Chapter Six

Will it be an “ASSET” sale or a “STOCK” sale? The first (and most fundamental) question when structuring either an internal or external transition of any business, is whether it will be structured as an “asset” sale or a “stock” sale. Since most companies are either corporations, or LLCs taxed as a corporation, this discussion will refer to corporations. If your business is a sole proprietorship or partnership, your situation will be similar to an “S” corporation.

Most sales are structured as an “asset” sale. In some cases a “stock” sale is more appropriate, although the parties to the sale may not realize this. There are major legal and tax issues involved, and they impact the buyer and the seller differently. The difference can be profound, with major operational, legal and tax ramifications.

This fundamental decision can become a highly contentious difference between what the buyer and the seller want in the sale!

Buyers: Although it will not always be the case, buyers will usually prefer an “asset” sale structure.

An “asset” sale exposes the buyer to less potential carry-over legal liability than a stock sale, so the starting point recommendation from most attorneys representing the buyer will be an asset sale. The tax effects in an “asset” sale also tend to favor the buyer compared to a stock sale, so most CPA’s for the buyer will also favor an asset sale. Accounting rules for publicly traded corporations favor “asset” sales, so big national buyers favor asset sales.

Although the starting point for most attorneys will be to favor an “asset” sale, the legal issues are complex and varied. There is much more involved than just potential carry-over liability, and other issues can sometimes favor a stock sale instead of an asset sale. For instance, favorable contracts of all kinds with third parties are often much easier to preserve in a stock sale. Legal issues are covered in more detail in other chapters.

Sellers: The decision is not as clear-cut on the seller’s side of the table. In some cases, taxes on the seller will be essentially the same regardless of whether a sale is structured as an “asset” sale or a “stock” sale. In these cases, the seller is usually neutral between an “asset” and a “stock” sale.

In some cases, the seller will be taxed much more heavily in an “asset” sale. In these cases sellers will strongly prefer a “stock” sale. The extra tax can be so high that it will actually kill the deal unless either the sale is structured as a “stock” sale, or some other way can be found to reduce the tax.

There are various ways to mitigate the tax damage; all of which add complexity, and none of which completely eliminate the problem. The simplest solution is to mutually agree to a “stock” sale. The disadvantages to the buyer can be offset by a reduced price.

An overview of the tax issues is provided at the end of this chapter. Ways to potentially mitigate the damage are covered in other chapters.

Basic Steps in an Asset Sale:
In an “asset” sale, the assets of the corporation are sold directly by the corporation – not by its shareholders personally. Let’s assume for purposes of illustration that the primary asset sold is the company’s customer accounts or book of business (an “intangible” asset) in a heavily intellectual property based business. The stock of the corporation is not sold – that would be a “stock” sale.

The basic steps in a typical “asset” sale by an incorporated business are as follows:
(1) The buyer is often an existing company that is already incorporated. That corporation is the “buyer”; not the shareholder(s) of that corporation. If seller financing is involved, the shareholder(s) of the buying corporation will generally be required to guarantee payment of the purchase.
(1.a.) NOTE: If the buyer is an individual who intends to operate the business as a corporation, that buyer should form the buying corporation PRIOR to the acquisition.

(2) The buying corporation pays the selling corporation for those assets. The money and/or seller-financed promissory Note goes to the corporation, not directly to the selling corporation’s shareholders.
(2.a.) The buying corporation may need to renegotiate various legal agreements, such as leases, contracts with key vendors or customers, etc. These negotiations are often started prior to closing of the sale, particularly if a favorable lease or critical vendor or customer contracts are involved.
(2.b.) The buying corporation becomes the NEW employer of the selling corporation’s employees. New employment contracts should have been presented to the employees prior to closing, with enough time for their attorneys to review the drafts prior to signing. In order to make non-piracy covenants in those new contracts enforceable, the employee should not do any work for their new employer until they have signed their new terms of employment.

(3) Next, the selling corporation pays whatever liabilities it owed at the time of the sale, plus any taxes owed on the sale of its assets. The corporate taxes are owed in the year of sale.
(3.a.) An often overlooked seller obligation is accrued employee vacation, even if the seller keeps its books on a cash basis.
(3.b.) An “S” corporation might not owe much tax; although this is not always the case. Always check with your CPA on this.
(3.c.) If the seller is a “C” corporation, the federal tax at the corporate level is likely to be 34% or more, plus whatever tax your state imposes. Much, but not all, of this draconian extra tax can be mitigated by pre-planning or a more sophisticated structure for the sale.

(4) After taxes and whatever other liabilities the selling corporation may owe are satisfied, that corporation then “liquidates” itself and distributes the remaining after-tax cash and/or promissory Note that it received from the buyer to the selling corporation’s shareholders.
(4.a.) Any remaining assets owned by that corporation that were not included in the sale are also distributed to its shareholders at this time. For instance, the seller’s company car is often in this category.

(5) The shareholders then pay personal capital gains tax on what they received. If significant taxes were owed at the corporate level first (such as with “C” corporations), then this is essentially a second tax on the same sale!
(5.a.) Counting state and federal taxes at both the corporate and personal levels, the combined tax on the seller can easily be over 60% of the total sale price. 

Taxes this high can obviously be disastrous to a seller. Worse, the impending tax hit may not be known by the parties until the seller's C.P.A. is brought in just before closing. All parties (particularly the seller) are dismayed by the taxes about to be owed, but it can be difficult to restructure a sale at that late date. But if the tax problem cannot be solved, it can rightfully become a “deal killer”.

Disasters like this can be avoided by advance planning by the seller prior to the sale, and by a more sophisticated sale structure at the time of sale. For instance, if the selling “C” corporation had switched to “S” status 10 years earlier, then most of the problem would have gone away. Likewise, it is often possible to greatly reduce the double tax problem with a more sophisticated sale structure at the time of sale. This is discussed in a later chapter.

When is an Asset Sale “OK” from a Tax Standpoint?
From a tax standpoint, an asset sale is most appropriate when the draconian tax at the corporate level can be avoided. This is most likely when the selling company is either not incorporated at all, or is an “S” corporation that was never a “C” corporation in the first place. In each of these cases, the corporate level income tax on the sale of the book of business can be avoided. There may still be other taxes, but this avoids what is usually the worst tax hit at the
corporate level.

If the selling company is an “S” corporation that used to be a “C” corporation, then the date of the conversion is crucial. A “C” corporation that converts to an “S” corporation must wait 10 years before most of the tax at the corporate level goes away. However, if 10 years have not gone by since the switch, an “S” corporation may have just as big a problem as it would have had if it were still a “C” corporation. For “S” corporations in this situation, the corporate level income tax will be on what the IRS refers to as “built-in gains”.

All shareholders are taxed in an asset sale, even if they are not selling their own shares. Hence, if one shareholder is selling but the business as a whole is not being sold, then an “asset” sale is rarely appropriate. Shareholders not involved in the sale would not appreciate having to pay taxes just because someone else sold. This situation is almost always a “stock” sale of that shareholder’s shares.

Basic Asset Sale Tax Effects on the Buyer
Assume the primary “asset” being sold by a company is its customer accounts. The price paid for this asset will be amortized (i.e., deducted for tax purposes) by the buyer over a 15-year period regardless of the length of time over which payments for it will be made. Obviously, a tax deduction spread out over 15 years is not worth as much as a deduction that the buyer gets to take right away; but it is still worth having.

If the buyer subsequently re-sells that book of business, the amortization that was taken each year will have to be “recaptured”. In most cases, this means the deductions taken each year must be reversed and treated as income in the year of sale. This “phantom income” in the year of the subsequent sale generates tax at the corporate level that must all be paid in the year of that sale! This is a major future tax that the buyer should consider and plan for at the time those customer accounts are originally purchased.

Amortization of intangibles (such as a company’s book of business) is covered by Section 197 of the tax code. In 2005, the rules were changed on how this amortization is “recaptured”. The intent was to collect more money (naturally). Under the new rules, it is very difficult to avoid “recapture” of the entire amount previously amortized when a purchased book of business is resold. Obviously, this has the potential to be a major unexpected tax hit in an
“asset” sale even for an “S” corporation.

There appear to be ways to avoid full amortization recapture. They are more likely to work if they are planned for at the time the accounts are purchased rather than after the fact when they are re-sold. These methods appear to be entirely consistent with tax law, but are a “facts and circumstances” issue that cannot be guaranteed. To your authors’ knowledge, they have not been tested in court.

Basic Asset Sale Tax Effects on the Seller
If the selling corporation is NOT a “C” corporation or an “S” corporation subject to the draconian corporate tax described above, then in most states the corporation itself will not owe income tax on the sale of its assets.

The selling corporation's shareholders will still owe capital gains tax at the personal level. Capital gains tax will be about 20% at the federal level, plus whatever state and local taxes your state imposes. For many sales, an additional Obamacare Net Investment Income Tax of 3.8% will also be included.

If the seller is a "C" corporation, then sellers will be taxed first at the corporate level, and then what’s left will be taxed at the personal level.

The selling corporation will owe corporate income tax on almost the entire amount received. State tax rates vary by state, but the federal tax will be about 34% depending upon the size of the sale. Next, the individual stockholders will then owe capital gains tax on what’s left at the personal level. The state tax will vary, but the federal tax will be about 20% plus a potential Obamacare Net Investment Tax of an additional 3.8%. The combined federal tax will be about 50%. When state and local taxes are added in, the total tax on the seller can easily exceed 60% of the total sale proceeds.

Many sellers would rather not sell at all than pay taxes this high. If the seller has this tax predicament, several basic tools are available to at least partially remedy the situation. They will be explained further in subsequent chapters.

Chapter 6 - Basic Asset Sale for an Agency

Will it be an “ASSET” sale or a “STOCK” sale? The first (and most fundamental) question when structuring either an internal or external transition of any agency, is whether it will be structured as an “asset” sale or a “stock” sale. Since most agencies are either corporations, or LLCs taxed as a corporation, this discussion will refer to corporations. If your agency is a sole proprietorship or partnership, your situation will be similar to an “S” corporation.

Most sales are structured as an “asset” sale.  In some cases a “stock” sale is more appropriate, although the parties to the sale may not realize this.

There are major legal and tax issues involved, and they impact the buyer and the seller differently. The difference can be profound, with major operational, legal and tax ramifications.

This fundamental decision can become a highly contentious difference between what the buyer and the seller want in the sale!

Buyers:  Although it will not always be the case, buyers will usually prefer an “asset” sale structure.
An “asset” sale exposes the buyer to less potential carry-over legal liability than a stock sale, so the starting point recommendation from most attorneys representing the buyer will be an asset sale. The tax effects in an “asset” sale also tend to favor the buyer compared to a stock sale, so most CPA’s for the buyer will also favor an asset sale.  Accounting rules for publicly traded corporations favor “asset” sales, so big national buyers favor asset sales.  
Although the starting point for most attorneys will be to favor an “asset” sale, the legal issues are complex and varied.  There is much more involved than just potential carry-over liability, and other issues can sometimes favor a stock sale instead of an asset sale. For instance, favorable contracts of all kinds are often much easier to preserve in a stock sale.  Legal issues are covered in more detail in other chapters.

Sellers:  The decision is not as clear-cut on the seller’s side of the table. In some cases, taxes on the seller will be essentially the same regardless of whether a sale is structured as an “asset” sale or a “stock” sale. In these cases, the seller is usually neutral between an “asset” and a “stock” sale.  

In some cases the seller will be taxed much more heavily in an “asset” sale. In these cases sellers will strongly prefer a “stock” sale. The extra tax can be so high that it will actually kill the deal unless either the sale is structured as a “stock” sale, or some other way can be found to reduce the tax.  

There are various ways to mitigate the tax damage; all of which add complexity, and none of which completely eliminate the problem. The simplest solution is to mutually agree to a “stock” sale. The disadvantages to the buyer can be offset by a reduced price.

An overview of the tax issues is provided at the end of this chapter. Ways to potentially mitigate the damage are covered in other chapters.

Basic Steps in an Asset Sale:  In an “asset” sale, the assets of the agency corporation are sold directly by the corporation -- not by its shareholders personally. The primary asset sold is the agency’s book of business (an “intangible” asset). The stock of the corporation is not sold – that would be a “stock” sale.

