CHAPTER 2
THE VARIOUS TYPES OF BUSINESS SALE SITUATIONS

 





Authors:  Gary E. Jacobson, J.D. and Larry Morrison, MBA, CBA, CMA

The first article was about getting ready, and included a general overview of a business sale from a seller’s perspective.  This should help both buyers and sellers start thinking about the key issues in a business sale right away, but a business 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 business sales in a variety of circumstances.  Not all business 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 company or an individual. 

If the buyer is another company then it is likely the buyer will be able to run the business 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 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 business successfully may not be as certain as it would be if the buyer were another company 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
These are the most common sales situations.  Whether you are a buyer or a seller, one of these situations most likely fits you.  Additional details applicable to each are covered later in subsequent articles.

Very Small Business - This is the most common business sale situation

• Sometimes referred to as “Mom & Pops”, “Main Street Businesses”, etc.
• Most of these businesses do not actually sell.
• This is usually a sale to an outside individual (an “External Sale”).
• Sometimes (although rarely) the sale will be to an insider (an “Internal Sale”).
• It is rare to have an employee with both the interest and the ability.
• The person needed can sometimes be recruited.
• Can often be creatively structured as a win/win, even if the buyer has little money.

Somewhat Larger Small Business - External Sale

• More likely to sell than a Mom & Pop, but many never do.
• Internal Sale
• Easier to structure than for a Mom & Pop, but still difficult to find the right successor.
• 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.
• Will most likely 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 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 tax.

Seller (business owners) has passed away

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

Financially Distressed Sale

• If the business is in trouble, the buyer will need to see a way to fix the problem, or a sale will not happen.
• Often involves simply liquidating the assets and walking away.
• May be forced by the company’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 
• May involve tax-advantaged strategies involving the buyer’s stock.
• Large, closely held buyers
• May be easier to attract than a publicly held buyer.

Start-ups

• Often done with personal funds.
• If funding is from family and friends, then their ownership must be decided.
• If Venture Capital is involved, then complexity goes way up.
• Usually only available if the upside potential is very high.
• Initial Public Offerings (“IPO’s”)
• Basically, this is selling part of the company to the public in the form of company stock.
• Often involves venture capital at an earlier stage.
• VERY complex.

Employee Stock Option Plan (ESOP)

• Very complex and expensive.
• Can have significant tax advantages.
• Might have motivational effect on employees.
• Not as popular as initially expected when these were created.

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

Attempted sale of these businesses is the most common business sale situation.  Unfortunately, most of the time they never actually sell.  Some estimates are that only one in seven of these businesses will actually sell once they are listed for sale.  Many more simply shut down once the owner decides to move on to something else.

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

The value of these companies is NOT the value of the company to the seller, which may be quite high.  Instead, the maximum value is limited by the cost a potential buyer would incur to start a similar business instead.  That means the value may be determined by the value of the equipment, plus something extra for the “running start” available to the buyer from buying the existing business instead of starting a similar operation from scratch.

Formal valuation approaches based on the net present value of expected future cash flow, net of reasonable compensation to the owner, often do not apply.  Instead, rules of thumb based on some multiple of sales plus the value of the equipment acquired are often used.  These rules of thumb have even been published in a book, the Business Reference Guide, The Essential Guide to Pricing Businesses and Franchises, compiled annually by Tom West and available through Business Brokerage Press and available on the web at www.bbpinc.com.  (One of the authors of the article you are reading right now is one of the contributors to this book.)

It is important to remember that these rules of thumb are GENERAL rules, and may not be valid for a specific situation.  It is also important to remember that these rules of thumb were developed based on businesses that actually sold.  That means they are biased in favor of the most attractive businesses offered for sale.  The businesses that never sell have very little impact on these rules of thumb.

Ultimately, the value of these businesses 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.

One way to sell these businesses is to arrange an internal sale.  The key to this is finding a person(s) who has the necessary skills and entrepreneurial drive.  Entrepreneurs are often harder to find than the people with the necessary skills.  For companies that do not already have that person, it may be possible to recruit them based on the possibility of their buying the company 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 Small Businesses
Once a business has grown past the “Mom & Pop” size, it may be a bit easier to sell.  There is no generally agreed minimum size for this, but these businesses often have ten or more employees.

Many of these businesses are only marginally profitable, and will be priced using similar methods to their smaller cousins.  Those that are profitable enough 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 business profitably in the future, which often means the seller will need to help with the transition.

Much of the literature on buying and selling a closely held business is focused on businesses this large or larger, and assumes the buyer will be either an outside individual, or another business.  Little attention is paid to the possibility of an inside sale.

