The 2013 BizBuySell report stated a dramatic increase in small business sales in 2013. What’s caused the increase? The increase is due mainly to aging owners, a spillover of sales held off in the recession, a stronger economy, more qualified business owners, and an improvement in small business performance. This trend should continue into 2014. So now is a good time to figure out how this process works and to get your documents in order in case someone comes knocking at your door interested in buying your business.
The business acquisition dance typically begins with a confidentiality agreement. The buyer will need to see financial and business information to see if the business is a good investment. Sellers won’t give out that information unless the buyer agrees to keep it confidential. So they typically enter into a confidentiality agreement. Some sellers even hesitate to provide the information under a confidentiality agreement for fear that the buyer will use it against them. That’s just a risk the seller has to take if they want to sell the business. It also allows the seller and the buyer to come up with a price for the business.
The sale price is the key item of the sale. If the buyer and the seller can’t agree on a price, then there will be no sale. They can use the information provided under the confidentiality agreement to come up with a price.
But how do you value a company when there’s no public market to gauge price, especially for small businesses? You can’t just look up the price on a stock market or input a bunch of numbers and variables and spit out a price. Instead the business is worth whatever someone is willing to pay for it. This often means how much a buyer can afford and their return on their investment.
Here are a few formulas to help you determine a number that’s in the ballpark. There are lots of other ways of coming up with a price, but these are the main methods.
This sounds easy enough. Just check the balance sheet and you’re good to go. But this formula doesn’t account for intangible assets like reputation and goodwill. In some cases that’s okay. It works well if you’re just starting out or are marginally profitable in a highly competitive business. It doesn’t work well for a profitable, mature company.
Multiple of Earnings
This method takes the average of yearly earnings such as net profit or EBITDA (three years is a good number) and chooses a multiplier of that number. This method works well for businesses that have operated for a long time, have consistent profits, and have a good future. The multiplier depends on the industry, but normally is not higher than three. If you’re one of those lucky businesses with great earnings, a niche, and a solid cash flow, you might be able to go as high as ten.
This method is simple. You hire a professional appraiser who decides the value. Or the buyer chooses an appraiser and the seller chooses an appraiser who each comes up with a value on their own. If those two appraisals are too far apart, then the two appraisers hire a third appraiser to provide the final value. This approach can be really expensive and take a lot of time. Since it’s more art than science, it can also be subject to dispute.
The buyer of a small business will typically work in the company and will typically get financing to pay the purchase price. The buyer will need to pay himself or herself a salary and have enough left over from the profit to make monthly payments on the loan. Whatever loan those monthly loan payments can support is the most a buyer can pay for the business. That reality often drives the price.
Letter of Intent
The buyer and seller may consider entering into a letter of intent some time after they sign a confidentiality agreement and after they come up with a price, but before they sign a business purchase agreement. When the parties reach this point they can go ahead and sign a letter of intent or they can immediately start negotiating the business sale agreement.
Typically the parties will choose to sign a non-binding letter of intent for any of the following reasons: they don’t want to take their chances that one of the parties will change the basic terms; they want to exclusively negotiate a deal; or they want to create a moral obligation to negotiate a deal in good faith. The letter of intent should be nonbinding. Otherwise it makes sense to just negotiate the final business sale agreement.
Be careful in how you word the letter. Otherwise you might end up with a binding agreement when you didn’t intend to have one. The letter can include things such as price, a list of assets to be purchased, how to handle liabilities, whether the parties will exclusively negotiate with each other, negotiation schedules, further investigations, and whatever else the parties want to include so long as you don’t include the essential terms of the sale to make it a binding agreement.
With a letter of intent in place, the buyer can take steps to figure out how to pay for the business. There are a number of ways a buyer can pay for a business. The buyer can pay with cash, use savings, ask for help from family and friends, or get a bank loan.
Another option is owner financing where the buyer makes a down payment and signs a promissory note to pay the remaining amount. The seller secures the loan with cosigners on the note, a personal guarantee, first or second mortgages on the buyer’s home or other real property, a security agreement on personal assets, the right to take back the lease, a pledge of stock or llc membership interests, etc. What sort of security the seller asks for all depends on the buyer’s financial strength. If the buyer defaults on the loan, the seller seizes and sells the secured assets to pay off the loan.
Stock/Membership Interest Sale or Asset Sale
Along with financing, the buyer and seller have to choose either an asset sale (including trademarks, copyrights, liabilities, customer lists, etc.) or a stock sale if it’s a corporation or membership interest sale if it’s an LLC. The buyer will more than likely want an asset sale. The advantages of buying the assets includes tax advantages with depreciation, the ability to exclude unattractive assets, removing the company’s debts and liabilities from the deal, etc. The main disadvantages to an asset sale for a buyer is losing valuable assets such as a lease that can’t be transferred to the new owner. If the buyer and seller agree to an asset sale, they will divide the assets and allocate a price to each one. The allocation affects depreciation and the cost basis of each asset.