The basic steps in a typical “asset” sale by an incorporated agency are as follows:
(1)  The buyer is often an existing agency that is already incorporated. That corporation is the “buyer”; not the shareholder(s) of that corporation. If seller financing is involved, the shareholder(s) of the buying corporation will generally be required to guarantee payment of the purchase.
(1.a.)  NOTE:  If the buyer is an individual who intends to operate the agency as a corporation, that buyer should       form the buying corporation PRIOR to the acquisition.

(2)  The buying corporation pays the selling corporation for those assets. The money and/or seller financed promissory Note goes to the corporation, not directly to the selling corporation’s shareholders.
(2.a.)  The buying corporation may need to renegotiate various legal agreements, such as leases, contracts with       carriers, etc. These negotiations are often started prior to closing of the sale, particularly if a favorable lease or           critical carrier contracts are involved.
(2.b.)  The buying corporation becomes the NEW employer of the selling corporation’s employees. New                   employment contracts should have been presented to the employees prior to closing, with enough time for their           attorneys to review the drafts prior to signing. In order to make non-piracy covenants in those new contracts               enforceable, the employee should not do any work for their new employer until they have signed their new terms of     employment.

(3)  Next, the selling corporation pays whatever liabilities it owed at the time of the sale, plus any taxes owed on the sale of its assets.  The corporate taxes are owed in the year of sale.
(3.a.)  An often overlooked seller obligation is accrued employee vacation, even if the seller keeps its books on a cash basis.
(3.b.)  An “S” corporation might not owe much tax; although this is not always the case.  Always check with your CPA on this.
(3.c.)  If the seller is a “C” corporation, the federal tax at the corporate level is likely to be 34% or more, plus whatever tax your state imposes. Much, but not all, of this draconian extra tax can be mitigated by pre-planning or a more sophisticated structure for the sale.

(4)  After taxes and whatever other liabilities the selling corporation may owe are satisfied, that corporation then “liquidates” itself and distributes the remaining after-tax cash and/or promissory Note that it received from the buyer to the selling corporation’s shareholders.  
(4.a.)  Any remaining assets owned by that corporation that were not included in the sale are also distributed to its shareholders at this time.  For instance, the seller’s company car is often in this category.
​
(5)  The shareholders then pay personal capital gains tax on what they received. If significant taxes were owed at the corporate level first (such as with “C” corporations), then this is essentially a second tax on the same sale! 
(5.a.)  Counting state and federal taxes at both the corporate and personal levels, the combined tax on the seller can easily be over 60% of the total sale price.  

Taxes this high can obviously be disastrous to a seller. Worse, the impending tax hit may not be known by the parties until the seller's C.P.A. is brought in just before closing. All parties (particularly the seller) are dismayed by the taxes about to be owed, but it can be difficult to re-structure a sale at that late date. But if the tax problem cannot be solved, it can rightfully become a “deal killer”.

Disasters like this can be avoided by advance planning by the seller prior to the sale, and by a more sophisticated sale structure at the time of sale. For instance, if the selling “C” corporation had switched to “S” status 10 years earlier, then most of the problem would have gone away. Likewise, it is often possible to greatly reduce the double tax problem with a more sophisticated sale structure at the time of sale. This is discussed in a later chapter.

When is an Asset Sale “OK” from a Tax Standpoint?
From a tax standpoint, an asset sale is most appropriate when the draconian tax at the corporate level can be avoided. This is most likely when the selling agency is either not incorporated at all, or is an “S” corporation that was never a “C” corporation in the first place. In each of these cases, the corporate level income tax on the sale of the book of business can be avoided. There may still be other taxes, but this avoids what is usually the worst tax hit at the corporate level.

If the selling agency is an “S” corporation that used to be a “C” corporation, then the date of the conversion is crucial.  A “C” corporation that converts to an “S” corporation must wait 10 years before most of the tax at the corporate level goes away. However, if 10 years have not gone by since the switch, an “S” corporation may have just as big a problem as it would have had if it were still a “C” corporation. For “S” corporations in this situation, the corporate level income tax will be on what the IRS refers to as “built-in gains”.

All shareholders are taxed in an asset sale, even if they are not selling their own shares. Hence, if one shareholder is selling but the agency as a whole is not being sold, then an “asset” sale is rarely appropriate. Shareholders not involved in the sale would not appreciate having to pay taxes just because someone else sold. This situation is almost always a “stock” sale of that shareholder’s shares.

Basic Asset Sale Tax Effects on the Buyer
The primary “asset” being sold by an agency is its customer accounts. The price paid for this asset will be amortized (i.e., deducted for tax purposes) by the buyer over a 15-year period regardless of the length of time over which payments for it will be made. Obviously, a tax deduction spread out over 15 years is not worth as much as a deduction that the buyer gets to take right away; but it is still worth having.

If the buyer subsequently re-sells that book of business, the amortization that was taken each year will have to be “recaptured”. In most cases, this means the deductions taken each year must be reversed and treated as income in the year of sale. This “phantom income” in the year of the subsequent sale generates tax at the corporate level that must all be paid in the year of that sale! This is a major future tax that the buyer should consider and plan for at the time that book is originally purchased.  

Amortization of intangibles (such as an agency’s book of business) is covered by Section 197 of the tax code. In 2005, the rules were changed on how this amortization is “recaptured”. The intent was to collect more money (naturally).  Under the new rules, it is very difficult to avoid “recapture” of the entire amount previously amortized when a purchased book of business is resold. Obviously, this has the potential to be a major unexpected tax hit in an “asset” sale even for an “S” corporation. 

There appear to be ways to avoid full amortization recapture. They are more likely to work if they are planned for at the time the book of business is purchased rather than after the fact when the book of business is sold. These methods appear to be entirely consistent with tax law, but are a “facts and circumstances” issue that cannot be guaranteed. To your authors’ knowledge, they have not been tested in court.

Basic Asset Sale Tax Effects on the Seller
If the selling corporation is NOT a “C” corporation or an “S” corporation subject to the draconian corporate tax described above, then in most states the corporation itself will not owe income tax on the sale of its assets.  

The selling corporation's shareholders will still owe capital gains tax at the personal level. Capital gains tax will be about 20% at the federal level, plus whatever state and local taxes your state imposes. For many sales, an additional Obamacare Net Investment Income Tax of 3.8% will also be included. 

If the seller is a "C" corporation, then sellers will be taxed first at the corporate level, and then what’s left will be taxed at the personal level.  

The selling corporation will owe corporate income tax on almost the entire amount received. State tax rates vary by state, but the federal tax will be about 34% depending upon the size of the sale. Next, the individual stockholders will then owe capital gains tax on what’s left at the personal level. The state tax will vary, but the federal tax will be about 20% plus a potential Obamacare Net Investment Tax of an additional 3.8%. The combined federal tax will be about 50%. When state and local taxes are added in, the total tax on the seller can easily exceed 60% of the total sale proceeds.  

Many sellers would rather not sell at all than pay taxes this high.

If the seller has this tax predicament, several basic tools are available to at least partially remedy the situation. They will be explained further in subsequent chapters.

CHAPTER 5
NEGOTIATIONS


In prior chapters, we’ve discussed how to get ready before starting negotiations to buy or sell an agency.

Now it’s time for the first meeting (or two).

The First Meeting
Both buyer and seller should think through very carefully, in advance, what they are willing to disclose to help establish mutual interest. For instance, the seller may be willing to disclose overall commissions and contingent bonus numbers, but not profitability or who the company’s best accounts are.

Until mutual interest is established, a Confidentiality Agreement is generally not signed and confidential information is not exchanged. Hence the first meeting may not include an exchange of confidential information.  

Although confidential information is probably not exchanged at this point, the first meeting is very important.

At this meeting, a seller should be able to clearly explain to a potential buyer:

·      Why the seller’s agency is for sale?

·      Why now?

·      What is most important to the seller in the sale transaction?

·      What the seller will do to help the buyer post-sale with key account retention?

Likewise, the buyer should be able to clearly explain to the seller at that same meeting:

·      Generally speaking, what is most important to the buyer in this potential acquisition?

·      What makes the buyer a strong potential candidate to buy this specific agency?

The first meeting is generally NOT the time to talk price. Instead, we recommend starting with only a general discussion of the items above. 

Set the Basic Rules For the Negotiation
If the initial discussion goes well and a possible sale seems likely to be worth further discussion, then it’s helpful to set some basic “Rules” the parties intend to follow during further negotiations. Nothing can guarantee success, of course, but following these basic rules will greatly improve the odds:

Rule #1:  Win/Win negotiating. 
Both sides must believe the sale will be a mutual “win” for them. Never let negotiations become a contest to see who “wins”.  In almost every case, BOTH sides will lose as soon as EITHER side believes they have “lost”. 

It is rare for a buyer to feel they simply must buy the seller’s specific agency. Most of the time, a buyer can simply walk away if the proposed sale becomes a “lose” for the buyer.

Likewise, few sellers feel they have only one potential buyer. Even if only one potential buyer is currently at the table, the seller often has the option of simply not selling. Even in those situations when it seems the seller simply MUST sell to one specific buyer, your authors have encountered many prospective sellers who would rather just hang on to their agency and “retire in place” to milk it for years, than feel like a “loser” in the negotiations.

Even if circumstances are such that the “loser” decides not to withdraw from the negotiations altogether, there will almost certainly be multiple ways the “loser” can try to even the score. Everyone loses once this kind of thing starts, including the side that thought they “won”.

Rule #2:  The sale must “work” for both sides.
Both buyer and seller should agree to cooperate to improve the overall aggregate tax effects of the transaction for both sides.

The seller should cooperate to structure the sale in ways that will “pencil-out” for the buyer. If the sale must be an “all-cash deal”, the seller should recognize the buyer must still justify the money spent based on the cash flow the buyer expects to be available.

Rule #3:  Both sides will control their respective professional advisors.
The technicalities of the sale of a closely held business can be very complex. Both sides are likely to need their own attorneys and C.P.A.s and perhaps others to be involved in the process. 

The principals involved in the negotiations on both sides need to insist that all of their respective advisors respect rules #1 and #2 above. Your advisors know more about the technicalities than you do, or you would not need them. They will want you to get the “best” deal you can, and sometimes work a little too hard to “improve” on the results the buyer and seller have been negotiating. Although your advisors are virtually certain to find a few things to argue about, don’t let their discussions about the fine points of a deal turn a win/win into a win/lose. 

Your advisors do not know as much about your specific business as you do, and they will not be the ones living with the results. This material will help you become an “issue spotter” even if you are not an attorney or CPA.  And although you may not know all the technicalities, you are likely to know more than many professional advisors do about the practical side of buying or selling an insurance agency. 

The cliché about “deal killer” attorneys or C.P.A.s can easily become more than a cliché. It is the opinion of your authors that trying to get the last 2% out of a deal is absolutely not worth the damage that pushing for that last concession may cause. In particular, letting an advisor talk you into changing something that the principals have already agreed on with a handshake can be quite damaging to the overall negotiations.

Attorneys often prove to be in love with their documents, and they love to make revisions to the other side’s revisions – and so on and so forth, often costing many thousands of dollars in wasted legal fees hassling over style points that really don’t matter in the overall scheme of the deal. Without direction from you, they can easily end up “majoring in the minors”, with their precious documents taking on a life of their own. They are not businessmen, and often behave more like professional gladiators. Tell your counsel in advance that that’s not what you want to happen, and that you will terminate their services if you feel it’s going in that direction. In fact, it’s often advisable not to use the services of your usual attorney who helps with your estate planning or zoning issues or trial work; instead, ask around to find an experienced “transactional” attorney whose main focus is doing business deals, hopefully having done hundreds of these. After all, they specialize just like you do within your industry – so a general practice attorney can rarely match-up against specialized transactional counsel.

The same applies with C.P.A.s. For example, most C.P.A.s have no business doing valuations of agencies; but virtually all of them will tell you they can do it. Just like specialized legal counsel, you need a C.P.A. or comparable valuation expert who has credentials and/or extensive experience not only in agency valuations if that is part of what’s needed in the deal, but also with broad tax background in business purchases and sales who can advise you on the optimal structuring of your deal. There can easily be tens of thousands or even millions of dollars left on the table merely because of the way a business sale is structured.

The bottom line: Professional advisors are absolutely necessary in the purchase and sale of virtually any agency; but you need to use them wisely and control them.

Still Too Soon to Talk Price 
Until you:

·      Have a meeting of the minds regarding the way negotiations will be handled, and

·      A substantial amount of confidential information has been exchanged, and

·      The buyer has had a chance to assess the overall situation,

Talking “price” is premature. 

