The sale of a privately-owned business is often the most significant financial event in the life of the owner. It marks the culmination of years of hard work and converts paper wealth into real wealth. It is a one-time opportunity with no do-overs. Every business owner surely desires the best economic outcome, yet, time and time again, business owners leave money on the table by not adequately preparing for the sale of their company. This article suggests five actions that private business owners can take to avoid leaving money on the table when selling their business.
1. Manage the Business as an Investment
A privately-owned business should be managed and evaluated as an investment similar to any other financial asset. How do business owners treat their stock portfolio and other financial investments? They periodically review and evaluate the financial performance of their investments. They set target sale prices, review dividend or interest yields, routinely monitor increases or decreases in market value, and assess the market value of their investments relative to alternative investments, broader markets, and comparable companies. They decide if and when to buy or sell investments based on their current value and how much they have increased or decreased in value. Business owners who fail to pay attention to the investment nature of their business all too often lose control over the liquidity process, suffer tax inefficiencies when they sell their business, and miss the optimal time to sell their business.
So what is the lesson? The key is to be proactive, rather than reactive. Long before an opportunity to sell the company arises, a business owner should obtain regular valuations of the company by a qualified business appraiser and establish a relationship with an investment banker who can inform the business owner of current market trends, the market values in the company’s industry, and the broader M&A (mergers and acquisitions) market. The M&A market moves in cycles, generally and specifically by industry, that are affected by broader economic cycles. Valuations are higher in some periods than in others and industries go in and out of favor. The valuation of a business is also affected by its condition and stage of development. To maximize the sale value of their business investments, business owners should routinely monitor the value of their companies and seek to sell their companies when market valuations for their business are higher, rather than selling in reaction to an external event, such as an unexpected offer to buy the company. Otherwise, they get what the market conditions dictate at the time when an opportunity to sell their company arises. No business owner would leave her or his stock portfolio to that fate.
2. Reduce Post-Sale Uncertainty
Shakespeare wrote in The Tempest that “What’s past is prologue.” Businesses are sold on a similar premise, that past performance is indicative of future performance. Sellers want buyers to value their businesses based on the best possible view of their historical and projected operating results. Buyers look for assurance that a company’s business will continue as in the past and punish uncertainty by offering a lower purchase price. Any potential uncertainty regarding the ability to sustain past performance after sale will diminish the perceived value of the business. A few key areas of potential uncertainty are discussed below.
Assurance regarding the accuracy of the financial operating results of a business is paramount to maximizing the sale price of a business. Audited financial statements provide this assurance. The absence of audited financial statements can be mitigated by a quality of earnings report by an independent accounting firm that assesses the accuracy and sustainability of historical earnings, as well as the achievability of future projections, but it is not equivalent to an audit. The sale process is faster and smoother for a company with audited financial statements, and every experienced M&A advisor knows the saying that “time is the enemy of all deals.” In addition, the financial representations and warranties of the seller, and the associated post-transaction indemnification risk for representations and warranties, are generally more extensive for a company without audited financial statements. The positive effect of audited financial statements on the selling price of a company is difficult to quantify, but the value to the seller is unquestionably significant and far exceeds the cost of the audit.
A primary concern of a buyer is whether existing customers of the business will continue with the business after its sale. Customer contracts that are assignable and have expiring terms beyond one year add value. Customer contracts that automatically renew also have value. Customer relationships that are not based on a written contract or that are based on a written contract that has an expiring term or is not assignable without the approval of the customer create uncertainty regarding whether the customer will stay with the business after its sale.
A business that has many customers who each represent a very small percentage of its revenue will not suffer a material financial impact from the loss of any particular customer. Consequently, a buyer has more comfort that it will be able to sustain the business after sale. On the other hand, a business that is reliant on one or a few customers for a substantial portion of its revenue has more uncertainty regarding its ability to sustain its past operations. The loss of a primary customer will materially diminish revenue, unless the company can “replace” the revenue with new customers. Customer concentration is a business condition that should be addressed before a decision or opportunity arises to sell the company. The best solution is to grow the business and the customer base to reduce the concentration. Another solution is to enhance customer retention though a written contract for a term of years that is assignable to a buyer of the business without the approval of the customer.
The dependency of a business on a single supplier can also diminish the value of the business. The loss of a major supplier could adversely affect product quality or result in substantially higher expenses if an alternate supplier of comparable quality is not readily available. The uncertainty associated with supplier dependency can be eliminated by developing multiple suppliers for the same goods or services and can be mitigated by entering into a written supply contract for a term of years that is freely assignable and assures continuation of the supply, absent business failure of the supplier.
Financial buyers, more so than strategic buyers, count on the continued active management of the business by its existing management. The dependency of a business on the owner, founder, or other key executive who will or could exit the business after the sale creates uncertainty regarding whether the business can run at the same level after its sale. This uncertainty can be mitigated by cultivating capable successor management in advance of sale and by a key person’s willingness to continue working for the company for a post-sale transition period.
3. Get Your House in Order
Selling a business is a lot like dating. You need to put your best foot forward. A buyer’s first intensive look at a business usually occurs during due diligence, when the buyer reviews, among other things, the leases, permits, licenses, tax returns, benefit plans, corporate records, customer contracts, and employment agreements of the business. The sale process will be faster and the perceived value of the business will be enhanced if all these items are buttoned down, readily accessible, and convey the impression of a diligent, meticulous, well-organized business.
