In Part 3, we discussed “cleaning up your act,” to get your business in order for a potential buyer to perform due diligence.
In this part, we talk about the dynamics of managing the terms of the sale.
Manage the Terms.
If you can manage the terms of the sale, you will probably be able to better control the outcome. If you’re using an investment banker, one of their important functions is to manage the terms. Otherwise, your M&A attorney typically will perform this function.
Early in the sales process a term sheet or letter of intent will be prepared and circulated, listing the price and terms, as the initial negotiating document. Critical terms include:
Price. Probably the single biggest reason that sales of businesses fail is that the sellers have an unrealistic view of the value of their business, and thus an unrealistic expectation of the purchase price.
One common way to determine the value of your business is to multiply the EBITDA times the current industry multiple. EBITDA means “Earnings Before Interest, Taxes, Depreciation and Amortization.” Each industry has a range of commonly used multiples. For example, in one industry the current accepted multiples may be 2-3, whereas in another industry the current accepted multiples are 8-9. If your company has an EBITDA of $1,000,000, and your industry multiple is 8-9, your company valuation will likely be in the range of $8,000,000 – $9,000,000. “Likely” is the operative word, as calculations of EBITDA and choice of multiple are often subject to discussion and negotiation.
Some sellers may be tempted to make cuts in critical spending areas, such as advertising or key personnel, to increase EBITDA, with the idea that increased EBITDA will result in a higher valuation, at least short-term. An experienced buyer will realize that these items must be added back to make the business viable, and thus will propose a reduced EBITDA number.
The accepted multiples in the market change over time. Currently the market values companies relatively highly, with relatively high multiples. So a seller who wants to wait for a year to sell the business, hoping he or she can increase EBITDA in that time, may find that the multiples have dropped when it is time to sell. For this reason, postponing the sale and working to increase EBITDA may, or may not, result in an overall purchase price increase.
Business valuation is a complex subject and is outside the scope of this article. It is also outside the expertise of many accountants. You should consider consulting with an investment banker or other valuation expert well in advance of beginning any price negotiations.
Structure. Sales of companies are generally structured as either (i) stock (or LLC interests in the case of an LLC) sales, or (ii) asset sales. The structure of the transaction is a critical issue. Consult with your attorneys and accountants before agreeing on the structure.
Stock Sale. In a stock sale, the buyer purchases all (or a controlling interest) of the stock (or other equity). Sellers may prefer stock sales, for a number of corporate, contract and tax reasons.
Asset Sale. In an asset sale, the buyer buys specific assets and assumes specific liabilities, with the seller retaining the “unwanted” assets and liabilities. Many buyers prefer asset purchases, as tan asset purchase generally allows for reduced exposure to unknown liabilities. Key contracts may not be assignable in an asset sale, however, so the contracts must be reviewed carefully.
Tax Treatment. A stock sale is basically taxed at one level, i.e. the seller pays tax on the gain on the sale of the stock. An asset sale is taxed at two levels: the gain on the sale of assets is taxed to the company, and the distribution of the cash to the shareholders is taxed to the shareholders. How asset sales are taxed to the company depends on the type of assets, whether they qualify for capital gains or ordinary income treatment, depreciation recapture, and other factors.
Merger. A merger is a legal combining of two companies into one company. In a simple merger, Company A (the acquirer) will issue shares of its stock to Company T (the target). The former T shareholders become A shareholders. T is merged into A, meaning all of the assets and liabilities of T are transferred into A, and T disappears as a separate legal entity. Mergers have advantages and complexities that are outside the scope of this article. Mergers can be advantageous to selling owners, particularly if they are structured as a tax-free reorganization, and the stock the owners receive is publicly traded and can easily be sold for cash. Discuss with your attorney if a merger might be the right structure for your situation.
Other Terms. Some other important terms that should be considered in your term sheet or letter of intent include:
Non-Disclosure Agreements. Before you send material information about your business to a potential purchaser, they should sign a non-disclosure agreement to protect your information.
Deposit. The seller will want a deposit paid into an escrow or similar account. A typical deposit might be between 10% and 25% of the purchase price. The conditions of the return of the deposit if the sale doesn’t close are subject to negotiation. Depending on the transaction, part of the deposit may go to the seller to pay for due diligence and legal expenses, whether the deal closes or not.
Seller-Retained Assets and Liabilities. The buyer may want the seller to retain specific assets and liabilities. The seller will want to retain his or her personal property, and may want to retain the cash in bank accounts or other company assets. These items should be spelled out in detail to avoid dispute.
Intellectual Property. Depending on the business, intellectual property rights may be critical. Be sure to go through an analysis of the intellectual property assets with your M&A attorney.
Licenses and Permits. The buyer will want to be sure that licenses and permits stay in effect in the new business. This may require consents of licensors, etc. which should be delivered at closing. If a change of ownership requires new licenses, whether that is done at closing or post-closing is a matter for negotiation.
Key Contracts. The buyer will want to be sure key contracts stay in place. A change of ownership may terminate contracts automatically without the consent of the contracting party, in which case the consent should be delivered at closing.
Purchase Price Adjustments. In certain cases, it may be appropriate to adjust the purchase price post-closing.
Earn-Out. An earn-out can bridge the gap between the seller’s asking price, and the amount the buyer is willing to pay. Basically, in an earn-out, the buyer says, “I’ll pay the extra $X you want, if the business does what you say it will.” In an earn-out, the buyer pays a certain amount at closing, and agrees to pay more over time if certain financial projections are achieved or other conditions are met. The extra amount may be a fixed amount, or may be subject to a formula based on earnings or other factors. Pay careful attention to the details of any earn-out clause. An earn-out adds risk to the seller, but may be necessary to close the deal.
Closing Financial Statements. The buyer will typically want to see financial statements as of the closing date, to confirm that there has been no reduction in assets, and no unexpected liabilities, between the date the purchase agreement was signed and the closing date.
No-Shop Clause. The buyer will want the seller to agree not to sell, or even discuss sale, of the business with any third party until the closing has occurred.
Announcements. Typically, there will be clause that neither party can make a public announcement about the deal without the consent of the other.
Indemnification. Buyers typically ask for Seller indemnification of key representations, warranties and liabilities. The buyer may want to withhold a portion of the purchase price for a period of time to be held as a reserve to cover indemnified claims. The seller will want to negotiate limitations and a “cap” on the indemnification obligations.
Resignations. The exiting owner(s) who serve as employees, officers and directors, and any others designated by the buyer, will resign from their positions effective as of closing.
If you as the seller can generate the first term sheet, it will generally be to your advantage. Whether you generate the first term sheet, or respond to a buyer’s term sheet, be sure to consider these important elements.
In the next part, we’ll discuss the subject of the critical communications about the transaction with your board, shareholders, employees and other stakeholders.