Talking “price” too early in the negotiations can lead to expectations that are too high or money left on the table if things end up looking better than expected. Either one can kill what would otherwise have been a successful sale.

Confidentiality Agreements
Therefore, once the buyer and seller have mutually decided that proceeding to the next step is justified and the basic “rules” for the negotiations have been agreed upon, the next step is for the buyer to sign a “Confidentiality Agreement”. 

The buyer will need to see a lot of sensitive and confidential information before deciding if even making an offer is really justified, much less what that offer should look like. However, the seller should not let this very sensitive and confidential information be seen unless the buyer is willing to commit in a signed writing to keeping it strictly confidential. 

This is a normal and reasonable part of all business sales.  It is so basic that a buyer who will not sign a reasonable Confidentiality Agreement should not be considered a serious buyer. These agreements are generally considered simple and straight forward, but that is not always the case.

A well prepared buyer or seller may even bring to the first meeting a Confidentiality Agreement they consider acceptable. Because these are such a standard part of a closely held business sale, it is common for a buyer to sign this type of agreement on the spot if they have in mind to push hard to close a transaction. That is not always wise.  It is perfectly reasonable for a buyer or seller to want the Confidentiality Agreement to be looked over by their attorney first.

A typical Confidentiality Agreement will bind the buyer and sometimes even the advisors the buyer chooses to share the information with. If the buyer is an individual, this is often all that is needed. If the buyer is a separate entity such as a corporation or an LLC, then this is not always broad enough. The key employees of the buying entity should also execute the Confidentiality Agreement personally if they are potential competitive threats to the seller, and the buyer entity should take responsibility if such an employee violates the agreement.

When a closely held business is sold, it is common for the buyer to be another closely held business. If that is the case, it may make sense for the mutual Confidentiality Agreement to also bind the owners of the buying agency individually as well as corporately.

Note:  Providing confidential information without insisting on an agreement to protect that confidentiality could jeopardize the legal status of the information.  The seller could accidentally have turned confidential information into publicly available information that can no longer be legally protected at all.

Reciprocal Confidentiality Agreement
The seller is quite likely to be asked to offer seller financing for part of the purchase price. If so, the seller is perfectly justified in asking for information sufficient to justify extending credit to the buyer just as a commercial lender would do. Depending on the information requested, it may be perfectly appropriate for the buyer to insist on a Confidentiality Agreement covering that information before providing it.

Another very useful route if the prospective buyer is reticent to share personal financials, is to have the buyer provide all such information directly to the seller’s C.P.A. instead of to the seller, with a written agreement that the C.P.A. shall not share that material with anyone else, but will simply evaluate the buyer’s credit worthiness on this prospective transaction and then return all such confidential materials directly to the buyer and simply render an opinion to the seller as to credit worthiness. Your authors have rarely encountered a prospective buyer who refused such an arrangement.

Information Needed, and When
Once a Confidentiality Agreement has been signed, the seller can then begin collecting the information needed to assess the opportunity prior to making an offer. The information needed at this stage is not as extensive as will be needed to complete the buyer’s due diligence later in the process.

Since no two sales are exactly the same, it is not possible to create a practical checklist of what information to collect regarding the selling agency. The typical minimum requirement at this stage includes five years of financial data including both internal company statements and company tax returns, carrier appointments and volume information as well as loss ratios, etc., copies of any key employee non-competes, plus whatever extra information may be needed based on specific agency details.

The representations and warranties ("rep's & warranties") in almost all Purchase & Sale Agreements require the seller to proactively disclose all material items. This is going to have to be done sometime during the process, and we recommend that sellers voluntarily disclose every item the seller thinks may be material early in this process. The buyer can then decide what additional information will be needed prior to making an offer, and can incorporate the results into the offer.

Buyers will often walk away if they conclude that a seller has been trying to hide something material, and failure to disclose a material item which the buyer does not discover until after the sale is consummated can be cited later as grounds to rescind the entire transaction. Withholding key information about the company will almost always backfire on the seller, sometimes in devastating fashion.

This is also the time to bring up all items the seller considers essential to an offer. Leaving sensitive items until late in the negotiation process in hopes that momentum will carry the day when they do eventually come to light is a high risk strategy and basically a waste of everyone's time. 

Much more information will be needed to complete the buyer’s due diligence if an acceptable offer is ultimately made.  This will be discussed at length in a later chapter.

The Price is NOT the Price
At this point, an offer is not yet on the table; but both buyer and seller should be consulting their respective professional advisors. The way a sale is structured can have an enormous impact on the final results, and it is much easier to avoid pitfalls if your advisors are included early in the process rather than consulting them at the 11th hour and discovering that you’ve made some serious mistakes in how you’re approaching the transaction. It can be extremely awkward to have to back-up and correct these, can seriously disrupt the momentum of your deal, and sometimes even kill it completely.

Taxes.  In the wrong circumstances with a poorly designed sale, the combined taxes on the buyer and seller can easily exceed 50% of the overall available cash flow from the target agency. It is quite common for your advisors to be able to restructure the sale in ways that greatly reduce the overall tax burden. 

For example, some of the total “consideration” for the sale may be allocated to an agreement by the selling shareholders personally (as contrasted with their corporation) not to compete with the buyer after the sale.  This is likely to have tax as well as legal effects, and can often result in lower overall taxation on the sale. Post-sale employment can also be a major tool to help improve the overall sale.  It must be “real work for real pay”, and cannot be sham “employment” of the former owner.

In some cases the oddities in the tax code make it possible to LOWER the price and simultaneously improve after-tax cash flow for both sides.  A lower price and better after-tax cash flow can be a win/win/lose (the loser being the IRS).

Risk.  Risk can be even more important than price.  Most sellers could reduce taxes by not being cashed-out, but are afraid they may not get paid if they don't get all their cash at the front end. 

Most buyers would be willing to pay more if they were confident they would succeed. It is common to see a variable price formula-based “earn-out” that pays the seller more if future results of the purchase are good.

Terms.  The payment terms are the key to reducing taxes and risk. Creative terms can easily end up more important than the supposed “price”. 

Letter of Intent
The culmination of this phase of the negotiations is normally memorialized in what’s called a non-binding “letter of intent” or “terms sheet” outlining all of the key elements of the proposed deal. We will discuss these further in later chapters.

CHAPTER 5
NEGOTIATIONS

In prior chapters, we’ve discussed how to get ready before starting negotiations to buy or sell a business.

Now it’s time for the first meeting (or two).

The First Meeting
Both buyer and seller should think through very carefully, in advance, what they are willing to disclose to help establish mutual interest.  For instance, the seller may be willing to disclose overall revenue numbers, but not profitability or who the company’s best accounts are.

Until mutual interest is established, a Confidentiality Agreement is generally not signed and confidential information is not exchanged.  Hence the first meeting may not include an exchange of confidential information. 

Although confidential information may not be exchanged at this point, the first meeting is very important.

At this meeting, a seller should be able to clearly explain to a potential buyer:

·      Why the seller’s business is for sale?

·      Why now?

·      What is most important to the seller in the sale transaction?

·      What the seller will do to help the buyer post-sale?

Likewise, the buyer should be able to clearly explain to the seller at that same meeting:

·      Generally speaking, what is most important to the buyer in this potential acquisition?

·      What makes the buyer a strong potential candidate to buy this specific business?

The first meeting is generally NOT the time to talk price.  Instead, we recommend starting with only a general discussion of the items above. 

Set the Basic Rules For the Negotiation
If the initial discussion goes well and a possible sale seems likely to be worth further discussion, then it’s helpful to set some basic “Rules” the parties intend to follow during the negotiations.  Nothing can guarantee success, of course, but following these basic rules will greatly improve the odds:

Rule #1:  Win/Win negotiating. 
Both sides must believe the sale will be a mutual “win” for them.  Never let negotiations become a contest to see which side “wins”.  In almost every case, BOTH sides will lose as soon as EITHER side believes they have “lost”.

It is rare for a buyer to feel they simply must buy the seller’s specific business.  Most of the time, a buyer can simply walk away if the proposed sale becomes a “lose” for the buyer.

Likewise, few sellers feel they have only one potential buyer.  Even if only one potential buyer is currently at the table, the seller often has the option of simply not selling.  Even in those situations when it seems the seller simply MUST sell to one specific buyer, your authors have encountered many prospective sellers who would rather shut the business down, than feel like a “loser” in the negotiations.

Even if circumstances are such that the “loser” decides not to withdraw from the negotiations altogether, there will almost certainly be multiple ways the “loser” can try to even the score.  Everyone loses once this kind of thing starts, including the side that thought they “won”.

Rule #2:  The sale must “work” for both sides.
Both buyer and seller should agree to cooperate to improve the overall aggregate tax effects of the transaction for both sides.

The seller should cooperate to structure the sale in ways that will “pencil-out” for the buyer.  If the sale must be an “all-cash deal”, the seller should recognize the buyer must still justify the money spent based on the cash flow the buyer expects to be available.

Rule #3:  Both sides will control their respective professional advisors.
The technicalities of the sale of a closely held business can be very complex.  Both sides are likely to need their own attorneys and CPAs and perhaps others to be involved in the process. 

The principals involved in the negotiations on both sides need to insist that all of their respective advisors respect rules #1 and #2 above.  Your advisors know more about the technicalities than you do, or you would not need them.  They will want you to get the “best” deal you can, and sometimes work a little too hard to “improve” on the results the buyer and seller have been negotiating.  Although your advisors are virtually certain to find a few things to argue about, don’t let their discussions about the fine points of a deal turn a win/win into a win/lose. 

Your advisors do not know as much about your specific business as you do, and they will not be the ones living with the results.  This material will help you become an “issue spotter” even if you are not an attorney or CPA.  And although you may not know all the technicalities, you are likely to know more than many professional advisors do about the practical side of buying or selling your specific business. 

The cliché about “deal killer” attorneys or CPAs can easily become more than a cliché.  It is the opinion of your authors that trying to get the last 2% out of a deal is absolutely not worth the damage that pushing for that last concession may cause.  In particular, letting an advisor talk you into changing something that the principals have already agreed on with a handshake can be quite damaging to the overall negotiations.

Attorneys often prove to be in love with their documents, and they love to make revisions to the other side’s revisions – and so on and so forth, often costing many thousands of dollars in wasted legal fees hassling over style points that really don’t matter in the overall scheme of the deal.  Without direction from you, they can easily end up “majoring in the minors”, with their precious documents taking on a life of their own.  They are not businessmen, and often behave more like professional gladiators.  Tell your counsel in advance that that’s not what you want to happen, and that you will terminate their services if you feel it’s going in that direction.  In fact, it’s often advisable not to use the services of your usual attorney who helps with your estate planning or zoning issues or trial work; instead, ask around to find an experienced “transactional” attorney whose main focus is doing business deals, hopefully having done hundreds of these.  After all, they specialize just like you do within your industry – so a general practice attorney can rarely match-up against specialized transactional counsel.

The same applies with CPAs.  For example, most CPAs have no business doing valuations of businesses; but virtually all of them will tell you they can do it.  Just like specialized legal counsel, you need a CPA or comparable valuation expert who has credentials and/or extensive experience not only in business valuations if that is part of what’s needed in the deal, but also with broad tax background in business purchases and sales who can advise you on the optimal structuring of your deal.  There can easily be tens of thousands or even millions of dollars left on the table merely because of the way a business sale is structured.

The bottom line:  Professional advisors are absolutely necessary in the purchase and sale of virtually any business; but you need to use them wisely and control them.

Still Too Soon to Talk Price 
Until you:

·      Have a meeting of the minds regarding the way negotiations will be handled, and

·      A substantial amount of confidential information has been exchanged, and

·      The buyer has had a chance to assess the overall situation,

Talking “price” is premature. 

Talking “price” too early in the negotiations can lead to expectations that are too high or money left on the table if things end up looking better than expected.  Either one can kill what would otherwise have been a successful sale.

Confidentiality Agreements
Therefore, once the buyer and seller have mutually decided that proceeding to the next step is justified and the basic “rules” for the negotiations have been agreed upon, the next step is for the buyer to sign a “Confidentiality Agreement”. 

The buyer will need to see a lot of sensitive and confidential information before deciding if even making an offer is really justified, much less what that offer should look like.  However, the seller should not let this very sensitive and confidential information be seen unless the buyer is willing to commit in a signed writing to keeping it strictly confidential.  

This is a normal and reasonable part of all business sales.  It is so basic that a buyer who will not sign a reasonable Confidentiality Agreement should not be considered a serious buyer.  These agreements are generally considered simple and straight forward, but that is not always the case.