These businesses are easier to arrange internal sales for than their smaller cousins, although it is still rare to see this done.  Finding entrepreneurs is always hard, and few advisors understand the issues enough to help.

Divorce
A divorce often means half the business must, in effect, be sold to the spouse who runs it.  If both spouses worked in the business 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 disagreement over value.  EVERY multi-owner business 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 this agreement.

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

Sale for Health Reasons
Many 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 business 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 business 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 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 being 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 business prior to that date as well.  In 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 businesses are put up for sale as a last ditch attempt to avoid bankruptcy or being forced to shut down.  In some cases the business will go through a formal bankruptcy process, with the court eventually approving a plan to reorganize the business or mandating the business be liquidated if a credible plan to return the business to profitability cannot be developed.

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 business, 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 business (if any) cannot be sold separately, then the business is unlikely to be salable as a going concern.  In that event the business will most likely be forced to simply sell off its assets, 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 are likely to be another company, often in the same industry.  They generally have the ability to run the acquired business successfully, and are often more sophisticated that the typical individual buyer. 

These buyers are not typically interested in “Mom & Pop” businesses.  The “price” they are willing to pay is likely to include a portion of the consideration in the form an “earn-out” based on performance of the acquired company after 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 a company is often done with personal funds and does not involve sale of part of the company.  If family and friends are used to help with funding then a loan will be required, or the other investors must have some equity in the company (or both). 

If the people helping provide the funding will also have equity, then 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 article will be devoted to this topic.

For those businesses with high upside potential, venture capital may be an option.  This is a complex option with the potential for the founder to lose control of the entity if things do not go well, but it can also be the best way to provide significant funding plus provide access to the sophisticated help that will be needed if the venture succeeds well enough to eventually go public.

Employee Stock Option Plan (ESOP)
An Employee Stock Option Plan (an “ESOP”) is a way to “sell” company stock to its employees, and gain some tax advantages for the owner as well.  Since the employees also become owners in the business, 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 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 company appraised essentially every year, which adds substantially to the cost. 

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 a business 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 articles.

Donald L. (Larry) Morrison

Larry is President of Business Transition Network, Inc., a consulting firm specializing in the tax and financial issues involved in mergers and acquisitions, business succession planning, and business valuation/appraisal.

He was selected as an Industry Expert, contributing his business valuation expertise to the Business Reference Guide, a leading reference book on business valuation.

Larry’s business appraisal credentials are some of the best anywhere. He is accredited to review the appraisals of other business appraisers, plus has two additional business appraisal credentials and a top accounting credential. He has been involved in hundreds of business sales, both internal and external. He has specialized in internal business succession planning.

Larry is more than just a business appraiser and M&A expert. He has been a partner in a small manufacturing firm and saw firsthand what happens when your business partner goes bankrupt. He has worked hands on with manufacturing firms that were spiraling towards bankruptcy and had to lay-off hundreds of employees to help the firm recover and restructure so they became a healthy business and employer again. He worked as a manager in the corporate business world, working with mergers and acquisitions. One of these companies was Chevron. He also worked with BP developing their technology based division.

Larry has gained his expertise through hands on experience as well as continuing education.

Credentials:                                                                  Education:

Accredited-Business Appraisal Review                    MBA-Finance/Economics

Certified Business Appraiser                                   MS-Engineering Management

Certified Management Accountant                           BS-Engineering Science

Chartered Financial Consultant

Accredited Valuation Analyst

Chartered Life Underwriter

Certificate in Business Succession Planning

HOW TO BUY, SELL, MERGE OR PERPETUATE A BUSINESS
The Series

A Comprehensive Look at the Best Ways to Handle the Biggest Events in the Life of Your Company

By Larry Morrison and Gary Jacobson

 



CHAPTER 1, PART 1 - INTRODUCTION  /  GETTING READY

Overview

Every business is eventually sold or shut down... you don't get to not do this!  

But most businesses that are put up for sale NEVER SELL!

The purpose of this column is to help Business Owners plan and execute a successful internal or external succession/transition of a business, and to help buyers find and successfully buy worthwhile businesses. We will teach practical “street level” nuts and bolts about how to do this, but we do not intend to make you a legal or tax expert. You will still need your attorney and C.P.A., but you will know how to spot key issues, and you’ll know the major options available to you. This should translate into a major advantage for you when the time comes to transition your business.

Get ready first. We’ll provide more details in future articles, but here’s an overview.

