest to appraise at the time of sale. Intangible assets are the abstract items like your business’s name and reputation, and recurring business or custom that you have built over time but whose value is not immediately obvious.
Combined, these intangibles form what is known as your “goodwill,” and may include:
- Your brand and identity
- Any trained employees who stay on after the sale (and removing trouble spots)
- Your clientele
- Supplier and distributor networks
- Phone numbers, websites, and your social media presence (Facebook, Twitter, Instagram, etc.)
- Proprietary technologies, processes, or systems that mark you out from your competitors
Additional intangibles can include intellectual property rights, such as trademarks, patents, and licensing agreements you have accumulated over the years. There might be IP clean-up to undertake, perfecting “work for hire” rights, procuring or renewing trademarks or patents; there might be equity “out there” held by co-founders or former employees that you’ve forgotten about; and there may also be outstanding litigation or threatened litigation. You may not be able to clear everything up before the sale, but considering as many of these things as possible upfront will mitigate if not obviate challenges.
Minimize the earn-out
Minimizing the time you remain in the business post-sale depends on the structure of the company and other factors. Ask yourself: do you hold all the client relationships? Is there a strong second layer of management? If you walked out tomorrow, what would happen? The closer the answer is to “everything would be fine,” the better the valuation you’ll likely get. Whether it is a service business or a software business with algorithms and other assets can also affect quantum of sale price, and it’s important to be aware that offers are often presented in multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization).
Get the paperwork right
Possibly the most time-consuming, mind-numbing, and important part of preparing for sale is to make sure all your paperwork is in and clean before a prospective buyer walks in. This means compiling at least two or three years of financials including:
- Corporate tax returns
- Income statements
- Balance sheets
- Accounts receivable
- Accounts payable
- Inventory lists
- Payroll records
- Lease or mortgage records
- Franchise records (if applicable)
- Outstanding loan agreements and/or liens
- Audited financials – helpful but rare with US SMEs
As the sales process advances, your counsel or prospective buyer may suggest you sign a variety of documents designed to facilitate the sale, and to protect both yours and the buyer’s interests while details are worked out. These may include, but may not be limited to:
- Nondisclosure Agreements (NDA), which should be created at the start of any negotiation, as they serve to ensure that sensitive corporate data is not divulged during the process. Most NDAs stipulate that information should remain confidential for a period of up to five years, and that confidential information will be returned to you should the negotiations fail.Additionally, some NDAs will stipulate that prospective buyers cannot solicit your employees for one to two years after the agreement is signed so that they cannot poach valuable talent should your deal break down and they decide to pursue other options. Also, it’s not unheard of that a competitor might just want a free look “under the hood” of your business. Click here to see our article on the perfect NDA.
- Letter(s) of Intent (LOI), a non-binding offer from the buyer outlining the key points of a proposed transaction. Typically, this letter may specify items such as the purchase price and closing date, and clarify issues surrounding escrow and indemnification.Although non-binding, an LOI sets the parameters for the deal and may have pitfalls. It is important to involve your attorneys in negotiating the LOI. Typically, these letters contain “no-shop” clauses that protect the buyer during the due diligence period by prohibiting the seller (you) from discussing or negotiating with any other parties to buy the business for a period of 30 to 60 days from the date of signing. Be aware that the buyer has a lot of leverage once you sign the LOI: the leverage shifts and you are tied up – usually for the no-shop period – while the buyer hasn’t really risked anything. There are “tire-kickers” out there who can just throw out a number. Doing a little reverse due diligence can be helpful for this and other reasons.
- Escrow, which in most cases may stipulate that 10% to 20% of the purchase price is locked up for a period of 12 to 18 months to ensure that the seller (you) have complied with all the representations and warranties spelled out in the purchase agreement.It is in your best interest to negotiate as low an escrow as possible, to last for as short a time as possible. Obviously you want to maximize the cash at closing and minimize the earn-out cash or delayed payments as they often have risk attached. Working on not in the business can convince buyers to hold less back in earn-out.
- Representation & Warranties, which is an area of significant negotiation between buyer and seller. As a seller, you will want to limit the nature, extent and duration of your reps and warranties regarding the business. Conversely, the seller will try to expand these, and they are often technical (e.g. tax, employment, litigation) and difficult to parse.
- Indemnification and Limitation of Liability – If, for some reason, you do breach any of the representations or warranties spelled out in the sales agreement, you can protect your financial exposure by using baskets and caps on indemnification, limiting the indemnification period, and including a limitation of liability clause.This is an area where it may take some negotiation in order to reach agreement, as the buyer generally does not want any limitations placed on the deal, while you would ideally like to see the money placed in escrow serve as the only financial risk you may face should problems arise.
Usually, depending on the type of business you’re selling and the level of expertise you and your employees possess, and whether or not there is an earn-out, buyers may seek to have you sign non-competition agreements or employment agreements to prevent you from returning to the industry for a period of time, generally three to five years, or to secure your assistance through a set transition period after the sale has closed.
Because selling your business will likely result in a healthy bump in your bank account, you’re going to want to do everything legally possible to limit your tax liability.
Investigate if you qualify for Section 1202 of the Internal Revenue Code (IRC), which allows the selling owner of a business to exclude up to $10 million of gains from income/capital gains tax, starting with our article on the subject. You may wish to explore other tax-planning strategies such as Grantor Retained Annuity Trusts (GRATs) with your tax attorney.
If you live in a high-tax state, you may consider relocating your permanent residence to someplace with a lower (or even no) state income tax, such as Florida, Texas, or Nevada. Because you may be required to provide proof of residency in order to protect your newly realized assets (although this is not common practice), it is something you need to do in advance.
Many selling clients we assist have a key team of managers, perhaps with minority “ownership” in the business. Some have promised to “take care of them” at exit; some actually transferred stock or options. Note that if that ownership is not conveyed one year or more prior to exit then long-term capital gains tax will not apply and that individual’s sale windfall will be taxed at ordinary income rates. Again, plan ahead!
The process of exiting your business can be long and complicated. Preparing early can mean you sell for more and minimize pain on an earn-out. Your legal team needs to have the breadth to handle the different disciplines that can make their way into M&A – individual and corporate taxation, corporate, employment, real estate, IP, immigration… to name just a few. One or two main deal lawyers can staff most of our small- and middle-market deals, and the specialty attorneys are only involved as issues in respective areas of expertise emerge; this keeps the time and legal cost in check.
We would be delighted to walk you through the process, and of course answer any questions.
Allan Rooney, Founding Partner – firstname.lastname@example.org