A well prepared buyer or seller may even bring to the first meeting a Confidentiality Agreement they consider acceptable.  Because these are such a standard part of a closely held business sale, it is common for a buyer to sign this type of agreement on the spot if they have in mind to push hard to close a transaction.  That is not always wise.  It is perfectly reasonable for a buyer or seller to want the Confidentiality Agreement to be looked over by their attorney first.

A typical Confidentiality Agreement will bind the buyer and sometimes even the advisors the buyer chooses to share the information with.  If the buyer is an individual, this is often all that is needed.  If the buyer is a separate entity such as a corporation or an LLC, then this is not always broad enough.  The key employees of the buying entity should also execute the Confidentiality Agreement personally if they are potential competitive threats to the seller, and the buyer entity should take responsibility if such an employee violates the agreement.

When a closely held business is sold, it is common for the buyer to be another closely  held business.  If that is the case, it may make sense for the mutual Confidentiality Agreement to also bind the owners of the buying business individually as well as corporately.

Note:  Providing confidential information without insisting on an agreement to protect that confidentiality could jeopardize the legal status of the information.  The seller could accidentally have turned confidential information into publicly available information that can no longer be legally protected at all.

Reciprocal Confidentiality Agreement
The seller is quite likely to be asked to offer seller financing for part of the purchase price.  If so, the seller is perfectly justified in asking for information sufficient to justify extending credit to the buyer just as a commercial lender would do.  Depending on the information requested, it may be perfectly appropriate for the buyer to insist on a Confidentiality Agreement covering that information before providing it.

Another very useful route if the prospective buyer is reticent to share personal financials, is to have the buyer provide all such information directly to the seller’s CPA instead of to the seller, with a written agreement that the CPA shall not share that material with anyone else, but will simply evaluate the buyer’s credit worthiness on this prospective transaction and then return all such confidential materials directly to the buyer and simply render an opinion to the seller as to credit worthiness.  Your authors have rarely encountered a prospective buyer who refused such an arrangement.

Information Needed, and When
Once a Confidentiality Agreement has been signed, the seller can then begin collecting the information needed to assess the opportunity prior to making an offer.  The information needed at this stage is not as extensive as will be needed to complete the buyer’s due diligence later in the process.

Since no two sales are exactly the same, it is not possible to create a practical checklist of what information to collect regarding the selling business.  The typical minimum requirement at this stage includes five years of financial data, including both internal company statements and company tax returns, copies of any key employee non-competes, plus whatever extra information may be needed based on specific company details.

The representations and warranties ("rep's & warranties") in almost all Purchase & Sale Agreements require the seller to proactively disclose all material items.  This is going to have to be done sometime during the process, and we recommend sellers voluntarily disclose every item the seller thinks may be material early in this process.  The buyer can then decide what additional information will be needed prior to making an offer, and can incorporate the results into the offer.

Buyers will often walk away if they conclude that a seller has been trying to hide something material, and failure to disclose a material item which the buyer does not discover until after a sale is consummated can be cited later as grounds to rescind the entire transaction.  Withholding key information about the company will almost always backfire on the seller, sometimes in devastating fashion.

This is also the time to bring up all items the seller considers essential to an offer.  Leaving sensitive items until late in the negotiation process in hopes that momentum will carry the day when they do eventually come to light is a high risk strategy and basically a waste of everyone's time. 

Much more information will be needed to complete the buyer’s due diligence if an acceptable offer is ultimately made.  This will be discussed at length in a later chapter.

The Price is NOT the Price
At this point, an offer is not yet on the table; but both buyer and seller should be consulting their respective professional advisors.  The way a sale is structured can have an enormous impact on the final results, and it is much easier to avoid pitfalls if your advisors are included early in the process rather than consulting them at the 11th hour and discovering that you’ve made some serious mistakes in how you’re approaching the transaction.  It can be extremely awkward to have to back-up and correct these, can seriously disrupt the momentum of your deal, and sometimes even kill it completely.

Taxes.  In the wrong circumstances with a poorly designed sale, the combined taxes on the buyer and seller can easily exceed 50% of the overall available cash flow from the business.  It is quite common for your advisors to be able to restructure the sale in ways that greatly reduce the overall tax burden. 

For example, some of the total “consideration” for the sale may be allocated to an agreement by the selling shareholders personally (as contrasted with their corporation) not to compete with the buyer after the sale.  This is likely to have tax as well as legal effects, and can often result in lower overall taxation on the sale.  Post-sale employment can also be a major tool to help improve the overall sale.  It must be “real work for real pay”, and cannot be sham “employment” of the former owner.

In some cases the oddities in the tax code make it possible to LOWER the price and simultaneously improve after-tax cash flow for both sides.  A lower price and better after-tax cash flow can be a win/win/lose (the loser being the IRS).

Risk.  Risk can be even more important than price.  Most sellers could reduce taxes by not being cashed-out, but are afraid they may not get paid if they don't get all their cash at the front end.  

Most buyers would be willing to pay more if they were confident they would succeed.  It is common to see a variable price formula-based “earn-out” that pays the seller more if future results of the purchase are good.

Terms.  The payment terms are the key to reducing taxes and risk.  Creative terms can easily end up more important than the supposed “price”. 

Letter of Intent
The culmination of this phase of the negotiations is normally memorialized in what’s called a non-binding “letter of intent” or “terms sheet” outlining all of the key elements of the proposed deal.  We will discuss these further in later chapters.

CHAPTER 4

ONCE THE PROCESS HAS STARTED

Prior chapters covered big picture issues that buyers and sellers should be familiar with before they start the process of buying or selling any agency. 

This chapter will finish-up these big picture issues by focusing on what to do once that process has actually started.  We will provide some tips on how to set the stage for successful negotiations, some crucial points you need to know about tax control early in the process, and finish with suggestions on how to evaluate in advance the odds that a transaction will actually “pencil-out.”

Buying or selling an agency is a lot of work, very time consuming and expensive, and the outcome is never certain.  You can raise the odds of success if both sides are ready before the process starts.

 
For Sellers
Many successful agency owners, especially founding entrepreneurs, have an intense emotional tie to their business.  This is generally good, and may even be a key part of their success thus far; but it can also interfere when the time comes to sell. It is surprisingly common to find a seller who is so emotionally tied to the agency that no offer and/or buyer will ever actually be good enough.

Therefore, before starting the sale process ask yourself honestly:

·      Are you really a willing seller? Why is your agency for sale? Why now? If you cannot answer these questions quickly and easily, you are probably not ready to sell.

·      What criteria are most important to you in the sale? Are there specific things that MUST happen as a condition of the sale, such as job security for certain long-term employees?

·      Who are your best potential buyers? Your agency is worth more to some than to others due to the potential for higher contingent bonuses or profit sharing from overlapping carriers.

·      Are you willing to help the buyer succeed post-sale? How and to what extent and for how long? 

·      Are you willing to sell for a realistic price and terms? Do you know what realistic price and terms actually are?  The majority of sales include seller financing for part of the price, and may include an “earn-out” for part of the price as well based on the buyer’s retention of key customers or various gross revenue targets.

Just how strong does a buyer need to be financially for you to feel comfortable with the deal? Will you provide seller financing for part or even the entire purchase price, or will only an all-cash deal (generally at a lower price) suffice to meet your particular needs financially and emotionally?

If you do not have realistic expectations as a seller, you are probably wasting your time as well as that of any prospective buyer.

But if you are really ready to sell, then you owe it to yourself and to your family to do the job right. Never lie or misrepresent; but be ready to clearly show a prospective buyer the true financial benefits of ownership plus all the other reasons why buying your particular agency makes sense for that particular buyer. 

For Buyers
What are your (and your own present agency’s) strengths and weaknesses? In light of that, what other agencies could you buy that result in a combined agency worth more than the sum of its parts (i.e., 1+1 = 3 (or 4))? Given the cost (both time and money) and the risk (all business acquisitions are risky), you might not want to buy at all if 1+1 is not going to be more than 2.

Most likely, if you are interested in buying a particular agency, then someone else is too. It’s not all about the money. Why should the seller sell to YOU? Are you ready to “sell” yourself and your agency as the best option for the seller to choose?

Especially if you already have an agency to run, do you have the time and management depth to make sure the acquired agency is a success post-sale as well?

Are you strong enough financially? Do you have a good enough banking relationship to borrow the down payment, or enough cash from your own resources to fund it? If borrowed funds or seller financing are involved, are you (and your spouse) willing to personally guarantee payment of the purchase price?

In other words, are you READY to buy?

For Both Sides
It is rare that either side is compelled to proceed, regardless of how the transaction is shaping-up. Once either side concludes that the sale is a “lose” for them, the sale is most likely off. This is so important, that we strongly recommend both sides explicitly commit to negotiating for a “win/win” result while it is still early in the negotiation process.

If it becomes apparent that the sale is not likely to actually happen, it's time to politely walk away. But don’t burn your bridges; the time for a sale may very well be better at some point in the future. Nevertheless, it is generally a waste time and money to chase after a deal once one side or the other feels the sale has become a “lose” for them.

Start With The Big Picture
Once both sides are talking, start with the big picture. Any deal needs to work well for both parties in the end. The seller needs to understand that the sale must “pencil-out” for the buyer, that the risk (both ways) must be acceptable, and that cooperation from the seller is likely to be needed after closing. 

Most agencies have key customer and/or carrier relationships that must be preserved, and specialized knowledge that must be taught to the buyer. Sellers should commit to helping the buyer with these key items. This reduces the risk for the buyer, and raises the chance that the sale will actually be completed. It may justify a higher price as well.

Sellers must also recognize that buyers are not interested in competing against the seller after the sale.Therefore, a seller’s reasonable agreement not to compete is an essential part of virtually all business sales. 

Buyers need to understand that this prospective deal is much more than just a financial matter to the seller. The successors should make an extra effort to respect the person selling.  We are dealing with people here -- not machines. They have expectations, dreams, fears . . . some rational, some not; but all are very real. If you do not recognize and address their "felt needs", you’re probably wasting everyone’s time.

Therefore, we recommend that you address the people issues first. The parties need to clarify what matters the most to each of them. Don't assume those items are self-evident, and do not leave until the 11th hour the issues you believe are likely to be the most difficult. It's better to discover and address these early-on, than to waste everyone's time and money working on a prospective transition that’s realistically never going to happen.
 

Risk can be more important than price for both the buyer and the seller. The buyer’s risk is well known (most buyers assume Murphy was an optimist…). But sellers are heavily influenced by risk as well. When a seller demands a large down payment, the reason is often their concern about not getting paid if the agency does not do well after the sale – so what is it that’s behind that concern?
 

Payment terms have a huge effect on cash flow, taxes and risk. Terms can even be more important than price!  Terms can be so powerful that it’s sometimes possible to lower taxes, improve after-tax cash flow for both the buyer and the seller, reduce risk for both the buyer and the seller, and LOWER the price – all at the same.  We’ll talk more about how to do this in later chapters.

Plan Early for Tax and Legal Issues
There are at least three parties to every sale: The buyer, the seller, and the IRS. The IRS thinks it is entitled to a big part of the seller’s cash sale proceeds, plus a big part of the buyer's cash as well. In a worst case scenario, the seller’s taxes alone can exceed half the value of the agency, with the entire tax bill due before the cash to pay the taxes has even been received by the seller (we’ll explain how this can happen, and how to reduce the problem, in later chapters)!

Maximizing long-term after-tax cash flow for both the seller and the buyer, with acceptable risk should be a fundamental objective for everyone involved. A carefully structured sale can be a win/win/lose (the "loser" being the IRS).

Bring in the attorneys and C.P.A.s early, before the parties' respective positions become "set" and ego prevents them (or their respective C.P.A.s and attorneys) from coming off of their respective positions. Tax and legal expertise can easily make or break a deal! Experienced advice early in the process can prevent irreparable errors in structuring the sale, and may keep the process from falling apart at the last minute when advisors point out unexpected legal and tax problems for the first time.

Cash Flow 
Cash is king! There must be enough cash for the buyer to earn a reasonable wage, make the required payments to the seller, earn a reasonable return on his or her money invested in the deal, and make the additional investments if necessary to keep the business viable.