Permits and Licenses
Before starting a sale process, a company should confirm that it has all permits and licenses from governmental authorities or third parties that are required for the conduct of its business and that it has copies of all its permits and licenses, including software licenses. If a company has proprietary intellectual property that is material to its business, it should verify that it has all the ownership rights to the property and that any legal rights in the property of consultants or other third parties who help create or develop the intellectual property have been assigned to the company. The failure to have all necessary permits and licenses in place can cause delay in the sale transaction, create liability or compliance risk that affects the business value, and result in an escrow holdback of a portion of the purchase price.
Employment agreements should be in place and current for all key employees of the business and, ideally, have terms that will extend beyond the sale of the company. In addition, and to protect against competitive harm following severance of employment, the employment agreements should include restrictive covenants that are assignable by the company without the consent of the employee and prohibit the employee, for a reasonable period of time after severance of employment, from competing with the company, using or disclosing confidential information of the company, and soliciting or doing business with the company’s customers and employees. Trying to extract these protections from key employees during the sale process can prove costly and difficult.
The corporate records of a business should be neat, complete, and up to date. These records include documentation of the issuance of all ownership interests and the minutes of meetings (or written consents) of the company’s owners and governing body (board of directors of a corporation or managers of a limited liability company) to authorize all actions that require their approval or authorization under applicable law or the governing documents of the company. Sloppy and incomplete records create a bad impression, can cause a snag or delay in the sale process, and cast doubt about the accuracy and reliability of other information concerning the business. There is no substitute for having a corporate lawyer review and clean up the corporate records of the company in advance of the sale process.
4. Invest in Tax and Estate Planning
Pre-sale tax and estate planning is required to optimize the economic results of the sale of a company and any desired transfers of resultant wealth to charities or family members. Depending on the facts and circumstances, opportunities exist under federal income tax law to make tax free distributions to owners in advance of the sale or to defer or exclude all or a portion of the taxable gain realized on a sale. It is unfortunate, and completely avoidable, when a seller fails to take advantage of potential tax benefits for want of planning.
Pre-Sale Gifts of Ownership Interests
The time to make gifts to charities or family members with the wealth to be generated from a sale of a business is before an offer is received or the sale process begins. Too often, business owners wait until after the sale to consider these matters, and then the gifts are funded less efficiently with after-tax dollars. Before starting a sale process, a minority ownership interest in a business usually can be valued under generally accepted appraisal practices for materially less than its ultimate sale value, enabling a business owner to transfer minority ownership interests to family members or an irrevocable trust for their benefit at a discount to its future sale value and remove that wealth from the business owner’s taxable estate for federal estate tax purposes. Gifts to family members also can be made through so-called “grantor retained interest trusts” (a GRAT or GRUT) that allow the donor to receive (after the sale of the company) annual or more frequent payments for a specified number of years and then transfer the remainder to family members. The donor is taxed on the income of the trust, but, if properly structured, the remainder interest can be transferred to the beneficiaries free of gift tax. Gifts of minority ownership interests can also be made to charities, whether outright or through charitable remainder trusts (a CRUT or CRAT), generating an income tax deduction for the fair market value of the donated interest and avoiding income tax on the taxable gain on the donated interest when the business is sold. Further, a number of charitable foundations accept gifts of business ownership interests in so-called “donor advised funds” that enable the donor to receive a charitable deduction for the entire fair market value of the gift in the taxable year when it is made and, in ensuing years after the business is sold, make grants from the resulting proceeds to charitable organizations of choice.
Transaction Tax Matters
Tax planning is also important, of course, for the sale transaction, to promote tax efficiency and improve tax consequences. The structure of the sale transaction, and tax elections and allocations with respect to it, can affect the character of gain as capital gain or ordinary income. Any so-called “equity rollover” should be structured to avoid income tax on the rolled equity. The payment of transaction expenses should be structured to preserve the benefit of the associated tax deduction for the selling owners.
5. Hire Good Advisors
A team of good professional advisors is crucial to a successful sale of a company. Many of the issues discussed in this article can be avoided or resolved by engaging capable professional advisors in advance of the sale process. The team of professional advisors should include an accountant, a tax advisor, an M&A lawyer, a wealth advisor, an investment banker, and a trusts and estates lawyer (if any estate planning or charitable giving is desired). Wealth advisors can help business owners assess their current and future cash needs and determine whether the net sale proceeds will be sufficient to achieve their desired post-sale lifestyle and legacy goals. A capable M&A lawyer who understands the deal process, the unique provisions of acquisition agreements, the issues presented by them, and how they are customarily negotiated is essential to a smooth deal process, reducing transaction risks, and enhancing transaction economics. The sale of a business is a complex and specialized process, and a good investment banker adds significant value in numerous ways. A good investment banker has the skills, resources, experience, extensive contacts, and specialized knowledge to conduct and manage the sale process (including due diligence), identify and canvass potential buyers, analyze offers from potential buyers, and negotiate the sale transaction. In addition, the use of an investment banker adds credibility to the seller, levels the playing field with buyers, and generally increases the sale price.
With advance planning and the help of good advisors, a business owner can avoid the common pitfalls that leave money on the table when selling a business. The cost of neglected opportunity can be significant.
The original article, "How to Avoid Leaving Money on the Table When Selling a Business," first appeared in The Mark, Volume 17, Issue 1 in January 2019.