Sellers

If you are not really a willing seller, with realistic price and terms expectations, then you are probably just wasting your time. Know what your business is realistically worth. Some companies are worth two times annual revenues for example, but most are not. Is your company for sale, but only if you can get X times annual gross revenues?

Know your tax situation, and what to do if you are sitting on a potential tax disaster. For instance, if your company is a “C” corporation (or has been within the last 10 years), then the wrong sale structure means some sellers might owe the IRS more than half of the total sales price for the company? Do you know if you have this problem? If so, do you know how to “fix” it?

What about payment terms? They affect both taxes and risk for both sides. The buyer can afford to pay more if the risk is less, or the tax effects are better.  Ultimately, the “Price” is not the “Price” -- terms are crucial. What counts is the after-tax cash-in-pocket you get to KEEP after you leave!

Perhaps MOST important: Be emotionally ready. This is your baby -- are you really ready to part with it?

Contractually protect what you are selling. Can some or all of your employees leave and take key accounts with them after you sell? Can you realistically sell a company that might lose large blocks of its business in that manner?  

Make it easy for successors to preserve what you are selling. Customer retention post-sale is crucial. How can you help the buyer keep what you just sold?  

Make the buying decision easy for your successors. Start by preparing a short summary of your business as follows: 


First, be able to answer three questions:
1.  WHO’s your best buyer (make a list of top prospects)?

2.  WHY would they want to buy YOUR business?

3. Why NOW?  If your business is so wonderful, why are you for sale?

• Create defensible pro-forma cash flow spreadsheets that show the true benefits of ownership you have received in the past. 
• If you receive benefits of ownership other than just profits and salary, make it easy for potential buyers to see it.  Provide explanations for all the adjustments you need to make. 
• You may sometimes see this referred to as “free cash flow”, “available cash flow”, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Regardless of the terminology used, the objective is to determine the true financial benefits of ownership.
• If you are selling more than just customer accounts, create a pro-forma balance sheet as well.
• Know how much business you do with your top accounts, and how you are going to ensure that they stay with the company after you are gone.
• Know your vendors and how they are likely to react when you retire.
• Be ready with all of these answers in advance, with most of them written down -- perhaps even prepare a presentation book.
• Put your best foot forward, but don’t misrepresent and don’t predict the future. You don’t know how the buyer will do in the future, and you don’t want to do anything that “predicts” results. Doing so can even be grounds for rescission of the transaction if things don’t work out for your successors.
• Be ready before you have the first meeting.
• Have abbreviated material ready to discuss and/or show, and be ready to provide more detailed information as soon as mutual interest is established and a confidentiality agreement has been signed.

This is probably the biggest sale of your life -- you owe it to yourself to be ready.

What about “Price”?:  “Price” deserves special attention, partly because it often quite an emotional issue.  “Price” can be much more than just money to a seller. It can even be subconsciously seen as a measure of the value of a person’s life’s work.  

One way to keep things in perspective is to keep in mind that the sale has to make financial sense to the buyer or you will not have a sale. It will have to “pencil out”.

What about payment Terms?:  Terms are crucial to how a sale will “pencil out”.  In fact, terms are often more important that price.  In addition to a major impact on annual cash flow, terms affect both risk and taxes for both sides. 

Win/Win Negotiations:  Most likely you do not HAVE to sell, at least to one specific buyer.  Likewise, the buyer most likely does not HAVE to buy your business.  That means the sale is likely to fall apart as soon as either party perceives the sale to be a “lose”.  Terms are often the key to a “win/win” result.  Creative terms can even be a “win/win/lose”.  (The “loser” is the IRS.)





Editor's note:  This is the first installment in a series of columns on buy/sell arrangements for any company, valuation and tax issues, shareholder internal buy/sell agreements, related estate planning, employment contracts and non-competes.

The authors will give you practical street-level understanding of the fundamental legal, tax and financial concepts you need to know about regarding the biggest financial events in the life of your business -- there is nothing else like it available. 

Since many business owners are buyers, and every business is eventually sold or shut down, this is a must for everyone who owns, plans to buy, or will eventually sell a business. 

You'll learn better ways to buy, sell, merge or internally perpetuate a company from a team of experts responsible for hundreds of successful business transactions.  You do not need to be a technical expert, but you need to know enough to guide your attorney and C.P.A.  This will teach you how.

In addition to the essential foundation on buy/sell arrangements for any company, this material covers related estate planning, valuation and tax issues, shareholder buy/sell agreements, employment contracts and non-competes, all as essential parts of a comprehensive package of business documentation.