Cash flow “scenario testing” can be used to assess the potential cash flow. A "scenario" is a collection of assumptions. "Scenario testing" uses a set of assumptions as a way of estimating future after-tax cash flow for both the buyer and the seller. Simplifying assumptions will be necessary, so don't expect exact results even if by some miracle you're fortunate enough to develop a set of assumptions that exactly match the future results.  But since no one knows the future, be sure to test more than one set of assumptions.

Cash flow scenario testing on an estimated after-tax basis is absolutely essential as part of the buyer’s due diligence. Taxes can be so high that what looks like plenty of available cash flow may not actually be enough to sustain the deal. Therefore, without including estimated taxes in the analysis, you have no way of knowing if a transaction is likely to make financial sense for the buyer.

The agency only generates so much cash flow. If both buyer and seller recognize that the sale must make financial sense for the buyer, and they agree on the basic reasonableness of the assumptions in the scenario, then the basic reasonableness (or lack thereof) of the proposed price and payment terms will become conspicuously self-evident from running those numbers. Besides providing a much needed reality check on the price and terms, this kind of testing can even reduce haggling dramatically. It becomes hard for a seller to insist on a particular price/terms combination when scenario testing demonstrates that that price and terms clearly cannot work out mathematically for the buyer even when using assumptions the seller agrees are reasonable.

IMPORTANT NOTE: Sellers should be careful not to make any promises or even predictions about future results for the agency in the hands of the buyer. If the seller supplies the numbers and/or the analytical framework, be certain to include a very strong and clear disclaimer. Otherwise, you may have inadvertently "guaranteed" at least a minimum result and may even be vulnerable to rescission of the entire transaction later on! It’s better for the seller to simply provide historical information for the buyer, and let the buyer and his or her professional advisors come up with their own projections of future performance of the agency.

Try to structure a transaction that still works under a reasonably foreseeable downside case as well. This can address the risk concerns of both buyer and seller. It can anticipate cash flow needs if things do not work out as well or as soon as hoped for, and can even lead to modified payment terms with flexibility built-in as needed to protect both sides later on.

For example, the buyer's promissory Note could defer principal payments if operating results are poor in a particular year (continuing to accrue interest, and adding any deferred amount to a balloon payment at the back end of that Note). Initial payments might be interest-only, perhaps until an outside lender or prior acquisition has been paid off.  Pricing based on customer retention could lower the risk to the successors enough that the seller can justify what will in fact become a higher price if customer retention is good (remember that “earn-out” concept described in a prior chapter). This also gives the seller a strong incentive to make things work after closing the sale.

No one wins if the seller does not get paid, and taking back a wrecked agency is generally a lose/lose proposition for everyone involved. Cash flow scenario testing coupled with creative use of payment terms can dramatically reduce the chances of that happening, and we’ll be discussing those a lot in later articles.

CHAPTER 4

ONCE THE PROCESS HAS STARTED

Prior chapters covered big picture issues that buyers and sellers should be familiar with before they start the process of buying or selling any business. 

This chapter will finish-up these big picture issues by focusing on what to do once that process has actually started.  We will provide some tips on how to set the stage for successful negotiations, some crucial points you need to know about tax control early in the process, and finish with suggestions on how to evaluate in advance the odds that a transaction will actually “pencil-out.”

Buying or selling a business is a lot of work, very time consuming and expensive, and the outcome is never certain.  You can raise the odds of success if both sides are ready before the process starts.

 
For Sellers
Many successful business owners, especially founding entrepreneurs, have an intense emotional tie to their business. This is generally good, and may even be a key part of their success thus far; but it can also interfere when the time comes to sell. It is surprisingly common to find a seller who is so emotionally tied to the business that no offer and/or buyer will ever actually be good enough.

Therefore, before starting the sale process ask yourself honestly:

·      Are you really a willing seller?

·      Why is your business for sale? Why now? If you cannot answer these questions quickly and easily, you are probably not ready to sell.

·      What criteria are most important to you in the sale? Are there specific things that MUST happen as a condition of the sale, such as job security for certain long-term employees?

·      Who are your best potential buyers? Your business is worth more to some than to others. Are there other businesses that would be a particularly good fit with yours? If the buyer would be an individual rather than another business, are there certain skills that would help an individual succeed if they bought your business?

·      Are you willing to help the buyer succeed post-sale? How and to what extent and for how long? 

·      Are you willing to sell for a realistic price and terms? Do you know what realistic price and terms actually are?  The majority of sales include seller financing for part of the price, and may include an “earn-out” for part of the price as well based on the buyer’s retention of key customers or various gross revenue targets.

Just how strong does a buyer need to be financially for you to feel comfortable with the deal? Will you provide seller financing for part or even the entire purchase price, or will only an all-cash deal (generally at a lower price) suffice to meet your particular needs financially and emotionally?

If you do not have realistic expectations as a seller, you are probably wasting your time as well as that of any prospective buyer.

But if you are really ready to sell, then you owe it to yourself and to your family to do the job right. Never lie or misrepresent; but be ready to clearly show a prospective buyer the true financial benefits of ownership plus all the other reasons why buying your particular business makes sense for that particular buyer. 


For Buyers
What are your (and your own present business’s) strengths and weaknesses? In light of that, what other businesses could you buy that result in a combined business worth more than the sum of its parts (i.e., 1+1 = 3 (or 4))? Given the cost (both time and money) and the risk (all business acquisitions are risky), you might not want to buy at all if 1+1 is not going to be more than 2.

Most likely, if you are interested in buying a particular business, then someone else is too. It’s not all about the money. Why should the seller sell to YOU? Are you ready to “sell” yourself and your company as the best option for the seller to choose?

Especially if you already have a business to run, do you have the time and management depth to make sure the acquired business is a success post-sale as well?

Are you strong enough financially? Do you have a good enough banking relationship to borrow the down payment, or enough cash from your own funds to fund that?  If borrowed funds or seller financing are involved, are you (and your spouse) willing to personally guarantee payment of the purchase price?

In other words, are you READY to buy?


For Both Sides
It is rare that either side is compelled to proceed, regardless of how the transaction is shaping-up. Once either side concludes that the sale is a “lose” for them, the sale is most likely off. This is so important, that we strongly recommend both sides explicitly commit to negotiating for a “win/win” result while it is still early in the negotiation process.

If it becomes apparent that the sale is not likely to actually happen, it's time to politely walk away. But don’t burn your bridges; the time for a sale may very well be better at some point in the future. Nevertheless, it is generally a waste time and money to chase after a deal once one side or the other feels the sale has become a “lose” for them.

Start With The Big Picture
Once both sides are talking, start with the big picture. Any deal needs to work well for both parties in the end. The seller needs to understand that the sale must “pencil-out” for the buyer, that the risk (both ways) must be acceptable, and that cooperation from the seller is likely to be needed after closing. 

Most businesses have key customer and/or vendor relationships that must be preserved, and specialized expertise that must be taught to the buyer. Sellers should commit to helping the buyer with these key items. This reduces the risk for the buyer, and raises the chance that the sale will actually be completed. It may justify a higher price as well.

Sellers must also recognize that buyers are not interested in competing against the seller after the sale.Therefore, a seller’s reasonable agreement not to compete is an essential part of virtually all business sales. 

Buyers need to understand that this prospective deal is much more than just a financial matter to the seller. The successors should make an extra effort to respect the person selling. We are dealing with people here -- not machines. They have expectations, dreams, fears . . . some rational, some not; but all are very real. If you do not recognize and address their "felt needs", you’re probably wasting everyone’s time.

Therefore, we recommend that you address the people issues first. The parties need to clarify what matters the most to each of them. Don't assume those items are self-evident, and do not leave until the 11th hour the issues you believe are likely to be the most difficult. It's better to discover and address these early-on, than to waste everyone's time and money working on a prospective transition that’s realistically never going to happen.
 

Risk can be more important than price for both the buyer and the seller. The buyer’s risk is well known (most buyers assume Murphy was an optimist…). But sellers are heavily influenced by risk as well. When a seller demands a large down payment, the reason is often their concern about not getting paid if the business does not do well after the sale.
 

Payment terms have a huge effect on cash flow, taxes and risk. Terms can even be more important than price!  Terms can be so powerful that it’s sometimes possible to lower taxes, improve after-tax cash flow for both the buyer and the seller, reduce risk for both the buyer and the seller, and LOWER the price – all at the same. We’ll talk more about how to do this in later chapters.

Plan Early for Tax and Legal Issues
There are at least three parties to every sale: The buyer, the seller, and the IRS. The IRS thinks it is entitled to a big part of the seller’s cash sale proceeds, plus a big part of the buyer's cash as well. In a worst case scenario, the seller’s taxes alone can exceed half the value of the business, with the entire tax bill due before the cash to pay the taxes has even been received by the seller (we’ll explain how this can happen, and how to reduce the problem, in later chapters)!

Maximizing long-term after-tax cash flow for both the seller and the buyer, with acceptable risk should be a fundamental objective for everyone involved. A carefully structured sale can be a win/win/lose (the "loser" being the IRS).

Bring in the attorneys and C.P.A.s early, before the parties' respective positions become "set" and ego prevents them (or their respective C.P.A.s and attorneys) from coming off of their respective positions. Tax and legal expertise can easily make or break a deal! Experienced advice early in the process can prevent irreparable errors in structuring the sale, and may keep the process from falling apart at the last minute when advisors point out unexpected legal and tax problems for the first time.

Cash Flow 
Cash is king! There must be enough cash for the buyer to earn a reasonable wage, make the required payments to the seller, earn a reasonable return on his or her money invested in the deal, and make the additional investments if necessary to keep the business viable.

Cash flow “scenario testing” can be used to assess the potential cash flow. A "scenario" is a collection of assumptions. "Scenario testing" uses a set of assumptions as a way of estimating future after-tax cash flow for both the buyer and the seller. Simplifying assumptions will be necessary, so don't expect exact results even if by some miracle you're fortunate enough to develop a set of assumptions that exactly match the future results. But since no one knows the future, be sure to test more than one set of assumptions.

Cash flow scenario testing on an estimated after-tax basis is absolutely essential as part of the buyer’s due diligence. Taxes can be so high that what looks like plenty of available cash flow may not actually be enough to sustain the deal. Therefore, without including estimated taxes in the analysis, you have no way of knowing if a transaction is likely to make financial sense for the buyer.

The business only generates so much cash flow. If both buyer and seller recognize that the sale must make financial sense for the buyer, and they agree on the basic reasonableness of the assumptions in the scenario, then the basic reasonableness (or lack thereof) of the proposed price and payment terms will become conspicuously self-evident from running those numbers. Besides providing a much needed reality check on the price and terms, this kind of testing can even reduce haggling dramatically. It becomes hard for a seller to insist on a particular price/terms combination when scenario testing demonstrates that that price and terms clearly cannot work out mathematically for the buyer even when using assumptions the seller agrees are reasonable.

IMPORTANT NOTE:  Sellers should be careful not to make any promises or even predictions about future results for the company in the hands of the buyer. If the seller supplies the numbers and/or the analytical framework, be certain to include a very strong and clear disclaimer. Otherwise, you may have inadvertently "guaranteed" at least a minimum result and may even be vulnerable to rescission of the entire transaction later on! It’s better for the seller to simply provide historical information for the buyer, and let the buyer and his or her professional advisors come up with their own projections of future performance of the business.

Try to structure a transaction that still works under a reasonably foreseeable downside case as well. This can address the risk concerns of both buyer and seller. It can anticipate cash flow needs if things do not work out as well or as soon as hoped for, and can even lead to modified payment terms with flexibility built-in as needed to protect both sides later on.

For example, the buyer's Promissory Note could defer principal payments if operating results are poor in a particular year (continuing to accrue interest, and adding any deferred amount to a balloon payment at the back end of that Note).  Initial payments might be interest-only, perhaps until an outside lender or prior acquisition has been paid off.  Pricing based on customer retention could lower the risk to the successors enough that the seller can justify what will in fact become a higher price if customer retention is good (remember that “earn-out” concept described in a prior chapter). This also gives the seller a strong incentive to make things work after closing the sale.

No one wins if the seller does not get paid, and taking back a wrecked company is generally a lose/lose proposition for everyone involved. Cash flow scenario testing coupled with creative use of payment terms can dramatically reduce the chances of that happening, and we’ll be discussing those a lot in later articles.

CHAPTER 3

GETTING READY 
FROM THE BUYER'S PERSPECTIVE

In the previous chapters, we talked about sellers who are in the process of considering a sale.  The focus in this third chapter starts instead with the BUYER, and then moves on to look at the big picture aspects of the PRICE.