The seller will typically want to sell the entity to pay capital gains rates rather than income tax rates. If the seller is a corporation, the seller will want to avoid the huge hit that comes from double taxation. Whatever the parties choose to do will affect the price. That’s why this decision will need to be made early.
People in Transaction
The people in the business are just as important as the assets, stock, or membership interest. Sometime the buyer will want to keep an owner as a consultant, a part-time or full-time employee, or an advisor. The buyer might want to consider a transition period for an owner. This requirement can either be included in the business sale agreement or negotiated separately. If an ex-owner becomes an employee, then treat him or her as you would any other employee by providing an employment contract or an at-will offer. Make sure to specify their duties. If the ex-owner is a consultant, then make sure to negotiate an independent contractor agreement.
Sometimes the business will have key employees that the buyer wants to keep. If the key employee has a contract, the buyer might just take over their contract. If it’s an entity sale, the contract will automatically be part of the deal. If it’s an asset sale, then the parties need to get proper consent to assign the contract to the buyer.
Sometime the seller’s owners will have no part in the business once it transfers to the buyer. If this is the case, the buyer should consider a non-compete agreement to protect itself from future competition. The seller might start a competing business or work for a competitor. The non-compete normally covers a geographic area (these days that might include the internet), the type of activities, and the duration of the non-compete. The non-compete can be part of the business sale agreement or a separate document.
The business sale agreement is the document that binds the parties to the sale based on a few conditions such as due diligence and financing. The business sale agreement includes the price, financing/payment terms, employment/consulting agreements, non-compete agreements, and many other terms including the parties who are part of the deal, assets or business purchase identification, liabilities, representations, closing terms, dispute resolution procedures and many more provisions. The buyer and seller should not rely on each other’s oral promises. Everything should be in writing.
The business purchase agreement may be followed by a due diligence period then closing. Sometimes all of the due diligence is done, so the business purchase agreement and all of the closing documents are signed at the same time.
The buyer wants to make sure he or she knows what they’re getting when they buy the business. No buyer wants surprises. The process of investigating the business is called due diligence. The documents and information the seller provides to the buyer under a confidentiality agreement is part of this process. The buyer will want to ask for information on bank loans, money owed to suppliers, potential claims, contracts, etc. The buyer will ask the seller to represent the accuracy and completeness of these records along with other representations and warranties.
The buyer will also want to look at public information. The buyer may search the recorder’s offices to see if the assets are encumbered by any liens such as UCC finance statements, mechanic’s liens, deeds of trust, etc. A title report will also show whether the property is owned free and clear or is subject to encumbrances. The buyer should search the court system records for any litigation and search other public records to make sure the company is in good standing. The buyer may get a Dun and Bradstreet report to find out the creditworthiness of the seller. Depending on the type of business, the buyer should search the records of other government agencies.
The seller will also want to check out the buyer, especially if the sale is owner financed. The seller can ask for financial statements, tax records, resumes, credit reports, references, court records, and some of the same records the buyer will review. The seller will also want representations and warranties from the buyer. If you’re the seller and are financing the transaction, then you want to make sure that you’re first in line as a creditor or if you’re second in line, that there will be enough left over for you.
The seller and buyer will need to respond to the results of the due diligence. This may mean adjusting the price, carving out liabilities, including indemnification language, etc. Whatever is done, the agreement is only as good as the financial soundness of the seller or buyer.
The closing is when all the parties who have the authority to sign the documents meet and finalize the transaction. This can take place at the business, an attorney’s office, or somewhere where it’s easy to make copies and last minute changes.
If the sale is owner financed, the buyer signs a promissory note, security agreement, UCC financing statements, deed of trust, etc. If the owner provides services to the buyer, the owner signs an employment agreement, consulting agreement, or offer letter depending on what the seller will do. If the seller does not provide services, the seller will typically sign a non-compete agreement.
If the sale is an asset sale, then the seller signs a bill of sale, warranty or quitclaim deeds, to transfer the assets from the seller to the buyer. The seller also assign leases, other contracts, and the rights to intellectual property such as copyrights, trademarks, and patents. The seller also needs to provide written consent from the contracts they assign to the buyer.
When all the documents are signed, the buyer walks away with a business and the seller walks away with cash or rights to receive cash.
Written by Andrew Mitton, owner Vellum, LLC
Portions of this article are taken from my book found online at: insideoutlegal.com