A critical question worth repeating as we move on to rules for buyers is:  Do you really have a willing seller?  Or, is the seller so emotionally tied to the business that no buyer will ever actually be good enough to pass muster?  Is the seller reluctantly willing to sell -- but only if the price/terms are unrealistically high?

Potential sellers should think these things through very carefully before spending a lot of everyone’s time and money on a seemingly desirable deal that is unlikely to actually take place. 

Once it becomes apparent to you as a potential buyer that the seller is not really ready to sell, then it's time to politely walk away.  Don’t burn your bridges though; the seller may very well be more ready at some point in the future and you can resurrect the deal at that point.  Just don't waste time and money before the overall timing is right.

Buyers
The following rules are presented from the buyer’s standpoint, but sellers should be acutely aware of these things too: 

First:  
The first rule for buyers is:  Know what YOU are looking for.  Buying a business is risky, expensive, and a LOT of work for the buyer.  Do your homework first.

*Not every business is worth the same to you as it is to other potential buyers.

• What business would fit the best with what you already own?
  
•  What can YOU bring to the table to enhance its value after the purchase?
  

In other words, what business can you buy that will result in a 1+1 = 3 scenario? (or even 4?)

• This is so important, that if the resulting effect of 1+1 is not more than 2, then perhaps you should not buy it at all.
  

Second:  
Another rule for buyers is:  YOU are for all practical purposes "selling" yourself personally and/or your existing company to the seller at this point as well.  That’s because if you really want to buy that target business, someone else probably does also.  It’s about a lot more than just price and terms. 

So, why should this seller sell to YOU?

*Be ready to sell yourself and/or your company as the most appropriate buyer for that particular business. 

• The seller is almost always looking for a buyer he or she feels comfortable with personally and believes will take proper care of the business, its employees and its customers post-sale.
  
• If you fail this unspoken test, you can lose the opportunity before you ever get to issues such as price and terms.  
  

Third:  
The third rule for buyers:  Be ready.

Be ready financially -- a strong balance sheet, good banking relationships, and enough uncommitted cash flow with which to do the transaction are essential. Be ready with your own time -- if your time is already fully committed, how are you going to handle the additional management burdens?

Fourth:  
Another rule for buyers:  Consider the basic steps in a business sale.

• Is there a business broker involved, and if so, on which side does their allegiance lie?  Which party pays the commission?  If I as the seller sign a listing agreement, can I get out of it, and how long does it last?  What if I bring the buyer to the table myself, do I still owe a commission to my broker under an “exclusive right to sell” agreement?
  
• Can or should both sides use the same attorney or C.P.A. in order to save professional fees?
  
• Should you sign a confidentiality agreement up-front?  At what point?
  
• Will this deal be seller-financed in whole or in part, or do I need to get a banker on-board early and see if financing is available beyond what cash I have for the down payment?
  
•  Am I willing to personally guarantee all or part of my company's promissory Note to the seller for the balance of the purchase price, or to pledge additional collateral?
  
• How much cash will I need for working capital until the cash flow situation in the new business settles down following closing?
  
• Do I need a business valuation, and if so should it be a full-blown appraisal or just an opinion letter?  Will my banker require an appraisal in order to loan me the down payment or all of the purchase price as the case may be?
  
• What role does a letter of intent (an "LOI" or "terms sheet") play?  What kind of LOI should you create?  Should it be binding on both parties or non-binding, or should only portions of it be binding?
  
• Will the seller request a good-faith cash deposit up-front, perhaps paid into escrow?  Refundable or non-refundable?
  
• What due diligence is needed, and when, and should the other party pay part of the cost if they back out prematurely for no good reason?
  
• What contracts are likely to be needed, and which side should have the subtle advantage of drafting first and controlling the documents (customarily the buyer, since it has the most risk in how the transaction is structured and written up)?
  
• What should you expect at closing?
  
• Will an independent third-party professional escrow be necessary for the eventual closing?
  

Fifth:  
The fifth rule for buyers:  Know the legal basics.

• What are the crucial legal distinctions between an "asset sale" and a "stock sale" that will determine the overall structure of the entire deal?
  
• What additional risks do I effectively assume if I buy the stock of the seller's corporation, as opposed to buying the assets out of that corporation and thereby shedding most of those risks?
  
• What to do with the employees? 
  
• What about a non-compete agreement with the seller entity as well as the individual owner(s) thereof, or with key employees of the target business who might leave following closing and go right into competition with the very business you just paid a lot of money for; or
  
• Does the target company already have those crucial non-competes in place with key employees, and if so are they enforceable and transferable?
  
• You need to know the basics, but you will definitely need professional help to get this right.
  

Sixth:  
Another critical rule:  Know the tax basics!

• If I personally buy the company's stock from the seller, I'll have no tax deductibility on the purchase price.  Does that matter to me, or would I rather have that higher tax basis and thereby pay less tax when I re-sell the company sometime in the future?
  
• Or, should I have my own company buy that same stock instead?  Can my corporation or LLC buy stock in another without causing serious tax consequences?
  
•  Am I comfortable with the hidden or unknown risks in this industry or this particular company that come along with a stock purchase format, including the risk of prior taxes unpaid or under-paid by the target corporation; or do I want to insist on an asset purchase format instead and thereby try to “shed” most of those potential liabilities?  Can I mitigate that risk by having the selling stockholder indemnify me for all or part of those taxes, interest and penalties, or even other unknown and/or unexpected exposures?
  

Never forget, there are three parties to every business sale -- the seller, the buyer and the IRS.  A sale can be a lose/lose/win (guess who the losers are…); or, the same sale can be re-structured to constitute a win/win/lose.  If there is a “loser” in this deal, you want it to be the IRS.

• The taxes on sale of a business can exceed 50% of the total sale proceeds if the sale is structured wrong!
  
• The seller can even end up owing more to the IRS at the front end than he receives as the down payment from the buyer . . . a particularly unfortunate (and generally avoidable) result of poor tax planning.
  
• You don’t need to be a tax expert; but you do need to know there are ways to mitigate this kind of tax disaster and also be able to point the seller in the right direction for professional help.
  
• You need to be willing to work with the seller to resolve what may be critical issues to the success of the sale. 
  
• You need to know the basics, but you will need professional help to get this right.

Seventh:  
The seventh rule for buyers:  Know how to use your own professional advisors, and when to bring them into the picture (earlier is better, even up to a year or more under some circumstances).

• CONTROL your professionals in order to keep expenses down and prevent them from killing your deal.  It’s YOUR transaction, not theirs.  Get advice from them, but do not let them renegotiate the sale.
  
• Keep relationships cordial.  You will almost certainly need help of some kind from the seller after the sale closes, so don’t let your professional advisors poison that well.
  

MOST IMPORTANTLY:  The most important rule for buyers (and for sellers too for that matter):   The sale must be perceived as a “win” on both sides.  In most cases, neither side is compelled to do the transaction.  If either side concludes that the sale is a “lose” for them, then the deal is likely off at that point.

Special Situations
Some special situations will be covered in more detail in later chapters but deserve a brief mention now:

Internal Sales  
Many business owners would love to sell their company to their key employees, but they don’t think it’s possible.  The most frequently cited reason is “but they don’t have any money.”

You work with these key employees every day.  You probably already know they have the basic talent to run the business, or you would not even consider selling to them.  They may already have been running it for many years already from a practical standpoint.  Only money seemingly stands in the way.

The fact is, the money issue can almost always be handled to everyone's satisfaction.  The REAL key issue is instead, “Do they have the fire in the belly, and the risk tolerance, to be an entrepreneur?” 

The heart of an entrepreneur is an intangible that can’t really be measured or pinned down; but if your key employees have what it takes to be one, then you can probably arrange win/win terms that work financially for them and give you a better long-term after-tax price than you could receive from an outside third-party sale.

As always, YOUR expectations need to be reasonable.  Just as with a third-party sale, the price and terms must “pencil-out” for the buyers in any internal succession.  The down payment is likely to be less, and the seller financing will probably run for more years.  Terms are likely to include a way to split the fruits of future success.

We’ll discuss this more in subsequent chapters, but suffice it to say that if your key employees have what it takes to succeed after you are out of there, then internal succession can be your best exit strategy financially.  It can also be an excellent way to attract and retain top-notch employees with an expectation of participating in the buying group and a way to ensure a satisfactory sale of your business when the time is just right in the future.

Family Sales 
Family sales are a particularly difficult kind of internal sale.  All the usual considerations of internal succession apply, plus uniquely complex tax considerations.

The IRS is deathly afraid parents will do something nice for their children.  So an entire chapter of the tax code is devoted to making sure the IRS gets its “fair” share (they consider about half the total value of the business to be “fair”).  Needless to say, this adds to complexity.

Intra-family dynamics can be even more complex.  Just because a child has the talent, does not mean that he or she has the experience to run the business.  And talent + experience still do not mean the child has the intangible heart of an entrepreneur.  Even establishing the price can be more difficult than in an arms-length sale since a child can find negotiating with a parent over price and terms to be essentially impossible.

Price
What about “Price”?

Ultimately, the “Price” must be justified by (i) the future cash flow the buyer can reasonably expect from the acquired business, and (ii) the risk the buyer must take in order to receive that cash flow.

 But “Price” is much more than just money to a seller.  It can even be seen by him or her as a reflection of their individual worth as a person.  A buyer overlooks this only at their great peril.

Starting the conversation with comments designed to push down the price can be fatal to an emotional negotiation like this.  You are not haggling over the price of a car here.  “It will have to pencil-out, of course, but it’s probably worth quite a bit…” is often a good starting point comment for you as a buyer. 

Emphasize creating a “win/win” transaction overall.  Remember, the seller most likely does not HAVE to sell, and likewise you do not HAVE to buy.  As soon as either party perceives the transaction to be a "lose" for them, the sale will die.

An emphasis on AFTER-TAX cash to the seller is also extremely helpful.  Thanks to our overly-complex tax laws, it is often possible to restructure a sale with a lower stated “price”, but more actual after-tax cash for both the seller and the buyer.

An “all-cash” deal is low risk for the seller, but much riskier for the buyer.  Therefore, the price is almost always significantly lower in an all-cash transaction in order to compensate for this mismatch in the risk area.

What about payment terms? 
Terms are not as emotional, but in a practical sense can be even more important than price.  In fact, your authors are fond of saying "The price is not the price . . . terms are everything!"  Terms determine how the sale will “pencil-out” for the buyer.  For example, seller financing over a period of 10 years is much easier for the buyer to pay for out of ongoing cash flow from the business, and thus justifies a higher price. 

Terms can also dramatically affect taxes for both sides.  Since it only counts if you get to keep it, this consideration alone can be more important than price.

Terms affect the risk for both sides.  Terms so stiff that the sale cannot possibly pencil-out will obviously raise the risk for the buyer.  Less obvious, the seller may incur more risk from draconian terms like this as well.  An upside down buyer is much more likely to look for an excuse to rescind a sale or some way to sue the seller for misrepresentation or a breach of the seller's representations and warranties in the purchase and sale agreement. 

Terms can be massaged to share the risk, thus lowering the effective risk for the buyer.  Lower risk translates to a higher price.  It is fairly common for part of the price to be dependent on future results and retention of business (called a partial "earn-out"), which is a great way to share risk and reward.

Other factors will affect the price as well.  For example, do key employees have, or can you create at closing, enforceable non-competes (see our later chapter entitled NON-COMPETES)?  What about major customer accounts?  Will key vendors terminate their contracts when the "founder" of the business is no longer around? 

What about the building occupied by the company?  Does the target company’s owner also own that building?  Is the Lease transferable, and/or how much longer will it run?  Are there any options to extend or to buy the building and not have to incur major expenses in moving the entire business later on?  Is the business owner a personal guarantor on that existing Lease, and will the landlord release him or her from that guarantee at closing or simply execute a brand new Lease with the new owner?  Is rent likely to be raised post sale?

Finally, it’s not all about “Price” anyway.  Price certainly matters; but is rarely the key to a sale. 

A seller is likely to have other “hot buttons” that can make or break the deal.  Some are obvious, such as how key employees will be treated post-sale in all respects.  The seller may want to see to it that a couple of his "pet" long-term employees are retained for a number of years at the buyer's expense. 

Other hot buttons can be quite unusual.  Your authors well remember a sale that hinged on providing a parking space on company property for the retiring seller’s yet to be purchased RV.  The buyer initially balked, which would have killed the sale.  It has been many years now since the closing, and the seller never did quite get around to parking his RV in that spot that seemed so crucial to him at the time.

CHAPTER 3

GETTING READY FROM THE BUYER'S PERSPECTIVE
In the previous chapters, we talked about sellers who are in the process of considering a sale.  The focus in this third chapter starts instead with the BUYER, and then moves on to look at the big picture aspects of the PRICE.

A critical question worth repeating as we move on to rules for buyers is:  Do you really have a willing seller?  Or is the seller so emotionally tied to the agency that no buyer will ever actually be good enough to pass muster?  Is the seller reluctantly willing to sell -- but only if the price/terms are unrealistically high?

Potential sellers should think these things through very carefully before spending a lot of everyone’s time and money on a seemingly desirable deal that is unlikely to actually take place.

Once it becomes apparent to you as a potential buyer, that the seller is not really ready to sell, then it's time to politely walk away.  Don’t burn your bridges though; the seller may very well be more ready at some point in the future and you can resurrect the deal at that point.  Just don't waste time and money before the overall timing is right.


Buyers
The following rules are presented from the buyer’s standpoint, but sellers should be acutely aware of these things too: 

First:  
The first rule for buyers is:  Know what YOU are looking for.  Buying an agency is risky, expensive, and a LOT of work for the buyer.  Do your homework first.

*Not every agency is worth the same to you as it is to other potential buyers.

• What agency would fit the best with what you already own?

• What can YOU bring to the table to enhance its value after the purchase?
  

In other words, what agency can you buy that will result in a 1+1 = 3 scenario? (or even 4?)

• This is so important, that if the resulting effect of 1+1 is not more than 2, then perhaps you should not buy it at all.
  

Second:  
Another rule for buyers is:  YOU are for all practical purposes "selling" yourself personally and/or your existing company to that seller at this point as well.  That’s because if you really want to buy that target agency, someone else probably does also.  It’s about a lot more than just price and terms. 

So, why should this seller sell to YOU?

*Be ready to sell yourself and/or your company as the most appropriate buyer for that particular agency. 

• The seller is almost always looking for a buyer he or she feels comfortable with personally and believes will take proper care of the agency, its employees and its customers post-sale.

• If you fail this unspoken test, you can lose the opportunity before you ever get to issues such as price and terms.  
  

Third:  
The third rule for buyers:  Be ready.

Be ready financially -- a strong balance sheet, good banking relationships, and enough uncommitted cash flow with which to do the transaction are essential. Be ready with your own time -- if your time is already fully committed, how are you going to handle the additional management burdens?

Fourth:  
Another rule for buyers:  Consider the basic steps in an agency sale.

• Is there a business broker involved, and if so, on which side does their allegiance lie?  Which party pays the commission?  If I as the seller sign a listing agreement, can I get out of it, and how long does it last?  What if I bring the buyer to the table myself, do I still owe a commission to my broker under an “exclusive right to sell” agreement?

• Can or should both sides use the same attorney or C.P.A. in order to save professional fees?

• Should you sign a confidentiality agreement up-front?  At what point?

• Will this deal be seller-financed in whole or in part, or do I need to get a banker on-board early and see if financing is available beyond what cash I have for the down payment?

• Am I willing to personally guarantee all or part of my agency's promissory Note to the seller for the balance of the purchase price, or to pledge additional collateral?

• How much cash will I need for working capital until the cash flow situation in the new agency settles down following closing?

• Do I need an agency valuation, and if so should it be a full-blown appraisal or just an opinion letter?  Will my banker require an appraisal in order to loan me the down payment or all of the purchase price as the case may be?

• What role does a letter of intent (an "LOI" or "terms sheet") play?  What kind of LOI should you create?  Should it be binding on both parties or non-binding, or should only portions of it be binding?

• Will the seller request a good-faith cash deposit up-front, perhaps paid into escrow?  Refundable or non-refundable?

• What due diligence is needed, and when, and should the other party pay part of the cost if they back out prematurely for no good reason?

• What contracts are likely to be needed, and which side should have the subtle advantage of drafting first and controlling the documents (customarily the buyer, since it has the most risk in how the transaction is structured and written up)?

• What should you expect at closing?

• Will an independent third-party professional escrow be necessary for the eventual closing?

Fifth:  
The fifth rule for buyers:  Know the legal basics.

• What are the crucial legal distinctions between an "asset sale" and a "stock sale" that will determine the overall structure of the entire deal?

• What additional risks do I effectively assume if I buy the stock of the seller's corporation, as opposed to buying the assets out of that corporation and thereby shedding most of those risks?

• What to do with the employees? 

• What about a non-compete agreement with the seller entity as well as the individual owner(s) thereof, or with key producers of the target agency who might leave following closing and go right into competition with the very agency you just paid a lot of money for; or

• Does the target company already have those crucial confidentiality agreements and non-piracy agreements in place with key employee producers and/or independent contractors, and if so are they enforceable and transferable?

• You need to know the basics, but you will definitely need professional help to get this right.

Sixth:  
Another critical rule:  Know the tax basics!

• If I personally buy the company's stock from the seller, I'll have no tax deductibility on the purchase price.  Does that matter to me, or would I rather have that higher tax basis and thereby pay less tax when I re-sell the company sometime in the future?
  
• Or, should I have my own company buy that same stock instead?  Can my corporation or LLC buy stock in another without causing serious tax consequences?
  
• Am I comfortable with the hidden or unknown risks in this industry or this particular agency that come along with a stock purchase format, including the risk of prior taxes unpaid or under-paid by the target corporation, or do I want to insist on an asset purchase format instead and thereby try to “shed” most of those potential liabilities?  Can I mitigate that risk by having the selling stockholder indemnify me for all or part of those taxes, interest and penalties, or even other unknown and/or unexpected exposures?

Never forget, there are three parties to every agency sale -- the seller, the buyer, and the IRS.  A sale can be structured as a lose/lose/win (guess who the losers are…); or, the same sale can be re-structured to constitute a win/win/lose.  If there is a “loser” in this deal, you want it to be the IRS.

• The taxes on sale of an agency can exceed 50% of the total sale proceeds if the sale is structured wrong!
  
• The seller can even end up owing more to the IRS at the front end than he receives as the down payment from the buyer . . . a particularly unfortunate (and generally avoidable) result of poor tax planning.
  
• You don’t need to be a tax expert; but you do need to know there are ways to mitigate this kind of tax disaster and also be able to point the seller in the right direction for professional help.
  
• You need to be willing to work with the seller to resolve what may be critical issues to the success of the sale. 
  
• You need to know the basics, but you will need professional help to get this right.
  

Seventh:  
The seventh rule for buyers:  Know how to use your own professional advisors, and when to bring them into the picture (earlier is better, even up to a year or more under some circumstances).

•  CONTROL your professionals in order to keep expenses down and prevent them from killing your deal.  It’s YOUR transaction, not theirs.  Get advice from them, but do not let them renegotiate the sale.
  
• Keep relationships cordial.  You will almost certainly need help of some kind from the seller after the sale closes, so don’t let your professional advisors poison that well.
  

MOST IMPORTANTLY:  The most important rule for buyers (and for sellers too for that matter):   The sale must be perceived as a “win” on both sides.  In most cases, neither side is compelled to do the transaction.  If either side concludes that the sale is a “lose” for them, then the deal is likely off at that point.

Special Situations
Some special situations will be covered in more detail in later chapters but deserve a brief mention now:

Internal Sales  
Many agency owners would love to sell their company to their key producers, but they don’t think it’s possible.  The most frequently cited reason is “but they don’t have any money.”

You work with these key producers every day.  You probably already know they have the basic talent to run the agency, or you would not even consider selling to them.  They may already have been running it for many years already from a practical standpoint.  Only money seemingly stands in the way.

The fact is, the money issue can almost always be handled to everyone's satisfaction.  The REAL key issue is instead, “Do they have the fire in the belly, and the risk tolerance, to be an entrepreneur?” 

The heart of an entrepreneur is an intangible that can’t really be measured or pinned down; but if your key producers have what it takes to be one, then you can probably arrange win/win terms that work financially for them and give you a better long-term after-tax price than you could receive from an outside third-party sale.

As always, YOUR expectations need to be reasonable.  Just as with a third-party sale, the price and terms must “pencil-out” for the buyers in any internal succession.  The down payment is likely to be less, and the seller financing will probably run for more years.  Terms are likely to include a way to split the fruits of future success.

We’ll discuss this more in subsequent chapters, but suffice it to say that if your key producers have what it takes to succeed after you are out of there, then internal succession can be your best exit strategy financially.  It can also be an excellent way to attract and retain top-notch producers with an expectation of participating in the buying group and a way to ensure a satisfactory sale of your agency when the time is just right in the future.

Family Sales 
Family sales are a particularly difficult kind of internal sale.  All the usual considerations of internal succession apply, plus uniquely complex tax considerations.

The IRS is deathly afraid parents will do something nice for their children.  So an entire chapter of the tax code is devoted to making sure the IRS gets its “fair” share (they consider about half the total value of the agency to be “fair”).  Needless to say, this adds to complexity.

Intra-family dynamics can be even more complex.  Just because a child has the talent, does not mean that he or she has the experience to run the agency.  And talent + experience still do not mean the child has the intangible heart of an entrepreneur.  Even establishing the price can be more difficult than in an arms-length sale since a child can find negotiating with a parent over price and terms to be essentially impossible.

Price
What about “Price”?

Ultimately, the “Price” must be justified by (i) the future cash flow the buyer can reasonably expect from the acquired agency, and (ii) the risk the buyer must take in order to receive that cash flow.

 But “Price” is much more than just money to a seller.  It can even be seen by him or her as a reflection of their individual worth as a person.  A buyer overlooks this only at their great peril.

Starting the conversation with comments designed to push down the price can be fatal to an emotional negotiation like this.  You are not haggling over the price of a car here.  “It will have to pencil-out, of course, but it’s probably worth quite a bit…” is often a good starting point comment for you as a buyer. 

Emphasize creating a “win/win” transaction overall.  Remember, the seller most likely does not HAVE to sell, and you likewise do not HAVE to buy.  As soon as either party perceives the transaction to be a "lose" for them, the sale will die.

An emphasis on AFTER-TAX cash to the seller is also extremely helpful.  Thanks to our overly-complex tax laws, it is often possible to restructure a sale with a lower stated “price”, but more actual after-tax cash for both the seller and the buyer.

An “all-cash” deal is low risk for the seller, but much riskier for the buyer.  Therefore, the price is almost always significantly lower in an all-cash transaction in order to compensate for this mismatch in the risk area.

What about payment terms? 
Terms are not as emotional, but in a practical sense can be even more important than price.  In fact, your authors are fond of saying "The price is not the price . . . terms are everything!"  Terms determine how the sale will “pencil-out” for the buyer.  For example, seller financing over a period of 10 years is much easier for the buyer to pay for out of ongoing cash flow from the agency, and thus justifies a higher price. 

Terms can also dramatically affect taxes for both sides.  Since it only counts if you get to keep it, this consideration alone can be more important than price.

Terms affect the risk for both sides.  Terms so stiff that the sale cannot possibly pencil-out will obviously raise the risk for the buyer.  Less obvious, the seller may incur more risk from draconian terms like this as well.  An upside down buyer is much more likely to look for an excuse to rescind a sale or some way to sue the seller for misrepresentation or a breach of the seller's representations and warranties in the purchase and sale agreement. 

Terms can be massaged to share the risk, thus lowering the effective risk for the buyer.  Lower risk translates to a higher price.  It is fairly common for part of the price to be dependent on future results and retention of key target accounts (called a partial "earn-out"), which is a great way to share risk and reward.

Other factors will affect the price as well.  For example, do key employees have, or can you create at closing, enforceable non-competes (see our later chapter entitled NON-COMPETES)?  What about the major customer accounts? Will key carriers terminate their contracts when the "founder" of the target agency is no longer around? 

What about the building occupied by the agency?  Does the agency’s owner also own that building?  Is the Lease transferable, and/or how much longer will it run?  Are there any options to extend or to buy the building and not have to incur major expenses in moving the entire agency later on?  Is the agency owner a personal guarantor on that existing Lease, and will the landlord release him or her from that guarantee at closing or simply execute a brand new Lease with the new owner?  Is rent likely to be raised post sale?

Finally, it’s not all about “Price” anyway.  Price certainly matters; but is rarely the key to a sale. 

A seller is likely to have other “hot buttons” that can make or break the deal.  Some are obvious, such as how key employees will be treated post-sale in all respects.  The seller may want to see to it that a couple of his "pet" long-term employees are retained for a number of years at the buyer's expense. 

Other hot buttons can be quite unusual.  Your authors well remember a sale that hinged on providing a parking space on the agency’s property for the retiring seller’s yet to be purchased RV.  The buyer initially balked, which would have killed the sale.  It has been many years now since the closing, and the seller never did quite get around to parking his RV in that spot that seemed so crucial to him at the time.

Non-competes can literally constitute the primary value of certain types of companies, by protecting trade secrets and confidential information as well as preventing key employees from competing with the company in either a narrow or fairly broad marketplace niche depending on the situation.

In order to be enforceable, however, they must be "reasonable" in all respects in light of the facts and circumstances of both your company and the particular employee's personal situation; otherwise, they will likely be thrown out or severely limited by a court.  Nevertheless, contrary to rumor and supposition, they are very enforceable if well drafted. Signing one carelessly can virtually cost an employee their career in that industry for all practical purposes.  Having a non-compete in place for each key employee can result in a company being worth multiple times what it might be otherwise to a prospective purchaser of the business; whereas lack of a non-compete or an inadequate one can literally destroy the value of a company to a prospective purchaser.

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THE VARIOUS TYPES OF AGENCY SALE SITUATIONS

The first chapter was about getting ready, and included a general overview of an agency sale from a seller’s perspective. This should help both buyers and sellers start thinking about the key issues in an agency sale right away; but an agency sale is not a one size fits all situation. The details that apply in a specific situation will not all be the same.  Before proceeding further, it’s important to step back a bit and look at the big picture for agency sales in a variety of circumstances. Not all agency sales are for the same reasons, and the circumstances of the sale can have a big impact on how a sale should proceed. 

What KIND of Buyer is it?
Before considering the various sale situations, it helps to consider the KIND of buyer. In almost all cases, the buyer will be either another agency or an individual. 

If the buyer is another agency, then it is likely the buyer will be able to run the agency successfully. The buyer’s ability to pay may be fairly secure. Training the buyer may not be critical, but assistance with customer retention after the sale may be critical. The buyer may be more sophisticated, or at least have more sophisticated advisors.  Consideration for the sale may include some form of performance and/or retention-based incentives (i.e., an earn-out).

If the buyer is an individual, training the buyer may be even more important than assisting with customer retention.  Since the buyer’s ability to run the agency successfully may not be as certain as it would be if the buyer were another agency with a proven track record, the cash and/or collateral the buyer brings to the table may be a major factor in the sale.

The Most Common Sales Situations
The following are the most common sales situations, and whether you are a buyer or a seller, one of these situations most likely fits you (additional details applicable to each will be covered later in subsequent chapters):

Very Small Agency
These are usually sold to an outside buyer - an External Sale.


If the buyer is another agency:

• The book of business is often all that is sold, with the accounts folded into the buying agency’s operations.
• This often leads to economies of scale and better carrier contracts than the selling small agency was able to achieve on its own, thus justifying a higher price than the profits of the seller prior to the sale would otherwise seem to justify.
• This is not commonly seen with other types of small business sales, and can be especially confusing to banks with experience with other types of business, but not with agencies.

If the buyer is an outside individual who will simply step into the seller’s shoes, then the potential for operating economies of scale and better carrier contracts is much less.

• The price for this sale may be less as a result.
• The price differential can sometimes be bridged with creative terms.

Sometimes a sale will be to an insider - an Internal Sale.

• Very small agencies may not have a producer with both the interest and the ability.
• The person needed can sometimes be recruited.
• If the right person is available, these can often be creatively structured as a win/win, even if the buyer has little money.

Somewhat Larger Agency
External Sale

• Generally, many potential buyers.
  

Internal Sale

• May be easier to structure than for a very small agency, but can still be difficult to find the right successor.
• NOTE:  Finding the right successor(s) is almost always the most difficult step in an internal sale.

Family Sale

• The IRS has insanely complex rules designed to make sure they get all the tax revenue they think they are entitled to . . . which is A LOT!
• May need an appraisal to support the price.

Divorce

• Often VERY contentious, with expensive appraisal and attorney fees, and the eventual price and terms set by a judge.
• Can sometimes be greatly simplified with advance legal planning, such as, Shareholders Agreements.

Partner Buyout

• Can also be contentious.
• Can sometimes be greatly simplified with advance legal planning, such as, Shareholders Agreements.

Sale for Health Reasons

•  If the seller is in ill health but not clearly dying
• Time is not as critical as for a dead or dying seller.
• Potential buyers may try to take advantage of the situation.
• The seller’s help with the post-sale transition may be negatively affected.

If the seller is still alive but clearly dying

• A sale planned to occur upon death can sometimes be arranged.
• This has the potential to save a LOT of taxes.

Seller has passed away

• The agency may be in turmoil.
• Can be more difficult to find a buyer.
• Tax issues can be VERY complex.

Financially Distressed Sale

• If the agency is in trouble, the buyer will need to see a way to fix the problem, or a sale will not happen.
• Most of the time the book of business can still be sold, even if the agency itself must be shut down.
• May be forced by the agency’s lenders.

Sale to a Large Buyer

• Likely to be fairly sophisticated buyers.
• Likely to include an earn-out as part of the price.
• Publicly traded buyers (Brown & Brown, Gallagher, etc.)
• May involve tax-advantaged strategies involving the buyer’s stock.

Large, closely held buyers

• There are many of these, many of whom can offer competitive price/terms to what is offered by a publicly held buyer.
  

Start-ups

• Often done with personal funds, or support from family.
• Can be difficult to secure favorable carrier contracts.
• Several entities exist that support start-ups with access to contracts, etc.

Employee Stock Option Plan (an ESOP)

• Very complex and expensive.
• Closely-held agencies are rarely large enough to justify the cost and complexity.
• Can have significant tax advantages.
• Might have motivational effect on employees.
• Not as popular as initially expected when they were originally created.

Very Small Agencies
These agencies are sometimes referred to as Mom & Pops, Main Street Businesses, etc. Although each agency is small with only a few employees, they or course represent a huge part of the insurance services available in our economy, and are the embodiment of the American Dream for many people.

Sale of these agencies is the most common sale situation. As compared to most other businesses, it’s extremely rare for an agency to simply shut down once the owner decides to move on to something else. At a minimum, the book of business is usually salable even if the agency itself will be shut down.

Unrealistic expectations on the part of the seller, particularly the value of the agency, are one of the reasons blocking sale of many of these agencies.

Ultimately, the value of these agencies is determined just like the value of any other business: What a willing buyer and willing seller agree on. Both sides must see it as in their best interest to do the deal, or it will not happen.  In other words, it must be a win/win or it will not happen.

An often overlooked way to sell these agencies is to arrange an internal sale. The key to this is finding a producer(s) who has the necessary skills and entrepreneurial drive. Entrepreneurs are often harder to find than the people with the necessary skills. For agencies that do not already have that person, it may be possible to recruit them based on the possibility of their being able to buy the agency in the future. 

Sales of this type can be arranged even for buyers who do not bring much of their own money to the table. Finding advisors who can assist with this can be challenging as well.

Somewhat Larger Agencies
Many of these agencies are still small enough that they do not achieve the operating economies of scale and favorable contracts available to larger agencies. If so, then the highest price for these agencies can often be obtained by selling to another agency that will be able to obtain these benefits after the sale.

Those agencies that are large and profitable enough on their own will be priced based on the adjusted profits a buyer can reasonably expect in the future. The key to their sale will be the ability of the buyer to continue operating the agency profitably in the future; which often means the seller will need to help with the transition. As always, preservation of the book of business after the sale is critical.

Divorce
A divorce often means half the agency might, in effect, be sold to the spouse who runs it. If both spouses worked in the agency prior to the divorce, one of them most likely will seek employment elsewhere.

The biggest question in these sales is usually price. Terms tend to be based on asset trade-offs, with cash paid for whatever value cannot be offset by other assets. Bank financing is sought as necessary to provide the cash.  Appraisals are used to establish value, with a judge determining the final result if the appraisers used by each side differ in their opinion of value.

Advance legal planning, including agreement on how value will be determined, can help simplify the process dramatically.  Most owners are aware of the possible use of a pre-nuptial agreement, but do not have one. Less well known is that a proper Shareholders Agreement can simplify the divorce issues, including valuation, by quite a bit.

Shareholder/Partner Buyout
Buying out a fellow shareholder/partner may or may not be a contentious process, but it is still likely to involve disagreements over value. EVERY multi-owner agency should have a Shareholders Agreement (or equivalent) to address the multitude of issues that need to be spelled out in advance in this situation. How value will be determined, as well as the terms for a buyout, is just one of the topics that should be covered in that agreement.

This is a huge topic with its own chapter later in this series.

Sale for Health Reasons
Some agency sales are triggered because the owner is in ill health but not clearly dying. The seller has a very good reason to want to sell, but is not under pressure to do so immediately. These sales are very similar to any other sale for a similar agency, except the seller may not be able to provide as much help during a transition.  If an internal sale is desired, there may not be enough time to recruit key employees, and longer term planning may not be an option.

If the seller is facing a potentially terminal disease, the sale will be much more complex. Seller assistance post-sale is much more problematic, thus lowering the value to a potential buyer.  Likewise, the agency itself may be suffering from neglect by the owner because health matters take priority. The seller will be at a disadvantage in negotiations as well, since potential buyers may sense that the seller HAS to do the sale.

Tax planning for the seller’s heirs may play a major role for a seller facing a terminal illness. The tax issues include potential estate taxes, plus potentially dramatic differences in how the sale itself will be taxed. 

It is possible to plan a sale in advance, with the sale itself deferred until the seller’s death. As a protection to the buyer, the sale generally includes a no later than sale date, and may include provisions for the buyer to operate the agency prior to that date as well. Under the right circumstances, this can reduce taxes substantially provided the sale itself is structured properly. The technical elements in the sale structure for this situation may be quite different than for a typical sale.

Financially Distressed Sale
Some agencies are put up for sale as a last-ditch attempt to avoid bankruptcy or being forced to shut down, although this is very rare. 

If an outside buyer is sought, the potential buyer will need to see a way to fix the problem causing the financial distress, or the buyer will not buy. Sometimes this will involve buying only the profitable parts of the agency, leaving the difficult parts behind. This can also lead to unexpected legal complications on both sides of the sale, so be sure to include experienced legal counsel in the process.

If no way can be found for a buyer to solve the underlying problems, or the profitable portions of the agency (if any) cannot be sold separately, then the agency is unlikely to be salable as a going concern at anything close to what the owner was expecting to receive for it. In that event, the agency will most likely be forced to simply sell off its book of business in a distressed sale, apply the proceeds to its liabilities, and then go away. If liabilities remain and the owner is legally liable for them, the owner may have to personally make up the shortfall.

Sale to a Large Buyer
Larger buyers generally have the ability to run the acquired agency successfully, and are often more sophisticated that the typical individual buyer. The price they are willing to pay for a large and profitable agency is likely to include a portion of the consideration in the form an earn-out based on performance of the acquired agency after closing the sale. If the buyer is a publicly traded company, the sale may sometimes include use of the buyer’s stock to help improve the tax effects on the seller and to reduce the cash required by the buyer.

Start-ups
Starting an agency is often done with personal funds and LOTS of sweat equity.    

If multiple owners are involved in the new agency, a Shareholders Agreement, or its equivalent, is strongly recommended right from the beginning. This should include provisions covering how the entity will be run, how it will be valued, how owners will be bought out in the future, how to handle disputes, etc. A whole chapter later on in this series will be devoted to this topic.

Employee Stock Option Plan (ESOP)
An Employee Stock Option Plan (an ESOP) is a way to sell agency stock to its own employees and gain some tax advantages for the owner at the same time. Since the employees also become owners in the agency, an ESOP has the potential to be an employee motivator as well.

Technically, an ESOP is a qualified retirement plan with all the regulatory requirements that status entails plus a host of additional regulatory requirements to go with it. In other words, they are complicated and expensive. You will also need to have the agency appraised essentially every year, which adds substantially to the cost over time. 

Although initial expectations were high when ESOPs were first introduced, the complexity, costs, and restrictions on owners have proven burdensome enough that they are not a common form of ownership transition.

Conclusion
These are the most common situations buyers and sellers of an agency are likely to find themselves in. Each of them has unique elements that make them different than the others. We will cover each of them in more detail in subsequent chapters.